TL;DR: After three years of underperformance, the Russell 2000 has surged around 16% since November, double the Nasdaq-100's gains. The shift appears driven by Fed easing, domestic policy tailwinds and signs that the mega-cap tech rally may be cooling.
The Setup: Three Years of Divergence
We've watched the same dynamic play out over the past few years. A handful of mega-cap tech names drove the market while small caps languished. By November 2023, the gap was stark: The Nasdaq was up 145%, while the S&P 500 trailed far behind with a gain of 79% and the Russell 2000 lagged even further behind with a modest 43% gain.
The headwinds for small-caps were clear:
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The Fed raised rates from 4.25% to 5.25% throughout 2023
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Recession fears from weak GDP readings kept investors cautious about economically-sensitive small-cap stocks
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Traders favored the Nasdaq over Russell as momentum behind artificial intelligence outshadowed 100 basis points of easing since 2024
What's Changing
Three factors are creating a different environment for small caps since late last year:
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Easing resumes: The Fed has cut interest rates while the economy remains strong. This is unusual –- rate cuts typically happen during slowdowns, not expansions. Small caps, more sensitive to borrowing costs, tend to benefit disproportionately.
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Domestic policy advantage: Expected 2026 policy changes could favor U.S.-focused companies. Since small caps are more likely to operate domestically compared to mega-cap tech's global exposure, they're better positioned to capture these tailwinds.
Tech momentum slowing: Nvidia's 20% pullback in early November suggests potential rotation out of the most crowded positions. Whether this is temporary consolidation or the start of broader rotation remains to be seen.
Implementation Considerations
For investors interested in expressing a view on these conditions, pair trading with Equity Index options enables traders to express relative performance views between indices while maintaining defined risk parameters regardless of overall market direction.
The strategy's effectiveness hinges on thoughtful position construction, where traders must choose between dollar-neutral weighting – which equalizes notional exposure – or volatility-adjusted weighting that accounts for the historical behavior differences between indices like the Russell 2000 and Nasdaq-100.
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