The Russell 2000 has finally joined the S&P 500 in reaching new highs. Lower interest rates, and hopes for more, likely triggered the move. The path ahead is not so clear. Bulls could be either looking at a massive breakout or a triple top.
 

After a long wait, small-cap bulls have finally achieved what their large-cap peers did a long time ago. The Russell 2000 last Friday ticked a new all-time high of 2472, just edging past the prior high of 2466 posted last November and 2459 before that in November 2021. That said, Friday also saw a little bit of a reversal as the session finished lower. For the week, the small cap index added 2.2 percent to 2449 (Chart 1).

In contrast, large-caps such as the S&P 500 surpassed their prior highs a long time ago, subsequently recording one after another fresh high. The S&P 500 mid cap index, however, is still four percent under its high from last November.

The recent momentum behind the Russell 2000 comes against the backdrop of a Federal Reserve that has now adopted an easing bias. Small-caps by nature have a higher exposure to the domestic economy versus their large-cap cousins that also have international exposure. The hope is that lower interest rates will stabilize the softening jobs market without putting upward pressure on inflation.
 

In recent months, there has been a significant deceleration in job creation. In August, the economy only created 22,000 non-farm jobs. The jobs market meaningfully shifted lower beginning May, as the tariff uncertainty gripped the business community. In the four months through August, only 27,000 new jobs were added per month, and that included a loss of 13,000 jobs in June; this was the first monthly loss since December 2020.

Concurrently, the unemployment rate in August rose to 4.32 percent. This was the first time since October 2021 that unemployment crossed 4.3 percent. The unemployment rate has trended higher since April 2023 when it bottomed at a 54-year low of 3.45 percent (Chart 2).
 

Ironically, the deceleration seen in job growth does not uniformly reflect the true state of the economy. Real GDP did dip into negative territory in the March quarter, as the 0.5-percent contraction was the first drop in 12 quarters. Growth in the June quarter rebounded to 3.3 percent expansion, which was better than the post-World War II average of 3.2 percent (Chart 3).

With the September quarter nearly over, the Atlanta Fed’s GDPNow model is forecasting growth of another 3.3 percent in the third quarter, which probably goes to show that not everything is falling apart.
 

This is reflected in how the sell-side views where earnings are headed in 2026. First, these analysts tend to be an optimistic bunch. If past is prelude, they have a habit of starting out big and gradually reduce their estimates as time passes. Be that as it may, they are genuinely modeling in massive acceleration in earnings growth next year, and this is not because 2025 is on course to becoming a dud year (Chart 4).

As things stand, as of last Monday, with two quarters of earnings in the bag, S&P 500 companies are expected to bring home $258.30 in operating earnings this year; this would have grown 10.7 percent from 2024. Next year, growth is expected to accelerate to 17.3 percent ($302.91).

The expected acceleration in earnings growth is not specific to large-caps but also holds true for the mid- and small-caps. S&P 400 companies (mid-caps) are expected to grow earnings 14.3 percent this year ($169.63) and 23.2 percent next ($209.01). Similarly, S&P 600 companies (small-caps) are expected to grow the bottom line 14.2 percent this year ($70.65) and 36.7 percent next ($96.59).
 

The obvious question amidst this optimism is what is likely to trigger this. Large-caps have been rallying since they bottomed in April. Small-caps, too, have rallied since, but it is only the last few weeks that they are rallying with conviction, not to mention last week’s fresh high on the Russell 2000. Lower interest rates have clearly acted as the catalyst. Small-caps do tend to be leveraged, so lower rates will help. And the hope is that lower rates would then help the entire economy – or help reaccelerate, so to speak.

After lowering the fed funds rate to a range of 400 basis points to 425 basis points last week, the Federal Reserve has guided to two more 25-basis-point cuts this year and one more next year. This is where it can get tricky. For 2026, the futures market is betting on two cuts for sure and three maybe (Chart 5). These traders are probably sensing a more dovish FOMC than what we have today.

Chair Jerome Powell’s term ends next May; the central bank then will be under the leadership of a new chair. Powell’s term as governor does not end until January 2028. Should he also step down as governor in May, President Donald Trump will have an opportunity to appoint a new governor. He already appointed Stephen Miren, who is on leave as the chair of the Council of Economic Advisers, to fulfill the remaining term of Adriana Kugler, who resigned as governor last month. In addition, if the Supreme Court agrees with Trump’s attempt to oust Dr. Lisa Cook, governor, then the FOMC would begin to look a whole lot different than the current FOMC. This is what small-caps are betting on. It will all depend on if the number of bulls believing in a looser monetary policy next year grow in numbers in the weeks/months to come; a lack thereof will raise the odds of a triple top.

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