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2026 has begun with an asset class performance reversal in the United States. Small capitalization stocks, which lagged their larger-cap peers last year, have come out of the gate roaring ahead.1 There are several reasons for this shift. One is valuation: traditional investment theory suggests that valuations tend to revert toward a mean over time, and asset classes had become somewhat stretched relative to one another.
Another factor is interest rates. Small caps tend to benefit from the prospect of lower rates, and markets appear to expect that may be coming. Smaller companies generally carry more debt, and that debt is often shorter in duration.2
Consider a hypothetical example. Imagine you are an investment banker, and Apple Inc. (large cap) and Crocs Inc. (small cap) approach you to raise debt capital.
Crocs may say, "Look, contrary to your sartorial instincts, we are quite fashionable. And we designed this new texture on the bottom of the sandal that kind of massages your foot as you walk. We think people are going to love it!" You may think "My feet are tingling, but that's not much of a competitive advantage. I could take a little chisel and change the sandal mold myself fairly easily."
Then it's Apple's turn. There's a little swagger in their pitch because they are Apple. Maybe they say "Ok, it's true we’ve stumbled with Siri for three consecutive years. And our text autocorrect has probably broken up a few marriages. But have the customers left? No. They're deeply embedded in our ecosystem. And if needed, and we will hire our biggest competitor, Google, to help improve it." You think, "That's a very durable protective moat and large competitive advantage."
Under this scenario, Apple secures the long-duration, low-cost debt financing. And Crocs doesn't. But in theory, it means that when rates come down, Crocs, and small caps, will benefit more. As interest expenses fall for companies like Crocs, profitability improves, and markets often respond positively.
Moving beyond the hypothetical, I want to clear up a little definitional confusion about indexes, index funds, mutual funds, and ETFs.
An index is simply a defined collection of securities that you are going to invest in. It’s essentially a rules-based list. Constructing that list is harder than it sounds. Most large fund companies, such as State Street, BlackRock, or Vanguard, license these lists from index providers. As an example, the S&P 500 is created and maintained by Standard & Poor’s, an index provider.
Once the fund companies have the license, they then build funds that we can invest in for you. These generally take the form of either mutual funds or ETFs. Each form has advantages and disadvantages. But we almost always will use an ETF for liquidity and tax efficiency reasons.
Importantly, the ETF or mutual fund is simply the wrapper — the basket that holds the underlying securities defined by the index.
~Dan Cunningham
1. Small vs large-cap performance: Stockcharts.com
2. More technical discussion if you are interested:
Debt exposure is quite different between small and large caps. Net Debt to EBITDA is 3x for small cap vs large cap. (Source: State Street 7/18/25). Floating rate debt of the Russell 2000 is more than 5x the S&P 500 (Source: Goldman Sachs 11/4/25). Constituents of the Russell 2000 had weighted average debt maturity of 4.8 years versus 8.8 for large companies as of late 2022 (Source: Boyar Research Q3 2023 letter), meaning they have to refinance sooner into higher rates, or pay off debt sooner.
One of the things you see around the New Year, and it seems to happen every year, is a group of analysts saying "This year is going to be a stock picker's market." I've never been able to figure out what this means. I think they mean that there might be a divergence in winners and losers in the coming year. But if this is the case, why not buy the index and own all the positions, because you don't want to risk picking the loser? If there is not a divergence in winners and losers, what's the point of picking anything? If they all do about the same, why not just own the index?
Picking stocks can be fun, and if you do it, I suggest you keep the amounts small and limit yourself to, say, 3 trades per year.
It's only January and I don't want to rain on the stock pickers' parade yet, because they’re probably already feeling a little grumpy with Dry January dragging on and all the online sites telling them how great they’re supposed to feel with that, but I feel compelled to. Let's look at an issue in picking stocks, specifically in a taxable account, that's not talked about a lot. That issue is private equity, and there is a lot of it in this era. Private equity folks prowl around the markets, looking for firms they can take private. Sometimes the companies they buy are in tough shape, and they need new management teams, the corporate jet fleet has to get sold, etc. But in other cases the private investors see a great company and they believe it is better than the markets appreciate.
So you and private equity agree, this firm rocks, let's ride it to the moon. Except then private equity embraces the adjective in their name, and they proceed to take the firm private. Your romance with them ends as you realize that not only do you not get your moonshot, you get a significant tax bill handed to you as you are forced to recognize your existing capital gains, giving your returns a haircut.
Ok, say you get lucky and the founder of the firm is still in control, and she listens to the "go private" pitch from private equity and says "No, actually I like being sued by endless plaintiffs' attorneys every time our stock drops a little. That's fun for me and I'm going to stay public." And the private equity guys get ushered out of the conference room dejected but they are all thinking "Wow that was pure steel" and they're all buying her shares for their personal accounts on their iPhones as they enter the elevator.
So the stock keeps running up, but the problem is all good things come to an end. Today, half of all of the companies that were in the S&P a decade ago are no longer in it (though this includes buyouts).1 Eventually the business and the stock plateau, and now, as a shareholder, you're kind of stuck. It's tough to get out of the position because of the taxable gain. But you don't really want to be in it either. Note that real estate and other asset purchases have the same problem.
Index funds are so good at saying "I told you so" that it almost gets annoying over time. But here again the index says "Guess what, using some fancy financial technology, we swapped that mediocre firm without creating a taxable gain and added in a new firm with better prospects." And then if done correctly, One Day In July can manage the rebalancing system among indexes without ever recognizing gains. This can get a bit tricky, but the objective is that both within and among the indexes, no recognized capital gains are created, even over long periods of time.
So in addition to protecting you from the "stall out problem" of an investment, the indexing strategy helps minimize taxes. Indexing should get a seat at the table, perhaps the head seat, in any tax planning strategy discussion.
~Dan Cunningham
1. Innosight Corporate Longevity Report. https://www.innosight.com/insight/creative-destruction/
"By the age of 40," author Elizabeth Gilbert once wrote, "everyone could write a memoir titled 'Not Exactly What I Had Planned.'" That pretty much sums up 2025 as an investment year. Almost from the start, the year turned into a black hole for adjectives. It twisted and turned, riding the back of a wild policy year, and with twelve days to go... generally has turned in a strong performance.
In a way, the endless information that spills forth from our screens is making investment decision-making more difficult. For example, you can say "Here is a thing I believe." You can then find something that matches that belief. The problem with the Internet is that the frictional barrier to finding "information" that backs up the belief is low. But the root problem, and this affects investors, scientists, and really all of us, is that you ask the question already edging toward the result that you want. To avoid falling prey to behavioral errors in investing, it is best to steer away from this natural tendency.
This can be difficult to do, though. For example, this year many people have thought "Wow, the world seems like it is at peak chaos." And I agree! I mean I don't think many people look back on 2025, kick their heels up with a bottle of port that they didn't quite finish off from the 2024 holidays, and think "Well, that went as planned." But who knows, really. Maybe we just see a lot more turbulence in the information age. Maybe when a saber-tooth tiger was hunting you on Christmas Eve 10,000 BC the part of the cave behind the fire pit seemed chaotic too.
One thing I do know is that you can't map what you want, at least in investing, onto a chaotic system. Markets, businesses, human behavior... it's all pretty volatile. It makes life frustrating and fun at the same time. But it won't fit a specific plan. That's just something you accept as an investor as you build tools and a strategy on top of that reality.
By being part of One Day In July, you trust all of us here with an important part of your life. We recognize that. We find that challenging and invigorating. That trust is an intangible that no contract can define, and no spreadsheet can quantify. All of us here thank you for it.
A good friend of mine who thinks he is in finance but actually is a philosopher recently told me, "There are always problems. The fun thing about the future is the problems to solve are new."
Onward to 2026.
~Dan Cunningham
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