The Stocks Leading the Small-Cap Rally

Key Takeaways

• Small-cap stocks are outperforming large- and mid-cap stocks in the third quarter.
• The technology sector, specifically the semiconductor industry, has driven gains in small caps and the broader market.
• Falling short- and long-term rates are providing tailwinds for small caps.
• A reaccelerating economy could further boost small-cap gains.

After a long spell of underperformance, small-company stocks finally outpaced the rest of the market in August. For this reversal of fortune, small-cap investors can thank the same kinds of companies that have been driving the overall market: technology and other growth names. More specifically, semiconductors.

But the similarity between the rally in small-caps and the overall rise in stocks ends there. Industrials and financials are the next-biggest contributors to the move higher among small caps. Fueling the gains are a recent drop in bond yields and anticipation of the Federal Reserve cutting interest rates. But the strength of the US economy presents a potential headwind for small-company stocks in the months ahead.

With the Morningstar US Small Cap Index higher since the start of the third quarter, 1 percentage point ahead of the Morningstar US Market Index, here’s a look at the key stocks driving this rise.

• Astera Labs ALAB
• Credo Technology CRDO
• Ciena CIEN
• Unity Software U
• Rocket Lab RKLB

Small-Cap Stock Performance

Over the past 10 calendar years, small caps have only beaten the market twice—most recently in 2022, when they fell 18.5%, compared with the 19.4% drop in the broader market. 2016 is the most recent year in which small caps beat the market with a positive return, climbing 20.3% while the overall market rose 12.4%.

The Small Cap Index, which targets securities that fall between the 90% and 97% market cap thresholds of the investable universe, is up 8% in the third quarter. That’s better than the 7.8% return on the Morningstar US Large Cap Index and the 3.9% return on the Morningstar US Mid Cap Index. The overall stock market as measured by the US Market Index is up 7%.

Breaking down the returns by style, small-growth stocks have gained the most in the third quarter with an 8.4% rally, followed by an 8.2% rise in small-core stocks and a 7.4% gain in small-value stocks.

The outperformance by small caps is in stark contrast to the past two quarters. Small caps fell further than the overall market in the first quarter of 2025 and rebounded less than the overall market in the second. Even with their outperformance this quarter, their 8.9% gain in the year to date still lags the overall market’s 13.4% jump.

What Sectors and Industries Are Driving Small-Cap Gains?

The technology sector is the leading contributor this quarter, adding 2.2 of the 8.0 percentage points gained by the Small Cap Index. Tech has also been a leading contributor to the overall market, adding 3 of the 7 points gained by the US Market Index.

Beyond tech, the return attribution diverges between the Small Cap Index and the US Market Index because of their different sector weightings. While the US Market Index has nearly a 10% allocation to communication services—thanks to behemoths like Meta Platforms META and Alphabet GOOGL/GOOG—the Small Cap Index only has a 2% allocation. On the other hand, the Small Cap Index holds a 21% weight in the industrials sector, while the overall market index allocates just 9%.

As a result, the second-largest contributor to the Small Cap Index in the third quarter has been industrials, adding 2 percentage points. The financial services sector comes in third, adding 1 point. For the US Market Index, communication services have contributed the second-largest amount (1.6 points), while the consumer cyclical sector is in third (1.0 points).

At the industry level, semiconductor firms have been the top contributors to both the Small Cap Index (adding 0.9 percentage points) and the US Market Index (adding 1.7 points).

Leading Small-Cap Stock Contributors

For investors keeping track of the overall rally in the market over the last two years, some of the trends among individual stocks will look familiar. But others will be different. The top two individual contributors to the rise in the Small Cap Index—Astera and Credo—are both semiconductor companies.

Astera has surged 155.8% this quarter, adding 0.5 percentage points to the index’s return. Since its IPO in March 2024, the stock has climbed an eye-popping 272.9%. Astera designs and delivers semiconductor-based connectivity solutions for cloud and AI infrastructure.

Credo has soared 77.1% this quarter, adding 0.3 percentage points to the index’s return. Over the past 12 months, the stock has exploded 475.2%. Credo provides secure, high-speed connectivity solutions that deliver improved power and cost efficiency as data rates and corresponding bandwidth requirements increase exponentially throughout the data infrastructure market.

The next-biggest contributors each added 0.2 points to the Small Cap Index’s return—Ciena, Unity Software, Rocket Lab, EchoStar SATS, and FTAI Aviation FTAI.

EchoStar, a satellite telecom services firm, has seen the biggest share price jump of any stock in the index this quarter, at 159.7%. The stock carries a Morningstar Rating of 3 stars, a Very High Uncertainty Rating, and a Poor Capital Allocation Rating. The recent success comes after the firm agreed to sell nearly 70% of its spectrum holdings.

“For years, EchoStar has remained steadfast in its belief that it could build a wireless business to capitalize on the value of its wireless licenses,” says director of equity research Michael Hodel. “No real signs of success have emerged, and the firm’s finances have been left in tatters. However, the decision to sell licenses to AT&T T and SpaceX quickly realizes value for shareholders, dramatically reduces balance sheet risk, and opens a new chapter in EchoStar’s development. Regulators could still choose to block the spectrum sales, though, which would put the firm back in its troubled state with no clear path out.

Here’s the full list of the top contributors to the Small Cap Index in the third quarter.

Will the Small-Cap Rally Continue?

In the background, the economic backdrop turned in favor of small caps, but the outlook is more uncertain. “Historically, small-cap stocks do best when the economy is reaccelerating from a slowdown or recession, when the Federal Reserve is easing monetary policy, and when long-term interest rates are declining,” wrote chief US market strategist David Sekera in his September stock market outlook. “It appears that two of these three conditions are coming to fruition, with the third still an outstanding question.”

The two factors working as tailwinds for small caps are falling short- and long-term interest rates. The yield on the 10-year US Treasury has dropped to 4.06%, a nearly 52-week low. At the same time, the Fed resumed its rate-cutting cycle on Wednesday, lowering the federal-funds rate target to a range of 4.00%-4.25% from 4.25%-4.50%. The narrow majority of Fed officials projected two additional cuts later this year.

But the question is whether the US economy will reaccelerate in the coming quarters. “From a headline perspective, it appears this condition has already been met, as the reported gross domestic product of 3.3% for the second quarter of 2025 well outpaced the 0.3% contraction in the first quarter,” Sekera notes. However, “when stripping out the impact from imports, the real underlying fundamental economy slowed from the first quarter to the second quarter.” Looking ahead, Morningstar’s forecasts that tariffs will slow the economy further going into 2026.