Wall Street is ending 2026 on a generally positive note, with the benchmark S&amp;P 500 Index set to finish the year at a 17% return rate. All eyes are now on technology titans like Nvidia, Microsoft, Alphabet, and Amazon, which have dominated the headlines in 2025, and for good reason.



By and large, big technology stocks have outperformed the broad U.S. market in 2025, fueled by strong earnings and momentum in key areas like semiconductors and AI-related companies, with the Nasdaq-100 Index up 19.6% year to date and the S&amp;P 500 Information Technology Sector up 27% for the year.



Yet angst is rising over expanding valuations heading into 2026, especially in the information technology sector, which trades at a 26.6 forward P/E, one of the highest among S&amp;P 500 sectors, according to FactSet.



Concerns about the big AI stocks being overvalued is driving Wall Street to look into the next wave of nimble, small-cap AI plays for 2026.



Overvaluation is not only a concern for the Magnificent Seven stocks. The whole Nasdaq-100, a historically tech-heavy benchmark, is trading at a very high valuation relative to recent norms. One daily estimate pegs the Nasdaq-100’s P/E at approximately 34.15 as of Christmas Eve – much, much higher than its typical range over the past five years.



Make no mistake: AI capex is the fundamental fuel behind rising technology-sector premiums, and it’s massive. Goldman Sachs notes hyperscalers spent $106 billion in capex in Q3, up 75% year over year, with growth expected to slow but remain elevated into 2026, according to Goldman Sachs.



What does that mean for the “overvalued tech” scenario? For starters, AI keeps multiples elevated as long as market investors believe two things.



First, the spending wave is durable, and next is a focus on the monetization curve, which should show up in earnings soon enough. The risk is that AI demand stays real, but profits don’t scale fast enough (pricing pressure, competition, or capex/margin drag), and then “premium growth” quickly turns into “priced for perfection.” 



Analysts have already flagged how the AI spending spree is driving record tech debt issuance and straining some credit metrics.



<h2>Smaller AI Stocks May Be the Play In This Overvalued Market Environment</h2>



With investors worried about pricier AI stock plays, they may want to pivot into smaller artificial intelligence stocks, which are increasingly on the radar of Wall Street’s market mavens as 2026 arrives.



“The mega-caps like NVIDIA and Microsoft are great for stable returns, but the math on a 10-bagger just doesn’t work when you’re already at a $3 trillion market cap,” said Jenna Lofton, a market analyst at StockHitter.com. “Smaller AI companies (under $50 billion) can realistically grow from $10 billion to $100 billion if they execute well. That’s where you get asymmetric upside.”



These smaller players know their place and aren’t competing with NVIDIA on chips. “They’re solving specific infrastructure problems like networking (Arista), monitoring (Datadog), or enterprise AI deployment (Palantir),” Lofton said. “Once their products are integrated into a company’s AI stack, the switching costs are massive.”



What smaller AI stocks make good sense right now? Try these future high-climbers on for size.



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Arista Networks (NYSE:ANET). This Santa Clara, Calif.-based networking company makes the networking gear that connects AI data centers.



“AI-driven revenue is now 55% of their business, up from 35% last year,” Lofton said. “When hyperscalers build data centers, they need Arista’s 400G and 800G switches.”



JP Morgan lists Arista as one of its top stocks for 2025, noting the company has a durable moat thanks to rising demand for cloud and AI networking services. The stock is up 18% in 2025, but has plenty of room to grow, the investment bank noted.



Innodata (NASDAQ:INOD). This stock highlights are attached to the blue-collar vibe often attached to AI stocks. “While everyone is betting on who will build the best AI model, Innodata is the company cleaning and engineering the data that feeds those models,” said David Jaffee, a former investment banker and the founder of BestStockStrategy.com. “They are the ‘picks and shovels’ of the AI gold rush.” There’s more. Unlike 90% of small-cap AI stocks that are burning cash, Innodata is profitable, debt-free, and generating positive cash flow. Plus, Innodata has secured contracts with major “Big Tech” firms to provide high-quality data annotation and reinforcement learning. “In 2025, as the industry shifts from ‘training’ to ‘accuracy,’ Innodata’s services are becoming non-negotiable for enterprise AI,” Jaffee said. It is a legitimate business, not a “vaporware promise.”



Recursion Pharmaceuticals (NASDAQ:RXRX). This stock aligns with investors focused on longevity and biotech, as Recursion isn’t just focused on doing biology; it’s also digitizing it.



“If we boil it all down, Recursion Pharmaceuticals is using AI to create a map over the biology layer, almost like a software code,” said James Richman, CEO of OTLEN, a health-tech company. “This allows them to identify drug candidates way faster than humanly possible.”



Tapping into smaller AI stocks requires a specific skill set, and RXRX certainly fits the bill. “This stock is a classic example of how to use pattern recognition to attack and solve all of those inefficiencies of the FDA approval process,” Richman added.



<h2>Know the Risks With Small-Cap AI Stocks</h2>



The good news is that smaller AI stocks offer “pure play” exposure that you simply cannot get from the tech-heavy Magnificent Seven stocks.



“When you buy Microsoft or Google, your AI exposure is diluted by their massive legacy businesses,” said David Jaffee, a former investment banker and the founder of BestStockStrategy.com. “A 100% gain in their AI division might only move the total stock price by 5%.” 



However, small-cap AI stocks offer asymmetric leverage. “They’re agile, unburdened by bureaucracy, and can pivot faster to fill niche market gaps,” Jaffee notes. “The ‘why’ is simple: investors are looking for the next Nvidia before it becomes Nvidia.”



That’s where potentially significant risk comes into play. “The risk smaller stocks bring is high-stakes; you’re either buying a lottery ticket or a future giant,” Jaffee noted. “There’s rarely a middle ground.”



Consequently, investors must also accept the extreme volatility that comes with smaller AI stocks.



“Even small caps that eventually become successful can lose 70% of their value during a bull market correction,” Jaffee added. “This often shakes out retail investors right before the recovery. Larger capitalization stocks are generally less volatile and much easier to hold psychologically during market downturns.”

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Wall Street ends 2026 positively with tech stocks dominating, but concerns over valuations drive interest in smaller AI stocks. Analysts suggest investing in smaller AI companies like Arista Networks and Innodata for potential growth, as they offer asymmetric upside compared to mega-caps. These companies focus on specific infrastructure problems and have durable moats, making them attractive in an overvalued market environment.

3 Small AI Plays to Buy for 2026