February’s top headline is that market leadership has been taken over by small-caps. The S&P SmallCap 600 has edged ahead of the S&P 500 for the trailing twelve months largely as a result of robust earnings growth of constituent companies. That growth is forecast to continue in 2026, a good omen for the fortunes of many smaller companies. 

Ironically, this reversal of fortune does lead to increased levels of concern for small companies as they now face many of the valuation and return apprehensions that have shadowed the broader market over the last few years.

As we move through early 2026, the market landscape is defined by elevated levels of optimism balanced against razor-thin margins for error. While many analysts see room for the bull market to continue, several specific risks have emerged as the primary “walls of worry” for the year ahead.

The most cited risk for 2026 is the potential bursting of a technology bubble. While both 2024 and 2025 were defined by massive spending on AI infrastructure (including chips and data centers), 2026 is the year investors are expecting, or perhaps even demanding, to see realized productivity gains.

With multiple years of double-digit growth now behind the S&P 500, price-to-earnings (P/E) ratios are at historic highs, leaving stocks vulnerable to even minor earnings misses.

This is exacerbated by the lofty expectations investors have for hyperscalers like Nvidia, Microsoft, or Alphabet. If these tech goliaths report slowing revenues growth relative to their massive AI capital expenditures, it could trigger a broad market correction. The excessive tech concentration in the S&P 500 would likely magnify any slipups, as the top ten stocks in the index now represent roughly 40% of its total market cap.

Another factor to keep in mind is that 2026 is a U.S. midterm election year, which historically introduces seasonal volatility. 

This is on top of ongoing trade policy uncertainty and concerns about how companies will choose to manage costs of tariffs already paid and tariff refunds (if they come to pass). Typically, companies are quick to raise prices as input costs rise, but slow to lower prices after costs dwindle. Still higher costs could exacerbate the existing dampened consumer spending.

Ongoing anxiety regarding the independence of the Federal Reserve is at the top of the list for many market watchers who remain vigilant for signs of political pressure on interest rate decisions, which could destabilize capital market expectations.

U.S. debt levels (currently near 125% of GDP) and the extension of various tax cuts are also fueling long-term worries about fiscal stability and the potential for a hawkish pivot if inflation remains sticky.

Despite these concerns, the picture shaped by macroeconomic data remains mostly resilient. One area of worry is the return of the so-called “K-shaped economy” last seen in the pandemic era. The dispersion between different sectors of the economy has widened, primarily due to two factors. The first are the “potholes” in the labor market. While headline unemployment remains manageable, underemployment has risen. Analysts warn that if hiring continues to downshift, consumer spending—which drives 70% of U.S. GDP—could finally falter.

The second area of apprehension is the hidden risk in private credit and shadow banking. As the cost of capital remains higher than it was prior to 2020, defaults among highly leveraged companies may increase.

The market’s wall of worry is showing plenty of other cracks developing. Beyond ongoing conflicts in Ukraine and the Middle East, new strategic tensions are impacting market sentiment. Interest by the U.S. in Greenland for mineral exploitation and NATO posturing as well as continued friction in East Asia could further disrupt global supply chains. The U.S. dollar’s dominance is also under threat as BRICS nations are looking to create alternative currency systems. This “de-dollarization” could be a long-term “slow-burn” risk for the U.S. dollar’s dominance and global capital flows.

Dialing down into the small-cap market, the year has started strong for small-cap stocks, but they face additional  inflection points as the year progresses. Unlike mega-cap tech companies with fortress-like balance sheets, many small-cap firms rely on floating-rate debt. While the Fed delivered three rate cuts in late 2025 (bringing the funds rate to 3.50%–3.75%), the risk remains for companies with significant debt maturing in 2026. Rolling over this debt at current rates could eat into margins that are already under scrutiny.

While small-caps are touted as the disproportionate beneficiaries of AI (because a 2% margin gain impacts their smaller earnings more significantly), there is a risk of a “J-curve” effect. This is the period where initial AI investment costs are high, but actual productivity gains are not immediately materialized, leading to temporary earnings misses in mid-2026.

Because small caps derive a larger percentage of revenue from domestic sources, they are more exposed to U.S. consumer fatigue. If the K-shaped economic strain worsens and lower-income spending falters, small-cap retail and service sectors will feel the impact far sooner than global multinationals.

Could the small-cap growth spurt be related to a “flight to reality?” Evidence suggests that investors may be moving away from speculative AI names toward higher-quality reasonably-valued small companies with tangible assets, positive cash flow, and domestic resilience. This trend sits well with the SmallCap Informer approach and bode well for the rest of 2026 for our selections.

As is almost always the case, investors must be ready for the good and the bad, the upside and the downside. Returns in the stock market are never linear, so like a good Boy Scout market participants must be prepared for a range of outcomes.

Above all, investors must remain aware of the risks inherent in their portfolio selections and potential new candidates but never be governed by those possibilities. Over time and through all market cycles, focusing on quality companies is the best pathway towards stock market success.

In this issue of the SmallCap Informer, we revisit a pick from 2025 that has performed well to date but still carries an attractive premium for future results, especially for investors looking to round out their diversification in financial services stocks. 

Stay the course!

— DOUG GERLACH

Subscribers can read Doug's complete commentary and the in-depth profile of our recommended small company stock in the current issue of the SmallCap Informer stock newsletter. Not a subscriber? Subscribe to the SmallCap Informer and get monthly small company stock recommendations and updated buy/sell prices for each of the ~40 high-quality small company stocks currently covered in the newsletter.