A trader works on the floor of the New York Stock Exchange (NYSE) at the opening bell, in New York City on September 28, 2026. Photo by CHARLY TRIBALLEAU / AFP via Getty Images

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This column is the last in a series on small-cap stocks. The first column looked at small caps in general, and noted some historical performance.

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The second column looked at five stocks that delivered big gains.

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This column looks at what is needed for a continuation of the 2026 small-cap rally, or even a bigger one. Investors will be looking for the following factors.

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Overall market strength, but also stability

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Investors do not like to take risks on small-cap stocks if they are concerned about the overall market backdrop. Yes, it has been a good year for stocks so far, but there remain a lot of things to worry about. For small caps to continue their rally, we need both a strong overall market and less volatility. Volatility may increase as we head into the U.S. mid-term elections. Small caps could potentially do much better if we had resolutions to the trade war and the Iran and Ukraine wars.

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Tame inflation and interest rates

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This goes hand in hand with market stability but it may actually have a bigger influence. Some analysts argue that this year’s small-cap rally is less rate-dependent than past ones, but a sharp tightening of credit or unexpectedly higher-for-longer interest rates would still pressure small caps via refinancing risk and discount rates. A stable or gently-easing U.S. Federal Reserve would be supportive of the sector, but a spike in inflation would likely stop the small-cap rally dead in its tracks. We don’t want to see a repeat of 2022, when inflation spiked and small caps (the Russell 2000 index) declined nearly 22 per cent for the year.

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Valuation multiple expansion

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Small-cap stocks typically get a higher valuation multiple than large caps because they are faster-growing companies. But for the past decade, more or less, small-cap valuations have lagged both their historical averages and the average of large-cap stocks. Even more compelling is the valuation difference between profitable small companies and large companies. In September, U.S. small-cap profitable companies traded from 14.5 times’ earnings to 16.5 times’ earnings. Profitable large-cap stocks, as in the S&P 500, traded at about 21 times’ earnings. Companies must be profitable to get into the S&P 500 index, though not all stay that way. Optimists will see faster growth and lower valuations in the small-cap universe. So far, the 2026 small-cap move has been supported by strong earnings-per-share growth, but a bigger rally will occur if small caps go through a valuation multiple expansion.

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The market needs to broaden beyond a narrow AI-focused trade

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Yes, there are a few small-cap companies involved in the artificial intelligence sector. But due to the high capital expenditures required, the biggest winners in the space tend to be the largest companies with their billions in cash flow. This has skewed overall market performance, with a few giant winners accounting for a large portion of market and earnings-growth gains. For small caps to really get going, we need to see the market broaden out to include more sectors, particularly the industrial sector, and broaden to more investment styles, not just growth. If market leadership shifts back again to the megacap companies, small-cap performance could stall.