A strange thing is taking place underneath the surface of the stock market.
The long-term interest rates have risen to levels which ought to be causing a difficult time for smaller American companies, yet the Russell 2000, being the index most closely linked with U.S. small-cap stocks, is exceeding the S&P 500 by a large margin in 2026.
Until Thursday, August 20, the Russell 2000 had risen by 20.6% during the year, as opposed to 11.6% for the S&P 500, according to the Associated Press. The Nasdaq had also increased by 12.2%.
At the same time, the 30-year yield on U.S. Treasury bonds has reached as high a level as 5.34%, its highest point since 2007, because investors are dealing with ongoing concerns about inflation, huge federal borrowing and uncertainty concerning monetary policy.
The two developments are not meant to go together smoothly.
Small companies usually place greater reliance on financing, have weaker balance sheets and possess a higher amount of floating-rate debt compared to larger companies. They should therefore be the first to suffer from high rates.
On the contrary, they have been winning.
Why is the Russell 2000 outperforming the S&P 500 in 2026?
In 2026 the Russell 2000 is doing better than the S&P 500 since the effect of improved earnings, the fact that valuations had previously been low, the shift in investment away from the large-cap stocks and the strong demand for smaller companies in the technology, energy and industrial sectors have more than made up for the harm caused by higher interest rates. A new group of small-cap winners has also been produced by spending on AI infrastructure.
The final point might have been the one that Wall Street failed to appreciate.
For many years the artificial intelligence industry was mainly associated with companies like Nvidia, Microsoft, Alphabet and some of the other large firms that are included in the S&P 500.
The money is spreading.
Small caps found their own AI trade
The development of the AI system involves much more than just the use of advanced processors.
Data centres require power equipment, cooling systems, testing equipment, networking components, semiconductors, construction materials and an ever-growing energy infrastructure.
A large number of the companies that sell those products are not close in size to Nvidia.
Reuters said in June that the Russell 2000 technology index had increased by 45% during the year then, as against a 25% rise for the S&P 500 technology sector. Small-cap technology stocks had risen by about 70% from the market’s low in March.
The amount that hyperscalers are spending on capital this year is estimated to be about $800 billion, some of which is going to smaller companies that provide equipment, power infrastructure and AI testing.
Keith Lerner, who is the chief investment officer at Truist Advisory Services, said that over a dozen small-cap semiconductor companies had already increased in value by more than 100%.
This shows how great and far-reaching that demand has been.
The July market review published by the FTSE Russell Global Investment Research team reached the same conclusion. It stated that the strength seen in the small-cap sector had extended to include the technology, health care, industrial and financial sectors, while AI investments were increasingly providing benefits to what it referred to as “second-order beneficiaries” of the buildout.
That alters the story of the Russell 2000.
It is well past the point of merely being a wager that the Federal Reserve will reduce interest rates.
Certain sections of the index are taking a direct part in one of the biggest capital-spending cycles in modern American business.
Higher rates may be telling investors something else
There is yet another reason why the Russell 2000 has been resilient.
It doesn’t follow that if interest rates rise the economy will collapse.
Yields go up since the economy is still strong enough to enable investors to require higher returns on bonds.
That difference is of enormous importance to small companies.
Francis Gannon, who is one of the co-chief investment officers at Royce Investment Partners, said that the current strong economic conditions and earnings are outstripping the rate issue.
In my opinion, the earnings performance of the smaller companies is more than making up for some of the concerns about higher interest rates.
Gannon stated to MarketWatch that higher interest rates may also indicate that the economy is performing rather well.
This helps to account for a market movement which at first sight appears irrational.
It is possible that investors have concluded that for some small businesses stronger revenue and earnings growth are more important than having moderately cheaper financing.
The July market analysis carried out by Truist also mentioned starting prices.
Small caps started the year at around 20-year relative price and valuation lows, as Truist pointed out, before small-cap technology companies saw a surge as investment shifted away from the biggest stocks in the market.
The effect of that rotation can be enormous.
The company Truist points out that each of the five largest companies in the S&P 500 is greater in size than the whole of the S&P SmallCap 600 index.
You don’t need a large amount of money invested in mega-cap stocks in order to produce a strong movement in a smaller stock.
The interest-rate problem has not disappeared
This does not mean that the bond market is irrelevant.
It could in fact be the greatest threat to the rally of the Russell 2000.
Russell Investments points out that a great many small-cap companies have a greater level of exposure to floating-rate debt than do large companies and that a significant part of the Russell 2000 includes businesses which are not profitable.
That means that refinancing becomes a lot more difficult when borrowing costs stay high.
The pressure can already be seen.
On Thursday, August 20th, the Russell 2000 dropped by 1.3 per cent, which was a more significant fall than the 0.9 per cent loss suffered by the S&P 500, since Treasury yields had risen once again. The 10-year Treasury yield was about 4.7 per cent, and the 30-year yield stayed above 5 per cent.
The selloff had little effect in wiping out the Russell’s large lead for the year, but it did show exactly where the vulnerability is.
So long as yields keep rising and economic growth stays strong, robust earnings will continue to offset the extra financing risk for investors.
When inflation is accelerating and at the same time economic growth starts to weaken, the calculation changes rapidly.
Small firms would then have to deal with the situation they most dislike: costly money and fewer customers.
The Russell 2000 may be sending a bigger stock-market signal
The comparison between the Russell 2000 and the S&P 500 in 2026 is important not only to investors who hold small-cap stocks.
This could be revealing something about the entire bull market.
For most of the last few years the main worry of Wall Street has been concentration, since a small number of very large technology companies have accounted for a greater than proportionate share of market returns.
It’s starting to change now.
On August 14 the Russell 2000 closed at a record level of 3,068.42, whereas both the S&P 500 and the Nasdaq dropped on that day. The Russell had risen by 23.6% by that point in 2026, as compared to 13.7% for the S&P 500.
Small caps have since pulled back as bond yields rose, but their lead for the year to date is still considerable.
That means that the following few months will be particularly important.
If small companies are able to keep on producing strong earnings even though they are facing long-term Treasury yields of 5 per cent, the 2026 rally might turn out to be something more wholesome than yet another massive-cap technology boom. This would indicate that investors are discovering growth in a much broader part of corporate America.
The bond market is currently testing that thesis.
Small caps have already shown that they are able to outperform the S&P 500 while interest rates are high.
The more difficult question is how high those rates can be before earnings cease to be sufficient.