Goldilocks may be on to something.
Over the past week, investors have been busy figuring out the best way to act on the Federal Reserve’s decision to cut interest rates for the first time since 2020.
I asked a number of strategists which stocks will benefit the most in the future. Surprisingly, they are not large or small caps – the two trades that have dominated market news in recent months. On the contrary, mid-cap stocks, an often overlooked trade, may be best positioned for a breakout.
“Historically, midcaps really start to outperform once the Fed actually starts cutting rates,” Ryan Detrick of Carson Group told me.
Detrick expects small and mid-cap stocks to rise 20% over the next 12 months, easily outperforming their large-cap peers. The Russell 2000 (^RUT) – the small-cap index – is up 10% since the end of June, compared to the S&P 500’s (^GSPC) 4.7% gain.
A recent analysis from Goldman Sachs shows that mid-cap stocks tend to outperform large- and small-cap stocks in the 12 months following the first rate cut. As confidence in a soft landing grows, investors are becoming increasingly comfortable looking for options outside the largest companies.
“The start of the Fed rate cutting cycle is a potential source of rising equity demand and a boost to investor risk sentiment,” Jenny Ma of Goldman Sachs wrote in a note to clients earlier this month. “In the near term, the performance of midcaps relative to other segments will depend on the strength of economic growth rates and the pace of the Fed’s easing cycle.”
The team sees low valuations and resilient economic growth as catalysts for future gains and expects a 13% return for the S&P 400 (^SP400) index over the next twelve months.
“This is a sentiment-driven market rotation based on the hope of a soft landing, benefiting the riskiest parts of the market as the earnings backdrop plays out on another planet,” Emily Roland, co-chief investment strategist at John Hancock Investment Management, told me .
According to Jill Carey Hall of Bank of America, midcaps are the “best hedge” for the short term.
“Mid caps have seen better guidance and repricing trends recently, have outperformed small caps on average in recessionary regimes… and serve as a hedge against less than expected Fed cuts given the interest rate sensitivity/refinancing risks of small caps,” Hall wrote in a note for customers
Investors have priced in a cut of roughly 75 basis points before year-end and see the policy rate falling to the 3.00% to 3.25% range by mid-2025, exceeding the Fed’s own projections.
Keep in mind, though, that this isn’t new for Wall Street, which this year started pricing in roughly six rate cuts by 2024.
The risk of a slower Fed rate-cutting cycle and lingering recession fears are key factors behind the recent shift in preference from small-cap stocks to mid-cap stocks, as small caps tend to have weaker balance sheets and are less profitable.
Brian Jacobsen, chief economist at Annex Wealth Management, told me that small-cap trading “could become challenging before it becomes more attractive,” and that “fears of slower growth likely outweigh the benefits of lower borrowing costs.”
Citi’s Stuart Kaiser is also cautious on the trade, saying investors should approach the group ‘very cautiously’.
“Even if you get a soft landing, we believe you’re still going to get batches of data that look worse than that, and if the data looks worse, the market will have a hard landing like before. early August,” Kaiser warned. “Small caps will be the eye of the storm in that respect.”
While the Street remains skeptical of small caps, I wouldn’t be hasty in dismissing the group entirely. Goldman’s David Kostin wrote in a note to clients this week that a positive jobs report could further boost investor risk appetite.
“Positive job pressures could prompt some investors to swap expensive ‘quality’ stocks for less favored, lower-quality companies, as the market would likely see a lower probability of a substantial labor market weakening,” Kostin wrote.
Seana Smith is an anchor at Yahoo Finance. Follow Smit on Twitter @SeanaNSsmith. Tips about deals, mergers, activist situations or something else? Email seanasmith@yahooinc.com.
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