The S&P 600 Small Cap Index is only up 2.0% year-to-date, but the small-cap trajectory is trending to the upside, with the index returning 5.8% since July.
That trend is a worldwide one, with a favorable mix of economic indicators currently working in favor of small-cap stocks.
“Shifts in currency dynamics, including the weakening U.S. dollar and higher global yields, are driving international equity gains,” said Derek Izuel, chief investment officer and portfolio manager at Shelton Capital Management. “As international benchmarks now outpace the U.S., the valuation gap remains wide, prompting investors to lean into international small caps. Right now, small caps offer significant upsides in both valuation and diversification, and they have alpha potential.”
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Public policy also weighs in with small-cap stocks, with the Fed’s plan to keep cutting rates good news for smaller stocks.
“Investors need to look no further than to the Federal Reserve and monetary policy for a reason to be bullish on small-cap stocks,” said Robert R. Johnson, professor of finance, Heider College of Business at Creighton University. “The Fed appears to be entering an easing cycle. Historically, falling interest rates have been a tailwind for stocks, but particularly for small stocks.”
Johnson notes that, from 1966 through 2023, the S&P 500 returned 16.4% when the Fed was lowering interest rates and only 6.2% when the Fed was hiking rates. Inflation was also markedly higher when the Fed was hiking rates versus lowering rates (4.4% versus 3.1%), so the difference in real returns to stock investors was even greater.
“Typically, small stocks outperformed large stocks in a falling interest rate environment,” Johnson said. “The largest quintile of stocks returned 15.8% when rates were falling, while the smallest quintile of stocks returned 30.9% when rates were falling.”
3 Small-Cap Stocks To Back Right Now
With some wind in its sails, the small-cap sector has plenty of options for profit-minded portfolio players. All things being equal, these three stocks should be at the top of that list.
Aehr Test Systems
Year-to-date performance: 55.7%
Fremont, California, semiconductor equipment provider Aehr Test System (NASDAQ:AEHR) specializes in the test-and-burn corner of the chip sector. With semiconductor and advanced packaging demand on the rise, AEHR is in the right place at the right time in late 2025. The company easily cleared its Q1 target estimates and, after landing a few key contracts, is showing robust momentum in the AI and semiconductor testing market.
That said, AEHR faces stiff competition from larger OEMs and is exposed to the cyclicality of the semiconductor capital equipment cycle, which warrants close attention. Yet its one-year surge in share price growth suggests Aehr is on the right track heading into 2026.
Travelzoo
Year-to-date performance: -49.7%
Investors may be undervaluing Travelzoo (NASDAQ:TZOO), yet earnings prospects are up, cash flow is healthy, and it is poised to pop once consumers shed their economic angst and start traveling again in greater numbers.
At $10 a share, Travelzoo stock is a small price to pay for leveraging the expected return on global travel. The stock may be a low-margin, high-risk play, but it has plenty of upside when consumer wallets open again.
Jazz Pharmaceuticals
Year-to-date performance: -9.8%
Jazz Pharmaceuticals (NASDAQ:JAZZ), a Dublin, Ireland-based biopharma company, falls into the less speculative, safer small-cap stock category.
The company recently completed a promising study on HER2 cancer treatments, which typically involves a combination of chemotherapy, targeted therapies, and sometimes surgery and radiation. Jazz also recently received FDA approval for a new combination therapy for extensive-stage small cell lung cancer (ES-SCLC).
Financially, JAZZ has solid backing from stock market analysts, with Truist, Leerink Partners, and Bank of America Securities (which has a $230 target price) all issuing buy calls on the stock in the past month.
Jazz is a promising pipeline play, with a growing number of commercial drugs already on the market and significant upside for future clinical applications. Like any biopharmaceutical stock, investors will need to factor in clinical trial failures and regulatory reviews; however, so far, Jazz has been mainly on the upside in these categories.
Do Your Due Diligence On Small-Cap Stocks
First-time small-cap investors should approach the domain with extra vigilance and patience.
“Start by using limit orders where liquidity is thinner, and bid/ask spreads of 1–2% are common,” said John Murillo, chief business officer at B2B Broker in New York City. “Diversification is key: holding a basket of 8–12 stocks or using an ETF like iShares Core S&P Small-Cap ETF (IJR) helps buffer against idiosyncratic shocks.”
Additionally, a long-term mindset is essential, with a time horizon of at least three years (if it’s a strategic, rather than tactical, investment), as small caps often experience annual drawdowns of 25% or more. “Returns tend to skew positive only when earnings compounding is allowed to play out,” Murillo added.
Lastly, stay disciplined with small-cap stocks. “Aim to rebalance instead of chasing momentum,” Murillo said. “Trim positions that double, and consider adding when quality names trade below historical valuation benchmarks.”
Editorial content from our expert contributors is intended to be information for the general public and not individualized investment advice. Editors/contributors are presenting their individual opinions and strategies, which are neither expressly nor impliedly approved or endorsed by Benzinga.
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