Small caps are suddenly at risk of a correction

The AI boom is playing a role in higher rates, but the backdrop also has begun to create casualties.

Surging Treasury yields have begun to hammer parts of the stock market that might easily be overlooked, especially with the spotlight once again shining brightly on a small group of glamorous tech companies.

Re-energized enthusiasm for tech helped the S&P 500 SPX this week reclaim the lead over the Russell 2000 RUT for 2026, as small-cap stocks drop toward correction territory under the weight of higher Treasury yields.

It was supposed to be a year where healthy economic growth drove a broadening out of the stock market. Yet the Russell 2000 has now slid 9% below its record close set less than two months ago, ending at 2,793.20 on Wednesday and putting the small-cap index on the doorstep of correction territory. A market correction is generally defined as a decline of at least 10% from a recent peak - meaning the Russell 2000 would need to end at 2,761.58 or lower to officially enter one.

Notably, the small-cap index's performance has fallen behind the S&P 500's for the year, a sharp reversal from just weeks ago. That's a function of investors clamoring back into a narrow group of AI-driven technology stocks, which lifted the large-cap index to a fresh record earlier this week as other stocks lagged. The Russell 2000 has gained 12.5% so far in 2026, while the S&P 500 has risen 14% in the same period, according to FactSet data (see chart below).

"The first, and most important factor" behind the recent decline in small caps has been rising long-term Treasury yields BX:TMUBMUSD10Y, said Keith Lerner, chief investment officer at Truist Advisory Services. "The higher interest rates are biting - it's just that the technology sector has masked that."

Broadly, most rate-sensitive sectors have been under pressure over the past month. The S&P 500's financials XX:SP500.40 and real-estate XX:SP500.60 sectors were each off over 7% since early September, while the materials XX:SP500.15 and industrials XX:SP500.20 sectors have fallen 5.4% and 4%, respectively, in the same period, according to FactSet data.

"The story to me is that small caps are more interest-rate sensitive, they have more debt and more floating-rate debt than their large-cap counterparts," Lerner told MarketWatch on Wednesday.

Indeed, rising bond yields brought on by inflation fears, higher oil prices (CL00) (BRN00) and a swelling U.S. deficit can create valuation and refinancing pressures for small-cap stocks. Smaller and often unprofitable companies tend to rely heavily on an abundance of variable-rate debt to fund growth. When rates shoot higher, borrowing costs can eat into thin margins.

Megacap companies, including the "Magnificent Seven" group of tech stocks, have been almost rate insensitive in recent months, despite borrowing a deluge of new debt to fund the AI build-out. Investors have been flocking back into these companies, and others producing stellar earnings, for safety amid the volatile rate backdrop.

Small caps also tend to have less exposure to the tech sector. The recent rise in the S&P 500 has been driven by a rotation into higher-quality companies with stronger balance sheets. But even tech-focused small caps have struggled: the Invesco S&P SmallCap Information Technology ETF PSCT has fallen 10.4% from its record high on June 30, according to FactSet data.

In the view of Steve Sosnick, chief strategist at Interactive Brokers, while the economy remains healthy, the current environment hasn't been especially favorable for small caps. He characterized the economy as "good," but also has worries that it's become dominated by the build-out of AI data centers.

"The second-quarter GDP of 2.2% is not necessarily going to lift all the boats," he said. "So, you have this uneven economic growth, and with interest rates backing up substantially, that's a tough environment for small caps."

Most Federal Reserve officials assessed that another quarter-point rate hike would likely be appropriate before the end of the year, according to minutes of the Fed's September gathering released Wednesday. The U.S. central bank last month just raised its benchmark interest rate to a range of 3.75% to 4%.

U.S. stocks finished lower on Wednesday. The Russell 2000 slumped 1.3%, while the S&P 500 and the Nasdaq Composite COMP were each off 0.2%. The Dow Jones Industrial Average DJIA fell 0.7%, according to FactSet data.

-Isabel Wang -Joy Wiltermuth