Fed rate cut could catapult mid-cap stocks above S&P 500 as top trade, strategists say

Goldilocks might be on to something.

Over the past week, investors have been busy figuring out how best to play the Federal Reserve’s decision to cut interest rates for the first time in 2020.

We asked a number of strategists which stocks will benefit the most going forward. Surprisingly, it’s not about large caps or small caps – the two trades that have dominated market headlines in recent months. Rather, mid-cap stocks, an often-forgotten trade, may be best positioned for a breakout.

“Historically, mid-caps start to really outperform once the Fed actually starts cutting rates,” Ryan Detrick of the Carson Group told me.

Detrick sees small- and mid-caps rising as much as 20% over the next 12 months, far outperforming large-caps. The Russell 2000 (^RUT) — the small-cap index — is up 10% since the end of June, compared with the S&P 500’s (^GSPC) gain of 4.7%.

A recent analysis by Goldman Sachs found that mid-caps typically outperform large- and small-cap stocks in the 12 months after the first rate cut. As confidence for a soft landing grows, investors are becoming more comfortable looking for options outside of the biggest companies.

“The start of the Fed’s rate cut cycle is a potential source of incremental demand for stocks and boosting investor risk sentiment,” Goldman Sachs’ Jenny Ma wrote in a note to clients earlier this month. “In the near term, mid-cap performance relative to other segments will depend on the strength of economic growth data 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) over the next 12 months.

“This is a sentiment-driven market rotation, based on hopes of a soft landing, that benefits the riskiest areas of the market because the backdrop of gains is on another planet,” Emily Roland, co-chief investment strategist, told me John Hancock.

Mid cap is the “best hedge” for the short term, according to Bank of America’s Jill Carey Hall.

“Mid-caps have seen better recent guidance and revision trends, outperformed small caps on average in recessionary regimes … and serve as a hedge against less-than-expected Fed tapering given rate sensitivity /small-cap refinancing risk,” Hall wrote in a note to clients

Investors have priced in about 75 basis points of cuts before the end of the year and see the policy rate falling to a range of 3.00% to 3.25% by mid-2025, beating Fed forecasts.

Remember, though, this isn’t new for Wall Street, which started the year pricing in about six rate cuts for 2024.

The story continues

The risk of a slower Fed rate cut cycle and lingering recession fears are key factors behind the recent shift from favoring small-caps to mid-caps, as small-caps tend to have weaker balance sheets and are less profitable.

Annex Wealth Management Chief Economist Brian Jacobsen told me the small-cap deal may “become challenging before it becomes more compelling” and “the fear of slower growth will likely outweigh the benefits of lower borrowing costs “.

Citi’s Stuart Kaiser is also cautious about the deals, telling me investors should approach the group “very carefully.”

“Even if you get a soft landing, our view is that you’re still going to get lots of data that look worse than that, and when the data looks worse than that, the market will trade a hard landing, as it did- a. in early August,” Kaiser warned. “Small caps will be the eye of the storm in this one.”

While The Street remains skeptical of small caps, I wouldn’t be too quick to give up on the group entirely. Goldman’s David Kostin wrote in a note to clients this week that a positive jobs report could further increase investors’ appetite for risk.

“A positive jobs print could prompt some investors to rotate out of expensive ‘quality’ stocks into less-loved, lower-quality firms, as the market would likely have less chance of substantial labor market weakness” , Kostin wrote.

Sean Smith is an anchor at Yahoo Finance. Follow Smith on Twitter @SeanaNSmith. Advice on deals, mergers, activist situations or anything else? Email [email protected].

Click here for an in-depth analysis of the latest stock market news and events in changing stock prices

Read the latest financial and business news from Yahoo Finance