The fundamental case for small-cap underperformance was multifaceted and, for a time, compelling. The most pressing concern centered on interest rates. In January 2023, the Federal Reserve's benchmark rate stood at 4.25%, already elevated by recent historical standards. But with inflation still running hot, markets expected further tightening – and got it. By July 2023, the Fed had raised rates to 5.25%, adding 100 basis points of pressure.

Stocks included in the Russell tend to be extremely sensitive to short-term rates. Many of these smaller companies use revolving rates to conduct business, unlike cash-rich entities like Apple and Google. 

Economic uncertainty added another layer of concern. A disappointing 1.3% GDP reading in December 2022 sparked widespread fears of an imminent recession. Although those fears would prove premature – the recession never materialized – the anxiety lingered for several quarters, keeping investors cautious about economically-sensitive small-cap stocks.

This did not seem to stop traders from favoring the Nasdaq over the Russell. Even when the Fed pivoted to cutting rates in the fall of 2024, delivering 100 basis points of easing, the outperformance of the Nasdaq persisted. By then, the narrative appeared to have shifted. Rate sensitivity mattered less than the seemingly unstoppable momentum behind artificial intelligence and the mega-cap stocks positioned to capitalize on it.

By late 2025, however, three significant developments began to alter the equation.

First, the Fed resumed its easing cycle with 75 basis points of cuts. What makes these rate reductions particularly notable is their timing: they are occurring against a backdrop of economic expansion, not weakness.

The Fed's focus appears to be the labor market, where recent data have shown softening despite otherwise healthy economic indicators. Under its dual mandate of price stability and maximum employment, the central bank is responding to labor market weakness even as other measures suggest the economy remains on solid footing. 

Second, the Fed appears to be anticipating that the same AI that’s eliminating jobs might also combat inflation through productivity gains. If true, 2026 could bring a Goldilocks scenario of moderate economic growth, low unemployment and stable inflation – especially with potential tailwinds from tax cuts, deregulation and reshoring investment. Small caps are more sensitive to these domestic factors, as they are less likely than large caps to be doing business across the globe.

Third, AI exuberance itself is showing signs of fatigue. Nvidia shed 20% in early November and the entire Mag 7 lost 10%. While these are minor moves when viewed against their enormous multi-year rallies, they raise a critical question: Has this combination of factors provided enough incentive to cause a rush of liquidation in the long Nasdaq / short Russell trade?

If the answer is yes, and that liquidation has indeed begun, it suggests a path for continued outperformance of the Russell into 2026.

For investors interested in expressing this view, pair trading with Equity Index options enables traders to express relative performance views between indices while maintaining defined risk parameters regardless of overall market direction. 

The strategy's effectiveness hinges on thoughtful position construction, where traders must choose between dollar-neutral weighting – which equalizes notional exposure – or volatility-adjusted weighting that accounts for the historical behavior differences between indices like the Russell 2000 and Nasdaq-100.

By utilizing liquid CME Group Equity options contracts, market participants can structure trades that isolate their conviction about one index outperforming another, transforming directional market views into actionable positions with clear maximum loss thresholds.