Can US Small Caps Survive the Software Selloff?

Why It Matters

The rally in US small caps signals a potential reallocation of investor capital, offering higher return opportunities as large‑cap tech valuations compress.

Key Takeaways

• US software megacaps fell about 30% year‑to‑date
• S&P 600 trades ~16× earnings versus S&P 500 25×
• Small‑cap EPS grew faster than large‑cap EPS in H2 2025
• Lower Fed rates boost debt‑laden small‑cap valuations
• Ichor, Chemours, Powell led small‑cap gains YTD

Pulse Analysis

The recent software sell‑off has exposed the fragility of US megacap valuations, with giants like Salesforce and Adobe tumbling near 30% this year. Their steep price corrections have widened the earnings‑multiple gap between the S&P 500, now trading around 25 times earnings, and the S&P 600, which hovers near 16 times. This disparity is prompting investors to reassess the risk‑return profile of large‑cap tech versus the broader market, especially as global peers continue to outperform the US equity landscape.

At the same time, US small‑cap companies are demonstrating stronger fundamentals. FactSet data shows that trailing EPS for S&P 600 constituents surged in the latter half of 2025, outpacing the stagnant earnings of their large‑cap counterparts. Coupled with a dovish Federal Reserve stance and anticipated lower borrowing costs, debt‑heavy small caps stand to benefit disproportionately. Policy initiatives aimed at bolstering domestic production further enhance the outlook for smaller, more locally focused firms.

For investors seeking exposure, a range of vehicles now capture this emerging theme. ETFs such as iShares S&P SmallCap 600 UCITS and L&G Russell 2000 US Small Cap Quality provide diversified access, while specialist trusts like JPMorgan US Smaller Companies and Brown Advisory US Smaller Companies target niche opportunities. As profitability trends improve and valuations remain attractive, US small caps could become a key driver of equity returns in the coming years.

Can US small caps survive the software selloff?

New analysis from Goldman Sachs suggests that they have made their worst start to a year compared to global counterparts since 1995.

In the year to 18 February, the MSCI ACWI ex USA Index, which tracks large‑ and mid‑cap stocks across developed and emerging markets excluding the US, gained 9.1 %. During the same period, the S&P 500, which is effectively a proxy for large US stocks, gained just 0.5 %.

Some of the US’s leading software stocks have been caught in the storm. Salesforce (NYSE: CRM) fell 29.1 % in the year to 18 February, ServiceNow (NYSE: NOW) fell 29.6 % and Adobe (NASDAQ: ADBE) fell 24.8 %, amid fears that AI disruptors like OpenAI or Anthropic will erase their business models.

“Even highly profitable firms with strong balance sheets and deep proprietary datasets [are coming] under pressure,” said John Wyn‑Evans, head of market analysis at wealth and asset management group Rathbones. “That shift captures just how quickly investor sentiment has reversed from last year’s broad AI‑driven optimism to a wave of pessimism that treats the entire sector as vulnerable, regardless of fundamentals.”

Could US small caps be poised to gain?

The US big‑tech sell‑off doesn’t mean the entire US market should be overlooked. Large caps have surged over the last decade as markets priced in expectations of ever‑increasing returns, inflating their valuations and market capitalisation. As a result, the US market is now dominated by technology megacaps trading at significantly higher multiples than their global counterparts.

They are also overvalued compared to other US stocks. Specifically, the S&P 600, a preferred‑quality small‑cap benchmark, trades at around 15.5‑16 times earnings (according to Bloomberg data from January), compared with the S&P 500 which trades at around 25 times (as of 13 February).

“After a decade dominated by mega caps and narrow market leadership, the pieces might be falling into place for US small caps,” said Christopher Colarik, small‑cap portfolio manager at asset manager Aberdeen Investments.

There are several tailwinds playing out in favour of US small caps.

• Firstly, US small caps are improving their profitability faster than their larger counterparts. Analysis of FactSet data from investment manager T. Rowe Price shows that S&P 600 firms increased their trailing earnings per share substantially during the second half of 2025, while those of S&P 500 firms stagnated.

• This should continue as smaller, more domestically‑focused stocks are likely to benefit from policy initiatives like Donald Trump’s ‘One Big Beautiful Bill’ that aim to boost America’s domestic economy.

• The macroeconomic backdrop is also favourable. US interest rates are falling, with the Federal Reserve likely to become more dovish under Trump’s pick for its next chair, Kevin Warsh. Lower interest rates tend to disproportionately benefit small‑cap stocks as they tend to hold more debt than larger counterparts.

Which US small‑cap stocks could you consider buying?

The S&P 600 gained 7.9 % in the year to 18 February, closer to the performance of global non‑US large‑cap stocks than the S&P 500.

Some of its top performers during the year so far have been:

• Ichor Holdings (NASDAQ: ICHR) – a company that designs and manufactures critical fluid‑delivery systems for semiconductor equipment. Its stock gained 134 % in the year to 18 February.

• Chemours (NYSE: CC) – chemicals company, which gained 73 % in the year to 18 February.

• Powell Industries (NASDAQ: POWL) – electrical‑energy industry supplier, which gained 54 % in the same period.

But these industrial sectors, while posting spectacular gains so far this year, aren’t necessarily the best‑poised for future gains.

“We’re looking at consumer‑linked businesses, particularly those benefiting from rising discretionary spending,” said Colarik. “The unifying theme is profitable, well‑capitalised companies in structurally improving industries, with earnings revisions trending higher.”

For an exchange‑traded fund capturing US small‑cap stocks, you could consider:

• iShares S&P SmallCap 600 UCITS ETF (LON: ISP6)

• L&G Russell 2000 US Small Cap Quality UCITS ETF (LON: RTWP)

Investment trusts targeting US small caps include:

• JPMorgan US Smaller Companies (LON: JUSC)

• Brown Advisory US Smaller Companies (LON: BASC)