Small-Cap Investment Opportunity and Q4 2025 Bank Earnings Preview

The small-cap asset class has demonstrated exceptional momentum at the outset of 2026, with the Russell 2000 Index establishing new all-time highs and generating returns that significantly outpace large-cap equivalents. Francis Gannon of Royce Investment Partners articulated a compelling investment case during the January 7, 2026 CNBC appearance, emphasizing that small-cap stocks offer a compelling combination of valuation attractiveness, policy support, and earnings growth potential that distinguishes them from the mega-cap technology stocks that dominated market performance in 2024 and 2025 [1].

The Russell 2000’s 6.2% surge in the first trading week of 2026 follows a robust 12% gain in December 2025, when the index first crossed the psychologically significant 2,500 threshold [2]. The iShares Russell 2000 ETF (IWM) closed at $255.48 on January 7, 2026, representing a 14.71% gain over the past year and 16.27% over the past six months [0]. This performance reflects not merely technical momentum but a fundamental reassessment of small-cap valuation relative to large-cap alternatives, with small caps currently trading at approximately 15x forward price-to-earnings compared to the S&P 500’s 22x—a 22% discount to historical small-cap/large-cap valuation norms that approaches the lower bounds of historical ranges [2].

The Federal Reserve’s monetary policy stance has evolved into a significant tailwind for small-cap equities. Three consecutive 25-basis-point rate cuts in late 2025 reduced the federal funds rate to the 3.50%-3.75% range, directly benefiting small-cap companies that typically maintain higher leverage ratios than their large-cap counterparts [2]. Reduced borrowing costs lower debt servicing expenses and enable capital expenditures that drive future growth, creating a favorable fundamental backdrop for small-cap earnings acceleration.

A structural market rotation is underway, characterized by capital reallocation from expensive mega-cap technology stocks toward small-cap value opportunities. This “Great Rotation” reflects multiple converging factors that collectively support the small-cap investment thesis [2]. The valuation differential between small and large caps has expanded to levels that historically precede extended periods of small-cap outperformance. The Russell 2000’s weighting within the Russell 3000 Index stands at 4.4%, substantially below its long-term historical average of 7.6%, suggesting that passive index flows may underweight small caps relative to their economic significance [4].

Jefferies has established a year-end 2026 target of 2,825 for the Russell 2000 Index, representing approximately 14% upside from current levels [2]. This target assumes continued participation from regional banks, which benefit from a steepening yield curve and resurgence in merger and acquisition activity. Additional Federal Reserve rate cuts in 2026 and strong domestic industrial and infrastructure spending under pro-growth policies could provide further upside to this target.

The upcoming bank earnings season provides a critical test for the small-cap economic growth thesis, as regional bank performance directly correlates with small-cap sentiment and broader economic health. JPMorgan Chase is scheduled to report on January 13, 2026, followed by Wells Fargo on January 14, with consensus estimates suggesting continued earnings momentum across most major financial institutions [6].

The earnings preview reveals several encouraging trends for bank profitability. Global investment banking revenue rose 15% year-over-year to $103 billion in 2025, the second-strongest year since 2021, while global merger and acquisition volume reached approximately $5.1 trillion, representing a 42% increase from 2024 [6]. This investment banking renaissance directly supports small-cap deal activity and provides a catalyst for continued small-cap outperformance.

Bank-specific earnings expectations show varied performance across the sector. JPMorgan Chase is projected to report Q4 2025 earnings per share of $4.96, representing a 3.1% increase from Q4 2024’s $4.81. Bank of America is expected to show 17.1% EPS growth to $0.96, while Citigroup projects 32.1% growth to $1.77 per share. Wells Fargo’s consensus EPS estimate of $1.68 implies 17.5% year-over-year growth [6]. Goldman Sachs represents a notable exception, with consensus EPS of $11.37 representing a 4.9% decline from the prior year period.

The IWM ETF’s technical profile reveals sustained positive momentum with manageable volatility characteristics. The fund closed the December 16, 2025 to January 7, 2026 period at $255.48, having traded within a range of $245.86 to $256.80 [0]. Daily volatility registered 0.87% standard deviation, while average daily volume of 32.85 million shares reflects adequate liquidity for institutional positioning [0].

Sector performance on January 7, 2026, reveals a mixed market environment that nonetheless favors small-cap-sensitive segments. Healthcare led daily gains at +1.78%, followed by consumer cyclical at +0.62% and technology at +0.36% [0]. Defensive sectors underperformed, with utilities declining 3.32%, energy falling 2.64%, real estate dropping 1.87%, and financial services declining 1.03% [0]. The financial services sector’s pre-earnings positioning suggests investors may be adopting a cautious stance ahead of the January 13-14 bank reporting cycle.

The interconnection between small-cap performance, regional bank health, and broader economic growth creates a reinforcing feedback loop that supports the small-cap investment thesis. Regional banks serve as the primary lending source for small-cap companies, and their improved profitability—driven by a steepening yield curve and reduced regulatory burden—enables expanded lending capacity to small business borrowers. Simultaneously, the 42% surge in M&A activity and 15% growth in investment banking revenue validates the economic growth narrative that underpins small-cap earnings acceleration expectations [6]. This cross-domain correlation suggests that strong bank earnings could serve as a leading indicator for continued small-cap outperformance.

The 22% discount of small caps to their historical valuation relationship with large caps creates an asymmetric risk-reward profile that favors small-cap allocation. Historical analysis of small-cap valuations reveals that current levels near 15x forward P/E versus the S&P 500’s 22x have typically preceded extended periods of small-cap outperformance [2]. The Russell 2000’s weight in the Russell 3000 at 4.4% versus a historical average of 7.6% further suggests that passive index flows may eventually force rebalancing into small caps as the valuation differential persists [4].

Consensus estimates for Russell 2000 earnings in 2026 imply approximately 20% growth, a substantial acceleration from 2025 levels that provides fundamental support for current valuations [5]. This earnings acceleration reflects multiple tailwinds: the beneficial impact of Federal Reserve rate cuts on small-cap profit margins, the economic growth implications of pro-business policy initiatives, and the cascading benefits of improved consumer and business confidence. The investment banking revenue surge and M&A activity rebound directly benefit small-cap companies through both increased deal flow and improved financing conditions.

The small-cap investment thesis faces several risks that warrant ongoing attention. Economic sensitivity represents the primary concern, as small-cap companies typically maintain less diversified revenue streams and stronger balance sheets than large-cap equivalents, making them more vulnerable to economic downturns. Should economic indicators deteriorate or recession risks materialize, small-cap earnings could experience disproportionate negative impacts [2].

Valuation risk remains present if Federal Reserve rate cut expectations diminish. Small-cap valuations partially reflect the present value benefit of lower future interest rates, and any reversal in Fed policy easing could compress small-cap multiples. The historical 22% discount to large caps has compressed rapidly in recent months, suggesting that multiple expansion may be partially complete.

Credit risk deserves monitoring given small-cap companies’ higher leverage ratios. While the Fed’s easing cycle has reduced near-term debt servicing pressures, any deterioration in economic conditions could increase default risks for the most levered small-cap borrowers. The quality of small-cap balance sheets varies significantly across the index, necessitating selective security selection.

Continued mega-cap technology sector volatility could create broader market spillover effects that impact small-cap performance. The “Great Rotation” thesis assumes a sustained decline in mega-cap leadership, but any reversal of this trend could redirect capital flows away from small caps and back toward large-cap growth alternatives.

The convergence of attractive valuations, Fed easing, and improving earnings creates a compelling opportunity window for small-cap allocation. Jefferies’ year-end 2026 target of 2,825 for the Russell 2000 represents approximately 14% upside from current levels, with additional upside possible if economic growth exceeds expectations or if additional Fed rate cuts materialize [2].

Regional bank earnings represent a near-term catalyst that could validate the small-cap economic growth thesis. Strong bank earnings, particularly in net interest income guidance and loan growth projections, would support the view that small-cap financing conditions remain favorable. Regional bank stocks have historically correlated strongly with small-cap indices, making their earnings performance a critical data point for small-cap investors.

The M&A resurgence provides a direct catalyst for small-cap stock appreciation. The 42% increase in global M&A volume creates both direct price appreciation for acquired companies and indirect benefits through improved financing conditions and strategic positioning for surviving competitors [6].

The January 7, 2026 CNBC Market Domination Overtime segment featuring Royce Investment Partners’ Francis Gannon articulated a compelling case for small-cap equity allocation in 2026 [1]. The Russell 2000’s 6.2% first-week gain and 12% December 2025 advance reflect fundamental drivers including a 22% valuation discount to historical norms, Federal Reserve rate cuts reducing small-cap debt servicing costs, and a structural rotation from mega-cap technology stocks [2]. The index trades at 15x forward P/E versus the S&P 500’s 22x, representing the lower end of historical small-cap/large-cap valuation ranges [2].

Bank earnings season commencing January 13-14 provides a critical test for the small-cap thesis, with investment banking revenue up 15% year-over-year and M&A activity up 42% providing encouraging context [6]. JPMorgan, Bank of America, Citigroup, and Wells Fargo are expected to show strong EPS growth, while Goldman Sachs may face year-over-year pressure. Key monitoring factors include net interest income guidance for 2026, capital return plans, loan growth trajectory, and spending outlook.

The Russell 2000’s 4.4% weighting in the Russell 3000 versus a historical average of 7.6% suggests potential for continued index fund rebalancing inflows [4]. Jefferies’ year-end 2026 target of 2,825 implies approximately 14% upside from current levels, with further upside possible under favorable economic and policy conditions [2].

Risk factors requiring attention include economic sensitivity, potential valuation compression if rate cut expectations diminish, credit risk for highly levered small-cap companies, and continued mega-cap technology volatility. These risks should be weighed against the attractive valuation opportunity and improving earnings backdrop when considering small-cap allocation decisions.