Microsoft, Amazon, Alphabet, Nvidia and other AI behemoths atop the Nasdaq and S&P 500 continue to grab headlines as valuations hit ever more stratospheric heights, with investors also eagerly anticipating trillion-dollar IPOs from Anthropic and OpenAI.

But amid all this, companies with market caps below US$2 billion have undergone a stealth rally. The small-cap benchmark Russell 2000 index is up 17 percent this year, outstripping the S&P 500's 10 percent rise.

Of course, there have been a few notable exceptions. The $700 billion cloud computing giant Oracle has seen its market cap nearly double in under two months, while $300 billion PC-maker Dell's has doubled in less than two weeks.

But in general, the smaller players have led this year, primarily driven by two sectors, tech and energy. The small-cap indices in these areas have outperformed their more heralded megacap peers by some distance.

On the energy side, the S&P 500 subindex has gained an impressive 27 percent so far this year, but the equivalent Russell 2000 index is up 34 percent. Since Feb. 27, the day before the Iran war started, the Russell 2000 energy index has jumped 13 percent, while its S&P 500 counterpart has risen only 2 percent.

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Many smaller companies are better set up to benefit from an energy price spike than their larger peers. That is because a higher proportion of their costs tends to be fixed, so a rise in oil prices will more readily lead to increased cash flow. While crude prices are off their highs, they are still 30-35 percent higher than where they were on Feb. 27.

The small-cap outperformance has been even more pronounced in tech. The Russell 2000 tech index is up 45 percent this year, compared with the S&P 500 tech index's 25 percent rise, with much of this outperformance coming in the last two months. Since US equity markets bottomed on March 30, small-cap tech stocks are up an eye-popping 70 percent, while the large-cap tech index has increased a mere 45 percent.

What explains this? Small caps appear to be benefiting more from the AI capex boom than many had bargained for.

Tech may only account for about 16 percent of the small-cap index, compared with the “Magnificent Seven's” near-40 percent share of the S&P 500, but many of these smaller companies are considered part of the physical "picks and shovels" segment of the AI buildout.

And the deluge of hyperscalers' capex spending, estimated at roughly $800 billion this year, is flowing through the AI ecosystem to areas where many of these players are active, such as equipment, power and AI testing.

In fact, shares in more than a dozen small-cap semiconductor firms have risen over 100 percent this year, notes Keith Lerner, chief investment officer at Truist Advisory Services.

"This underscores how strong and widespread that demand has been," Lerner says. "As for whether it can continue [...] upside potential remains, particularly if the bull market stays intact and the AI-driven earnings cycle continues to broaden out."

Small caps face plenty of challenges ahead, however.

For starters, companies with smaller balance sheets, weaker credit ratings and lower market capitalizations are more exposed to rising interest rates than bigger firms.

For now, the rise in US Treasury yields across the maturity curve since the Iran war started has been offset by rising equity prices and shrinking credit spreads. Indeed, Goldman Sachs' US financial conditions index is at its lowest point in over four years, largely due to booming equity markets.

But inflation is creeping higher, with headline annual rates approaching 4 percent, meaning borrowing costs may keep heading north. At some point, this should curtail the equity boom, tighten financial conditions and put disproportionate pressure on smaller companies with high debt loads.

Any pullback in the AI capex splurge could also be a double whammy, hitting many small tech companies directly and via slower overall growth.

And if there is a resolution to the Iran conflict, energy prices could drop through year-end, erasing the boom smaller energy firms have enjoyed.

Bank of America's fund-manager survey showed conviction in the small-cap rally may be ebbing. A net 54 percent of respondents now expect large-cap stocks to outperform small-cap stocks, the most since June 2022.

Small caps are on a good run. How much stamina they have to extend it remains an open question.

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The writer is a columnist for Reuters. The views expressed are personal.

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