Visualizing Market Dynamics: Year-End Guide to Market Trends

Quality vs. Junk: The Long Game

Despite periodic junk rallies, quality wins over the long haul. AQR data going back to 1956 shows quality stocks outpacing junk by 3.3 percentage points annually in large caps and 7.1 percentage points in small caps. Quality's advantage comes not from spectacular individual years, but from smaller drawdowns and steadier compounding that generates stronger returns when markets recover.

The current environment illustrates why this is hard to exploit in practice: junk is rallying. Russell Core and Value ETFs are being dragged up by the high percentage of negative-earnings companies in their indexes — a dynamic that punishes disciplined managers who avoid these names.

The 2025 Pain Point

Only 10% of small cap value managers are outperforming year-to-date in 2025. This is an extreme reading — one that has historically preceded sharp reversals in manager performance. When the spread between quality and junk is this stretched, and when active manager underperformance is this concentrated, the setup for mean reversion is compelling.

Small cap managers have been here before. The data shows they have come back with a vengeance. The question is not whether, but when.

The Cycle Map

Since the 1930s, small cap performance relative to large caps has moved in distinct cycles. Using Kenneth French data:

1931–1946: Small caps outperform by 12% annualized (14 years)

1946–1957: Underperform by 4% (12 years)

1958–1969: Outperform by 10% (11 years)

1970–1974: Underperform by 16% (6 years)

1975–1983: Outperform by 14% (9 years)

1984–1999: Underperform by 8% (16 years)

1999–2013: Outperform by 7% (15 years)

2014–June 2025: Underperform by 6% (11 years)

July 2025–present: Outperform by 5% (ongoing)

The current underperformance cycle lasted 11 years — consistent with historical precedent. The data suggests a new outperformance cycle began in July 2025.

Style Drift in Small Cap ETFs

A popular small cap ETF has experienced significant style drift toward mid-cap territory as its AUM has grown. With $164 billion in assets, 71% of its holdings now exceed $6 billion in market cap — a threshold many would classify as mid-cap. This creates an opportunity for true small cap managers operating in the $80M–$6B universe: the benchmark is no longer measuring what it claims to measure.

Reports of Small Caps' Death Are Greatly Exaggerated

To paraphrase Mark Twain: this is the fourth time since the Roaring Twenties that small caps have been declared extinct. Each prior obituary was wrong. The structural case for small caps — valuation discount, earnings growth potential, active manager alpha opportunity — remains intact. The current cycle is painful. The historical record suggests it is also temporary.

*Originally published: CS McKee Thought Leadership, December 2025. Download the full report with charts on the Research page.*