By Joseph Adinolfi
Since the end of October, tech stocks have retreated while cyclical corners of the market – including financials, energy, materials and small caps – have barreled ahead
Big changes are afoot beneath the surface of the U.S. equity market. That could mean more opportunity for investors in 2026.
The S&P 500 index has barely budged since late October. Yet, beneath the surface of the U.S. equity market, big changes have been taking place.
Wall Street strategists refer to it as a “rotation trade,” or a broadening out of stock-market performance. Since the bull market began in October 2022, investors largely have favored technology stocks and other names expected to benefit from the advent of artificial-intelligence technology. But recently, investors have started to hunt for opportunities elsewhere as the relentless upward momentum on technology names has stalled out.
Nontech names could continue to benefit if the rotation gathers more steam in 2026 – although a lot of this hinges on calm in the bond market, and the Federal Reserve delivering more interest-rate cuts in the months ahead. Even so, things are off to a strong start, with investors feeling confident in the strength of the U.S. economy despite signs of a weakening labor market.
“We’ve already been seeing a little bit of broadening out,” said David Lefkowitz, head of U.S. equities at UBS Global Wealth Management, during an interview with MarketWatch. “We do think it could maybe even broaden further.”
For years, the capitalization-weighted S&P 500 SPX handily beat its equal-weighted sibling XX:SP500EW. But that relationship has recently inverted – a sign that the average stock in the index is finally outperforming the elite few tech names with trillion-dollar market capitalizations.
Since Oct. 31, the Invesco S&P 500 Equal Weight ETF RSP, which tracks a version of the S&P 500 that accords equal influence to shares of each member company, has outperformed the SPDR S&P 500 ETF Trust SPY, which tracks the traditional version of the index. The equal-weight ETF has risen 4.8% over that stretch, compared with 1.5% for its capitalization-weighted rival, FactSet data showed. The S&P 500 was on track for a fresh record closing high on Wednesday.
See: Investors are dumping stock-market winners and buying almost everything else. Why that’s a good sign.
Also, the Dow Jones Industrial Average DJIA, known for including an assortment of mostly value-oriented names, was up 2.9% on the year through Tuesday’s close – its best performance during the first three days of a calendar year since 2003, according to Dow Jones Market Data.
It isn’t just the Dow. Value stocks in the Russell 1000 index RLV have fared better than growth stocks in the index RLG since October, turning another longstanding market trend on its head. Value stocks tend to have more affordable valuations, and they often pay dividends. Companies in the growth-stock camp are expected to reinvest most of their rapidly growing earnings back into their businesses.
The iShares Russell 1000 Value ETF IWD has gained 5.2% since Oct. 31, while the iShares Russell 1000 Growth ETF IWF has fallen by 1.4%, FactSet data showed.
Goldilocks returns?
The composition of stock-market leadership started to shift over the past couple of months – a trend that carried over into the first few trading sessions in January.
The S&P 500’s information-technology sector XX:SP500.45 has fallen by 4.2% since Oct. 31, while energy XX:SP500.10, financials XX:SP500.40 and materials XX:SP500.15 have barreled ahead, rising 5.4%, 7.2% and 10.4%, respectively, Dow Jones Market Data showed. Communication services XX:SP500.50, the home of Google parent Alphabet (GOOGL) (GOOG) and Facebook parent Meta Platforms (META), also has big exposure to the AI theme, and has gained 5.1%.
Investors see a few things as drivers. Expectations are that the U.S. economy will remain on solid footing in 2026, or even accelerate. The pace of global economic growth is expected to pick up as well, while investors see inflationary pressures as remaining largely subdued. This has helped boost value stocks in more cyclically oriented sectors.
Investors think the trend should enable the Fed to cut interest rates a couple of times this year, potentially further juicing returns for interest-rate-sensitive corners of the market like the small-cap stocks in the Russell 2000 index RUT.
Stimulus from President Trump’s One Big Beautiful Bill Act, which pushed through more tax cuts for Americans, should help boost growth during the first quarter, said Charlie McElligott, a cross-asset strategist at Nomura, in commentary shared with MarketWatch. Optimism about the U.S. economy has persisted despite signs that the labor market has weakened, while consumer spending has held up OK.
The upshot is that investors are expecting the return of the “Goldilocks” economic environment that helped fuel strong returns in stocks during the 2010s, according to Jack Janasiewicz, lead strategist and portfolio manager at Natixis Investment Managers Solutions.
“With inflation cooling, the Fed easing and recession risks staying low, 2026 could mark the return of a Goldilocks economy – and a reset for both equity and fixed-income markets,” Janasiewicz said in commentary shared with MarketWatch.
Small caps
That isn’t to say that the AI trade is going away – although more turbulence could be in store, as investors appear increasingly willing to differentiate between winners and losers.
But those who own a broadly diversified equity portfolio can at least rest easy knowing that other stocks have started to pick up some of the slack. Strong gains for small-cap and midcap stocks over the past few months suggest investors see opportunities outside of the S&P 500.
Ed Yardeni, founder and president of Yardeni Research, even mused about the possibility that small- and midcap stocks could race ahead of their larger peers in 2026. After years of underperformance, he thinks the time for them to push ahead is long overdue. However, Yardeni also said he favors selectively investing in certain small-cap sectors like financials, industrials and healthcare.
After several years where the big AI players generated much of the earnings growth, Wall Street analysts expect smaller firms to see big improvement in profitability this year.
For the first time since the bull market began in late 2022, analysts expect members of the small-cap S&P 600 index SML to see faster earnings growth than their larger peers in 2026, according to forecasts collected by FactSet.
Within the S&P 500, companies outside of the tech space are expected to see strong earnings growth. That should help drive a rally in financials, materials and other sectors in 2026, UBS’s Lefkowitz said.
Stocks sensitive to commodity prices are already off to a strong start. A furious rally in metals prices has helped revive flagging materials stocks, including shares of metals miners. Energy stocks leapt higher this week following the U.S. capture of Venezuelan leader Nicolas Maduro. Cole Smead, CEO and portfolio manager at Smead Capital Management, said he believes this is just the beginning.
Concentration
In terms of how members of the S&P 500 fared in 2025, the story looked pretty similar to 2024 and 2023.
While there were some changes around the margins, the “Magnificent Seven” megacap tech stocks continued to power much of the S&P 500’s advance last year. The cohort accounted for about 40% of the index’s total return of 17.9%, which includes dividends, UBS Group data showed – even as only two members, Alphabet and Nvidia (NVDA), actually beat the index. All told, only 30% of S&P 500 companies outperformed last year, FactSet data showed. That was roughly on par with the figures from 2024 and 2023.
Because of these lopsided returns, the largest stocks in the S&P 500 have seen their weighting in the index climb to its highest level in decades. The top 10 stocks now account for more than 40% of the index’s value, Lefkowitz and his team found.
Valuations
Another reason investors might be tempted to continue hunting for stock-market bargains in the New Year: Over the past five years, a massive valuation gap has emerged.
Even after the recent shift in stock-market leadership, the S&P 500 still commands a significant premium. Its price-to-earnings ratio, a popular valuation metric used by investment analysts, is still 36% higher than that of the equal-weighted version of the index, according to Michael O’Rourke, chief market strategist at Jones Trading.
When compared with small-cap indexes, the gap is even wider: The S&P 500’s price-to-earnings ratio is 49% higher than the same ratio for the S&P 600 small-cap index.
“There have been plenty of false starts in recent years, so it remains to be seen if this trend will continue – but, if it does, there is a vast valuation chasm to close,” O’Rourke said in commentary shared with MarketWatch.
-Joseph Adinolfi
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