Small caps cheapest after record first-half rally

Morningstar’s Q3 2026 outlook shows small-cap stocks remain the cheapest segment of the U.S. market despite a record first-half rally. The firm’s composite valuation model, covering more than 700 U.S. stocks as of June 30, places the overall market at a price-to-fair-value ratio of 0.92, about an 8% discount.

Morningstar reports small-core trading at 0.79 and small-value at 0.85 price-to-fair-value. The firm recommends keeping an overweight position in small-caps because those segments sit below the broader market’s reading.

The research house updated its style guidance for Q3 2026. Earlier in the year Morningstar favored a barbell approach that increased exposure to growth and value while trimming core holdings. With valuations across style groups more even, the firm now favors equal weighting among value, core and growth.

Two exchange-traded funds illustrate different ways to access these exposures. The T. Rowe Price U.S. Equity Research ETF (TSPA) uses analyst research to overweight stocks viewed favorably relative to S&P 500 weights. Since launching in 2021, TSPA has gathered about $4.12 billion in assets and posted a roughly 10.2% year-to-date return.

The T. Rowe Price Small-Mid Cap ETF (TMSL) builds a portfolio of roughly 240 to 270 small- and mid-cap names selected for improving earnings trends, attractive prices and solid free cash flow rather than index tracking. TMSL launched in 2023, has about $2.69 billion in assets and has returned about 18.6% year to date.

Sector-level valuations are uneven. Communications stocks trade about 20% below Morningstar’s fair value estimates, with Meta Platforms roughly 34% below the firm’s fair value. Technology looks inexpensive on Morningstar’s measures overall, but the firm expresses caution on memory-chip manufacturers and networking hardware tied to AI data-center buildouts and prefers software companies.

Industrials trade about 14% above fair value, driven by firms supplying data-center construction and electrical equipment. Defense contractors such as Lockheed Martin and Northrop Grumman moved back into higher-rated territory after correcting from overvalued levels in March.

Morningstar noted that the single market reading masks wide valuation differences across company sizes and sectors and advised rebalancing style weights while keeping small-caps overweight to target cheaper segments or use active research to tilt portfolios.