Goldilocks Might Just Be Onto Something

A Shift in Market Sentiment

Over the past week, investors have busied themselves with deciphering the implications of the Federal Reserve’s decision to lower interest rates for the first time since 2020. Traditionally, this would spur various strategies to capitalise on this economic shift. Surprisingly, it’s not the large or small caps—typically at the heart of market speculation—that stand to benefit the most. Rather, it is mid-cap stocks, frequently overlooked, that might be poised for significant gains.

The Historic Performance of Mid Caps

Historically, midcaps truly begin to outshine once the Fed starts cutting rates. According to Ryan Detrick of Carson Group, both small and mid caps could see surges of up to 20% within the next year, significantly outperforming their large-cap counterparts.

Detrick’s optimism isn’t without merit. Consider that since the end of June, the Russell 2000 (^RUT), a small-cap index, has climbed 10%. Meanwhile, the S&P 500 (^GSPC) has only seen a 4.7% rise.

Why Mid Caps Could Outperform

Recent analysis by Goldman Sachs reveals mid caps usually outperform both large and small caps in the year following an initial rate cut. With increasing confidence in a soft economic landing, investors are shifting their gaze beyond the largest companies.

Jenny Ma of Goldman Sachs remarked earlier this month, saying the onset of the Fed’s rate-cutting cycle could spark incremental equity demand and boost investor sentiment towards risk. However, she acknowledged that mid-cap performance hinges on the strength of economic growth data and the pace at which the Fed eases its policies.

The Appeal of Mid Caps during Economic Shifts

In a note to clients, Bank of America’s Jill Carey Hall called mid caps the "best hedge" for the near term. Mid caps have witnessed more favourable recent guidance and revision trends. Historically, they’ve also outmatched small caps during market downturns. These factors make mid caps a safer option against fewer-than-expected Fed cuts, given small caps’ sensitivity to interest rates and refinancing risks.

The team at Goldman Sachs sees low valuations and resilient economic growth as potential catalysts, expecting a 13% return for the S&P 400 (^SP400) index over the next 12 months.

Mid Caps as a Sentiment-Driven Market Rotation

John Hancock Investment Management’s Emily Roland posits this market rotation is driven by soft landing hopes, benefiting riskier market areas, even as the earnings scenario appears disconnected from reality. The recent inclination towards mid-cap stocks highlights a strategic shift among investors.

The Risk Factors

Nonetheless, the risk of a slower Fed rate-cutting cycle and the persistent fear of recession are critical factors behind this shift from small-cap stocks to mid caps. Smaller companies often have weaker balance sheets and are less profitable, making them more vulnerable.

Brian Jacobsen, Chief Economist at Annex Wealth Management, warned that the small-cap trade might face challenges before becoming more appealing. Slow economic growth fears could overshadow the benefits of lower borrowing costs.

Similarly, Citi’s Stuart Kaiser advised investors to approach small-cap stocks cautiously, noting that even a soft landing would still present data fluctuations, causing the market to react as it did earlier in August. Small caps, he cautioned, could become the epicentre of this volatility.

A Glimmer of Hope for Small Caps

While skepticism surrounds small-cap stocks, dismissing them entirely might be premature. David Kostin of Goldman Sachs suggested that a positive jobs report could bolster investor appetite for riskier assets. Thus, a favourable job print might lead some investors to rotate out of expensive ‘quality’ stocks, favouring less popular, lower-quality firms instead.

Conclusion

Investors have priced in approximately 75 basis points of cuts by year-end, expecting the policy rate to drop to 3.00%-3.25% by mid-2025, surpassing the Fed’s projections. This isn’t novel for Wall Street, which began the year anticipating about six interest rate cuts in 2024.

Now, as the market navigation continues, mid-cap stocks might just be the Goldilocks of the investment world—positioned not too large, not too small, but just right.

Seana Smith is an anchor at Yahoo Finance. Follow Smith on Twitter @SeanaNSmith. Have tips on deals, mergers, activist situations, or anything else? Email seanasmith@yahooinc.com.

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