S&P 500 Outshines Small Caps Again as Treasury Liquidity Squeeze Saps Risk Appetite

The S&P 500’s dominance over small caps has become so routine that it’s almost boring—unless you’re the one holding the bag on underperforming Russell 2000 names. January’s market action hammered that point home with the subtlety of a margin call. While the S&P 500’s largest constituents held their ground, small caps continued their multi-year streak of irrelevance, failing to generate alpha and leaving portfolio managers wondering why they still bother with diversification.

Seeking Alpha didn’t mince words: “Bigger is still better. Small caps are useless, for now.” The data backs it up. Over the past five years, the S&P 500 has trounced small caps by more than 30%, and the gap only widened as 2026 kicked off. The real culprit? Liquidity, or rather, the lack of it. Treasury settlements have yanked $64.3 billion out of the system in recent days, according to Seeking Alpha, and the rising Treasury General Account (TGA) is draining the lifeblood from risk assets. When liquidity tightens, the market’s appetite for speculative small caps evaporates faster than a meme stock rally in a bear market.

The macro backdrop is hardly helping. With the Federal Reserve still in hawkish mode and inflation proving sticky, investors are crowding into the safety of mega-cap tech and dividend aristocrats. Even the promise of stable income from top Wall Street dividend picks—highlighted by CNBC—can’t tempt money managers back into the small cap pool. The message is clear: size matters, and right now, bigger is the only game in town.

This is not just a story about flows. It’s about survival. In a market where every basis point of liquidity counts, the S&P 500’s scale and depth offer a safe harbor. Small caps, by contrast, are left exposed to every tremor in the funding markets. As Treasury issuance ramps up and the TGA climbs, the risk-off trade is in full effect. The result? Small caps keep sinking, and the S&P 500 keeps pulling away.

Strykr Watch

Technically, the S&P 500 is consolidating near recent highs, with resistance at all-time peak levels. The index’s breadth remains narrow, with leadership concentrated in a handful of mega-caps. Small caps, meanwhile, are stuck below key moving averages, with no sign of a breakout. Watch for a break above resistance to signal renewed risk appetite, but don’t expect miracles unless liquidity conditions improve.

The divergence is stark. The S&P 500’s relative strength index (RSI) is hovering in neutral territory, while small caps are oversold but unloved. The next catalyst will likely come from the bond market. If Treasury issuance continues to drain liquidity, expect the status quo to persist. If, however, the Fed signals a dovish pivot or the TGA drawdown reverses, small caps could finally catch a bid.

The risk here is that liquidity remains tight, and any shock—be it geopolitical or macro—could send small caps even lower. For now, the path of least resistance is higher for the S&P 500 and sideways (at best) for small caps.

Opportunities exist for those willing to play the spread. Long S&P 500, short small caps remains a high-conviction trade. For the more adventurous, look for tactical entries on dividend stocks that can weather the liquidity storm. But don’t chase small caps until the tape tells you otherwise.

Strykr Take

The S&P 500’s outperformance is not a fluke—it’s a function of liquidity, scale, and market psychology. Small caps are dead money until proven otherwise. Stick with what’s working, manage your risk, and don’t overthink the rotation narrative. When the liquidity tide turns, you’ll know. Until then, size is your friend.