Donald Trump’s victory in the US presidential election sparked another record-breaking rally in the stock market, and smaller-capitalization stocks led the charge.

The Morningstar US Small Cap Index returned 6.7% last week—its best weekly performance so far this year—while the broader market returned a little less than 5% and large-company stocks—which have been leading the two-year bull market—gained 4.6%. Strategists credit the outperformance of small-company stocks to investor enthusiasm about their prospects under new Republican policies, coupled with relief that uncertainty surrounding the election was finally at an end.

The index gave up some of those gains early this week, losing 1.2% on Tuesday and another 0.6% on Wednesday. Can small caps finally enjoy a durable rally after years of underperformance? Here’s everything investors need to know.

The ‘Trump Bump’ Sends Small Caps Soaring

“Last week’s momentum and excitement was really driven by two factors,” explains Adam Turnquist, chief technical strategist for LPL Financial. First is the potential tailwind for small caps from policies expected to be implemented during a Trump presidency geared toward US-facing companies, many of which fall under the small-cap umbrella.

Then there are expectations of a lighter regulatory hand. Small-cap indexes are heavily weighted toward banks and financial companies, which stand to benefit from a looser regulatory environment. Looser regulation also tends to make mergers and acquisitions easier—another boon for the smaller players.

Another factor was the decisiveness of Trump’s victory. “There was a lot of angst built up around how long the election would get dragged out,” Turnquist says. “The fact that he won quickly was a big factor behind the ‘sigh of relief’ rally we witnessed.”

Small Caps Have Been Gaining Steam

Last week’s dramatic rally wasn’t the whole story, however. Strategists say that under the hood, small caps have been quietly gaining momentum for the better part of a year. The stock market’s gains are no longer concentrated in a handful of mega-cap technology stocks, and “de-globalization” has been a market buzzword for months.

“A lot of these trends were in place beforehand and magnified somewhat as a result of the election outcome,” says Jonathan Coleman, a small-cap portfolio manager at Janus Henderson Investors. He says the momentum for small caps began in earnest in July, when cooler-than-expected inflation data surprised investors. “That led the market to understand that the Fed was going to be able to cut rates,” and the result was the beginning of a rotation away from tech stocks into other areas of the market that were likely to benefit from accommodative monetary policy and strong economic growth, including small caps.

The market has since recovered from a subsequent dramatic selloff in August, and small caps are keeping pace with their larger counterparts. The US Small Cap Index is up 37% over the last 12 months, just barely behind the Morningstar US Large Cap Index and the market as a whole.

Look to Banks and Industrials

Because financial services companies make up a large portion of the small-cap category, strategists say that sector will be critical to any sustained rally. “Any leadership from small caps is predicated on financials leading, and that’s been our call,” says Chris Verrone, head of technical and macro research at Strategas Research Partners.

Coleman adds that industrial companies are also heavily weighted in small-cap indexes and could be another driver of small-cap gains, thanks to Trump’s policy focus on the domestic economy.

What Does the Interest Rate Outlook Mean for Small Caps?

In addition to the stock market’s rally, last week’s election sparked a selloff in the bond market and yields rose sharply higher—a sign traders are anticipating stronger economic growth, higher government deficits, and potentially higher inflation. Over the shorter term, markets have also pared back their expectations for the scope and speed of Federal Reserve cuts in 2025. Strategists are divided on what it all means for small-cap stocks.

In general, Turnquist says, “Small caps do not do well in an elevated rate environment because of their debt profile.” This time, he says he doesn’t believe the category’s advantage over large caps will last thanks to sticky inflation data and the likely inflationary effect of some potential Republican policies including tariffs. “For small caps to outperform, you’re going to need a soft landing scenario where growth comes down, inflation comes down, and the Fed continues to cut. We’re seeing evidence of a potential no-landing scenario where rates remain high.”

Verrone argues that the primary driver of rising bond yields over the past week has been new expectations for economic growth, rather than worries about inflation. In a strong growth environment, he says, “the most economically sensitive corners of the market, small caps, are poised to benefit.” That means higher long-term rates may not be bad news for the category. “Higher interest rates and small caps leading are not what people think of as typical bedfellows,” Verrone says. “But I think in this instance … those two can play together.”

Francis Gannon, co-chief investment officer at small-cap specialist Royce Investment Partners, isn’t worried that rates may remain a little higher than investors initially thought, given that investors now have more clarity on the Fed’s path and a return to the rock-bottom rates of the post-2008 years is unlikely.

“The normalization of rates is more important than where the Fed might go next year,” Gannon says. He finds that since 1957, small caps have outperformed large caps in the first three, six, and 12 months following an initial rate cut by the Fed, though he acknowledges that the inflationary risk posed by tariffs could dent returns down the road.

What’s Next for Small Caps?

Strategists are optimistic that some of the momentum that propelled small caps higher last week can last, at least in the medium term.

Verrone says the growing number of small-cap companies reaching new highs is one sign of a durable rally. “I don’t know if this is going to last six months or six years, but I think there’s considerable runway still in front of us … small caps are just getting into the fold.”

Even amid policy uncertainty surrounding the next Trump presidency, Coleman adds that there’s evidence smaller companies are well-positioned. Price/earnings ratios, which measure a company’s valuation, look attractive relative to large-cap companies, for instance. “There are some building blocks in place that seem to suggest that this is a regime change in the marketplace,” Coleman says.

The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar's editorial policies.