From Small Cap to Mid Cap Stocks, Analysts are Bracing for Optimism Across the Market

Market strategists had predicted that a substantial rate cut would invigorate small-cap stocks, which have lagged behind their large-cap peers for much of the past year.

James St. Aubin, chief investment officer at Ocean Park Asset Management, noted, “If you had been a little bit cautious about the outlook for small caps and midcaps because of the economy, you might feel that is one hurdle that has been taken off your list of worries.”

The anticipation of a rally in small-cap stocks is finally materializing. Historically, small caps tend to outperform larger stocks in the months following significant rate cuts. Jill Carey Hall, head of U.S. small and mid-cap strategy at Bank of America, pointed out that small-caps typically outperform large-caps by about one percentage point in the six months after a 50 basis point cut. This trend is bolstered by the fact that approximately 40% of the debt held by non-financial Russell 2000 companies is at floating rates, meaning lower interest rates directly enhance their profitability.

Lower rates generally give small businesses in the Russell 2000 index a bigger earnings boost than they do for a large corporation. Nonfinancial Russell 2000 companies owe about 40% of their debt in floating rate. In other words, when the fed-funds rate declines, so do the interest rates they pay on their debt. Small businesses would benefit financially from that since their interest costs will decrease. Most of the debt in the S&P 500 is fixed.

As investor confidence in earnings growth rises, analysts may revise their earnings estimates higher. However, Hall cautioned that for the Russell 2000 rally to extend beyond a short-term surge, a meaningful improvement in the economic environment is critical. “We still believe improvement in the fundamental backdrop for small-caps is necessary for leadership to resume,” she explained.

While small-cap stocks are gaining traction, Goldman Sachs analysts are particularly bullish on mid-cap stocks, citing their favorable valuations and historical outperformance. In a recent note, the firm highlighted mid-cap stocks exhibit strong quality and growth characteristics, trading at attractive valuations compared to their historical averages. These mid-cap companies are projected to experience faster earnings per share (EPS) growth and have better financial stability compared to small-cap stocks.

According to a Goldman Sachs note, nearly all S&P 400 stocks are generating positive net income, with only 9% of them being unprofitable. This contrasts sharply with the Russell 2000, where over 35% of companies report negative trailing 12-month net income.

Strategist Jenny Ma emphasized that “mid-cap earnings have historically grown at a faster rate than large-cap profits.” With low valuations and projections for ongoing economic expansion, Goldman Sachs anticipates a 13% return for the S&P 400 mid-cap index over the next year, a figure that aligns with historical performance trends.

Furthermore, during the year that follows the initial rate reduction in an easing cycle by the Federal Reserve, mid-cap stocks have generally performed better than large-cap and small-cap stocks.

"Today's low valuations and our economists' forecast for continued economic expansion imply a 13% return for the S&P 400 mid-cap index (SP400) over the next 12 months," added Ma. "This return would rank in the 50th percentile of 12-month returns since 1995."

Despite the prevailing optimism among small and mid-cap stocks, the broader economic outlook remains a pivotal factor in determining market performance. Federal Reserve Chair Jerome Powell reassured investors that the risk of an economic downturn is not “elevated,” highlighting robust growth rates and a solid labor market.

"I don’t see anything in the economy right now that suggests that the likelihood of a recession, sorry, of a downturn, is elevated,” he said.

However, concerns linger regarding the potential for recession, particularly due to the unexpected 50 bps rate cut. If the Fed is planning to fast and drastically lower its policy rate, it would indicate a panicky approach that reflects both anxiety and a desire to combat the recession that the Fed was a major contributor to by raising interest rates in the past in excess and in a way that reversed the curve.

Historical data suggests that the market tends to decline during recessionary periods following initial rate cuts. Any bull assumption for small-cap stocks could not thrive in this circumstance. The market median tends to go up when the economy successfully dodges a recession, according to Goldman Sachs' research.

Keith Lerner, co-chief investment officer at Truist Advisory Services, warned that “if the economy is falling into recession, the rate cuts aren’t enough of a support to offset the move down in corporate profits.” As investors weigh the implications of the Fed's actions and the economic landscape, the relationship between economic indicators and market sentiment will be critical. If the economy remains stable, the bullish outlook for small and mid-cap stocks could continue to gain momentum, reshaping the investment landscape in the months ahead.