Why quality looks expensive in U.S. large caps and attractive in small caps

Equity markets were strong this quarter, led by continued enthusiasm for artificial intelligence (AI) and the resumption of stimulative monetary policy. Factor performance was led by high‑risk, low‑quality, and less profitable securities (Figure 1). This pattern resembles what we observed in the final three months of last year and the second quarter of 2025 but was more extreme. The preference for low quality and risk seeking occurred across the regions we track, except for Pacific ex‑Japan. However, these trends were most significant in the U.S., especially in small caps, and are the focus of the rest of our newsletter.

Perspective on lottery‑ and option‑like payouts

Given the extreme outperformance of high‑risk and low‑quality stocks, we wanted to examine this market environment in the context of behavioral finance. 

Prospect theory holds that investors tend to overestimate the probabilities of positively skewed, lottery‑like payoffs. These tendencies underpin a preference for high‑risk stocks with high potential rewards, leading to these securities being overpriced, on average, and resulting in poor forward returns.

Three phenomena are exacerbating this effect:

• AI innovation, which is creating the opportunity for outsized gains and enticing investors to seek lottery‑like payouts;
• Market structure changes, such as growing retail participation and the popularity of options and thematic investing; and
• Lack of risk aversion, as fewer of today’s investors have experienced a sustained market correction.

The emergence of a potentially transformational technology like AI can produce an unusually wide dispersion of outcomes. Many firms will resemble the short‑lived Pets.com; only a few will become the next Amazon.com.

This breadth of possibilities increases the appeal of lottery ticket‑like narratives. As the perception of AI’s capabilities grows, the imagined jackpot grows as well, drawing in investors and driving price appreciation. The result is a reflexive loop in which rising prices reinforce conviction in the stock or theme, attracting more capital. Investors may also start treating stocks as options, where perceived fair value rises with volatility.

Importantly, because the true winners and losers from a major innovation wave may not be known for years, these lottery ticket‑like stocks tend to trade more on sentiment and narrative than on present‑day business fundamentals.

The result is greater demand for speculative, high‑volatility stocks, a scenario that reflects the factor returns from the past 12 months. 

We see signs of this speculative impulse in some of the themes that have fired investors’ imaginations. Stocks with exposure to quantum computing, cryptocurrency, space technology, the AI buildout, and AI energy demand have greatly outperformed this year, particularly in the third quarter (Figure 2).

Prospect theory suggests that long‑term investors should lean the other way. Highly speculative, lottery ticket‑like stocks tend to be overpriced, and the more exuberant investors become, the more overpriced these stocks are likely to be.

It’s tempting to chase these stocks, as some of the biggest winners have come from this group in the past. The mega‑cap internet and technology companies, for example, looked extraordinarily expensive early in their lifecycles, before the transformative nature of their products became clear. It’s also tempting to avoid these lottery tickets completely, as small shifts in sentiment, which is notoriously fickle, can translate into violent price swings and expensive valuations.

We think the best practice is to stay meaningfully underweight highly speculative stocks while diligently managing risk and respecting the possibility that, over time, some future winners may emerge from this cohort. We also favor a “basket approach,” believing that diversified portfolios are better equipped to handle this environment.

Market insight—What we’re monitoring

After significant high‑risk, low‑quality rallies in three of the last four quarters, the most common questions we’re getting from clients are how expensive risk looks and whether quality is attractive. 

Our valuation work suggests that the potential risk/reward setup in high‑quality stocks varies meaningfully with market capitalization:

• U.S. large caps: Quality remains expensive, although valuations are somewhat warranted by fundamentals and exposure to the AI theme. Investors should be cautious about overpaying for quality. We think that the market eventually will broaden, at which point quality could underperform modestly.
• U.S. small caps: Here, the story is different. Quality appears unequivocally cheap, while high‑risk stocks have become historically expensive. We believe the long‑term positioning of long quality, short risk appears highly attractive, although the ride could be bumpy at times.

What’s behind these differences in the appeal of quality and risk in U.S. small and large caps?

In small caps, lower‑quality, speculative stocks exposed to popular themes have led the way and trade at valuation premiums that are harder to justify.

Quantum computing stocks, for example, are up more than 450% since the U.S. election (Figure 2), even though many in the field believe that this emerging technology is still five‑plus years away. The pure‑play leaders in quantum computing could be unprofitable for some time. Similarly, companies involved with space technology have rallied significantly over the past year despite unproven business models and regulatory hurdles.

We are confident in our views on quality and risk. At the same time, it’s important to remain humble in our certainty about the future at a time when massive technological change can widen the dispersion of outcomes.

An exceptional run for risk vs. quality

In both the large‑cap Russell 1000 Index and the small‑cap Russell 2000 Index, high‑risk stocks’ returns outstripped their low‑risk counterparts by a wide margin over the past 12 months. Relatedly, high‑quality stocks underperformed low quality (Figure 3).

Going back to the end of 1990, this 12‑month risk rally was an 87th percentile outcome for U.S. large caps and a 90th percentile scenario for U.S. small caps.¹

Given the magnitude of the moves in high‑risk and low‑quality U.S. large and small caps, the obvious questions are whether risk has become too expensive, and whether quality appears attractive.

“Going back to the end of 1990, this 12-month risk rally was an 87th percentile outcome for U.S. large caps and a 90th percentile scenario for U.S. small caps.¹”

Valuation of quality and risk in U.S. large caps

Last quarter we wrote about high quality appearing expensive within U.S. large cap, a dynamic we suggested might resolve itself through a market broadening. 

As shown in Figure 1, quality significantly underperformed over the subsequent three months. This partial correction somewhat moderated the expensiveness of high‑quality U.S. large caps (Figure 4).

Quality remains somewhat expensive in U.S. large caps, but it may be warranted because profitability and other fundamentals are stronger than ever. Also, valuations for high‑quality U.S. large caps have trended higher over the past decade and a half; within this context, the cohort may even be somewhat fairly valued.

Valuation of quality and risk in U.S. small caps

In contrast to U.S. large caps, we see a dislocation emerging in U.S. small caps, particularly in the growth segment (Figure 5A and Figure 5B).

• Russell 2000 Index: Our analysis indicates that quality is 1 standard deviation cheap, while risk is 1 standard deviation expensive.
• Russell 2000 Growth Index: Quality is 2 standard deviations cheap, and risk is the most expensive in our data history.

Why are our conclusions so different for U.S. small and U.S. large caps?

1. The starting points were different. Prior to the fourth quarter of 2024, quality had been historically expensive in U.S. large caps, due in part to their historically strong fundamentals and the impact of passive investing. In contrast, quality has been relatively cheap in the small‑cap segment for a few years.
2. Quality and risk have a different relationship. Intuitively, risk and quality tend to be highly negatively correlated in small‑cap stocks. However, in the large‑cap universe, many of the high‑quality growth stocks have also tended to exhibit higher volatility. As shown in Figure 6, our proprietary metric classified a much larger percentage of high‑risk stocks in the large‑cap segment as high‑quality, durable growers² than in small caps.

Given the different starting points and different composition of risk, it makes sense that valuations for quality and risk would become more dislocated in U.S. small caps than in the U.S. large‑cap segment.

What our analysis means for investors

In U.S. large cap, high‑quality stocks still appear expensive. Given the strong fundamentals in this cohort, we think the mispricing is less significant than the data suggest. Still, we believe it makes sense to consider tilting away from expensive high‑quality large caps in favor of a broadening positioning.

In U.S. small cap, the data are unequivocal. Quality looks cheap, and risk is expensive—historically so in small‑cap growth. The narrative fits the data, as many of the lottery ticket‑like stocks offering exposure to quantum computing, space technology, and other popular themes reside in the small‑cap growth universe. For long‑term investors, this scenario suggests a strong tilt toward quality and away from risk, which is the strategic positioning for many small‑cap managers.

Still, it’s important to remain humble and consider countervailing evidence and arguments. Dislocated valuations do not necessarily mean that a correction is imminent. We must respect that today’s dynamics could allow these imbalances to persist in the near term. 

Here are three considerations for small-cap investors:

• In a world of rapid technological change, some of the lottery ticket‑like stocks will likely pay off even if the group appears overvalued in aggregate. We have previously researched the historical outcomes from investing in high expectation stocks—companies where valuations and consensus estimates implied a greater degree of optimism around future sales and earnings. Our analysis found that these stocks, on average, underperformed over longer time frames. However, history also shows that some of the biggest winners have come from this universe. Small‑cap portfolio managers need to be thoughtful about how they manage the potential for outsized risks and opportunities in these lottery ticket‑like stocks.
• Stocks with high short interest have become much more volatile than they were before the pandemic (Figure 7). This appears to be a structural shift, as retail investors have become more active in heavily shorted “meme” stocks that are often highlighted on social media sites. Accordingly, the volatility of low‑quality stocks will likely remain elevated, and what appears to be a 2‑standard deviation dislocation relative to history may not be that extreme in this new world.
• Strategic retail buying of heavily shorted stocks is creating a new factor risk profile. Prior to the coronavirus pandemic, highly shorted small‑ to mid‑cap stocks generally exhibited similar characteristics to the Russell 2500 Index. This dynamic has changed significantly, with highly shorted stocks exhibiting higher beta (Figure 8) and trading at more expensive valuations compared with the broader small‑ to mid‑cap universe (Figure 9). To the extent that retail involvement makes heavily shorted stocks more volatile, higher‑beta and expensive stocks may also become riskier. That said, we strongly believe the caricature of the retail investor as “uninformed” is not correct. Some retail investors now employ sophisticated strategies to target highly shorted stocks with low liquidity and self‑organize using social media. We have come to view retail investing as a sophisticated “risk factor” that we need to respect.

Bottom line: Although we favor tilting toward quality and away from risk in small caps, we expect continued volatility along the way. We favor an approach that manages the risk in these high‑volatility thematic stocks at three levels: stock‑specific risk, theme‑level risk, and aggregate exposure to thematic risk within the portfolio.

Conclusion

Many clients have asked how quality and risk are priced today after an extremely strong 12 months for high‑risk and low‑quality stocks. Our data suggest different answers in U.S. large and small cap.

Large caps started from a position of high quality being historically expensive; even after recent market movements, we still think quality is somewhat expensive. We recognize the historically strong fundamentals of these companies and see the potential for quality to underperform slightly if the market were to broaden.

In the small‑cap space, risk looks expensive—historically so in small‑cap growth—and quality looks cheap. These dislocations create a larger‑than‑usual opportunity for long‑term investors in quality small caps. But given structural changes in the market, we expect the quality/risk trade‑off to remain volatile—investors will need to be attentive to this risk and manage accordingly. We also believe that taking a “basket approach” within diversified portfolios is better suited for this environment than concentrated portfolios.

 

Appendix

Factors are our internally constructed metrics, defined as follows:

Valuation: Proprietary composite of valuation metrics based on earnings, sales, book value, and dividends. Specific value factor weighting may vary by region and sector.

Growth: Proprietary composite of growth metrics based on historical and forward‑looking earnings and sales growth. Factor selection and weighting vary by region and industry.

Momentum: Proprietary measure of medium‑term price momentum.

Quality: Proprietary measure of quality based on fundamental and stock price stability; balance sheet strength; and measures of profitability, capital usage, and earnings quality.

Profitability: Return on equity.

Risk: In this paper, risk is the standard deviation of trailing 12‑month returns. High‑risk stocks exhibit higher standard deviations, indicating a wider degree of variation or dispersion in their historical return.

Size: Market capitalization (positive return means larger stocks outperform smaller stocks).

Durable growth: Our durable growth factor is a proprietary blend of 5 fundamental metrics related to growth, earnings stability, profitability, and balance sheet.

Short interest: We define short interest with the Markit Short Interest factor. Short interest is calculated as the total share of stock on loan divided by free float shares.

Quintile spread: Also referred to as long‑short returns, a quintile spread is calculated by sorting securities based on a specific characteristic or factor criterion, dividing them into five groups (or quintiles), equal‑weighting the securities within each quintile, and then subtracting the bottom‑quintile returns (lowest 20%) from the top‑quintile returns (highest 20%).

Factors and indices cannot be invested in directly and are shown for illustrative purposes only. They do not reflect performance of actual investments nor do they reflect the reduction of fees associated with an actual investment, such as trading costs and management fees.

Other definitions:
Z-score: The quantity of (current score minus the average of previous periods) divided by the standard deviation of previous periods. In this paper, we apply this calculation to our proprietary valuation metric to indicate whether a group of stocks looks expensive or cheap.

Beta: Beta measures the volatility, or risk, of a stock or portfolio relative to the risk of the broad market.

Earnings yield: Earnings yield is a valuation metric that is the inverse of the price‑to‑earnings ratio. It is calculated by dividing a company’s earnings per share by its stock price.

For definitions of certain financial terms, visit https://www.troweprice.com/en/us/glossary.

All investments are subject to market risk, including the possible loss of principal. Past favorable company characteristics may not persist into the future.

Risks: Growth stocks are subject to the volatility inherent in common stock investing, and their share price may fluctuate more than that of income‑oriented stocks. The value approach to investing carries the risk that the market will not recognize a security’s intrinsic value for a long time or that a stock judged to be undervalued may actually be appropriately priced. Small‑cap stocks have generally been more volatile in price than large‑cap stocks. Investing in technology stocks entails specific risks, including the potential for wide variations in performance and usually wide price swings, up and down. Technology companies can be affected by, among other things, intense competition, government regulation, earnings disappointments, dependency on patent protection and rapid obsolescence of products and services due to technological innovations or changing consumer preferences. Investing in cryptocurrency carries a substantial level of risk. It is a nascent asset class that remains largely unregulated, and it is not suitable for all investors.

Methodology Disclosure regarding the T. Rowe Price thematic baskets:

We began actively creating and monitoring thematic baskets in 2024 for research and informational purposes. For each theme, the constituents represent publicly traded U.S. stocks that T. Rowe Price has categorized as companies involved in the relevant theme. All the results shown in the newsletter use the current thematic baskets. Each basket’s constituents are held constant through time for the date ranges shown, and we are showing capitalization-weighted results.