Why Small Caps Keep Losing in an AI-Dominated Market

Traders carrying coffee and a sort of quiet exhaustion drifted toward their desks on a gray February morning in lower Manhattan. The same well-known names flashed on screens: Amazon, Microsoft, and Nvidia. On paper, the market appeared wider than it actually was. It’s difficult to ignore how frequently the same few businesses are brought up in conversation, as though the rest of the economy were an afterthought.

Large-cap technology companies have dominated equity performance with unusual force since the introduction of generative AI in late 2022. By investing enormous sums of money in data centers, chips, and computing infrastructure, the so-called hyperscalers created what appears to be an industrial build-out rather than a technology cycle. Investors appear to think that these businesses are building the foundations of a new economy rather than just selling tools. Smaller businesses have found it difficult to keep up because they lack both cloud capacity and capital.

The performance of the index clearly demonstrates the imbalance. Even within the same industries, large-cap technology stocks have performed significantly better than their small-cap counterparts. Large tech companies have surpassed their smaller tech counterparts by an astounding margin over the last three years, indicating that scale has turned into a competitive moat. One gets the impression that size now equates to safety as they pass a brokerage window in the middle of town that shows market tickers.

Financial gravity is one factor contributing to the divergence. While smaller businesses rely on short-term borrowing and revolving credit, large technology companies have access to large cash reserves and can issue debt at a low cost. That disparity became existential in 2023 when interest rates spiked. Smaller businesses were immediately affected, and as borrowing costs increased, their margins tightened. In addition to slowing growth, the Federal Reserve’s tightening cycle increased the divide between those who could finance innovation on their own and those who couldn’t.

Economic ambiguity widened the gap. Fears of a recession hovered over the market like thin clouds in early 2023. The caution persisted even after those fears subsided. Compared to multinational behemoths with revenues spanning continents, small-cap firms seemed more vulnerable to domestic cycles and fluctuations in consumer spending. As a result, investors crowded into mega-caps and strengthened their position of power.

Then came the boom in AI spending. Outside of Phoenix and Columbus, data centers grew, server racks whirring under industrial lighting, and the demand for electricity increased. The build-out benefited chip manufacturers, utilities, and industrial suppliers, but the majority of investor interest remained focused on the platforms that managed the ecosystem. People who own infrastructure seem to benefit more from the AI trade than those who only use it.

However, the story has started to falter. Uncomfortable concerns regarding the returns on significant AI investments were raised in early 2025 when a cheaper Chinese AI model was released. Subsequently, analysts began speculating about “circular financing,” implying that AI companies were financing each other’s expansion in ways that only appeared viable in ideal circumstances. The market briefly appeared less certain of its winners when software companies sold off precipitously in early 2026 due to concerns about AI disruption.

Investors are now looking beyond the narrow leadership as a result of these tremors. Performance has expanded in recent months to include smaller businesses and value-oriented industries. Financial stocks have risen as a result of a steepening yield curve. AI infrastructure requires power generation and grid expansion, so utilities and industrial companies involved have quietly come together. As these changes take place, it seems more like an ecosystem reorganizing itself than a revolution.

Interest rates are still an important factor. Historically, smaller businesses that rely more on borrowing have benefited from falling yields. However, the anticipated recovery has taken a while to come to pass. The relief that lower rates might otherwise offer may have been obscured by the distortion of traditional market relationships caused by tech concentration. Although confidence is still hesitant, small caps may find a stronger footing if rates continue to decline.

Meanwhile, investor sentiment is changing. The market seems more vulnerable to valuation risk after years of pursuing growth at any cost. Capital has been pushed toward undervalued industries by the pursuit of value, especially in the latter stages of a bull market. A portion of this appears to be tactical. A portion of it appears to be weariness from crowded trades.

There is a sense that the AI era has not ended but rather grown as you watch the tape in the late afternoon as the volumes drop and the screen glow becomes softer. The giants are still in charge, and it is difficult to match their size. However, it’s still unclear if they will control the market’s next phase. The benefits could spread gradually, unevenly, and with the kind of hesitancy that markets rarely acknowledge out loud if AI turns into infrastructure rather than spectacle.