Stocks in This Corner of the Market Could Surge After the Fed Cuts Rates

An often-overlooked segment of the stock market is positioned for significant gains following an expected interest rate cut by the Federal Reserve, according to stock-market strategists at Goldman Sachs. The team at Goldman anticipates that mid-cap stocks will outperform both large- and small-cap stocks after the Fed starts lowering interest rates, which senior Fed officials have hinted could happen as soon as next week.

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Historically, mid-cap stocks have shown stronger performance than their larger and smaller counterparts in the 12 months following the Fed’s initial rate cut during an easing cycle. This insight was shared by the Goldman team in a note to clients that was later circulated by MarketWatch.

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In recent months, small-cap stocks have drawn more attention from investors. They were the primary beneficiaries of a market rotation in July, which briefly shook up the stock market. However, much of those gains have since been reversed, as small caps gave back much of the ground they gained during that period.

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While some analysts believe small-cap stocks could surge again once interest rates begin to decline, the Goldman team makes a case for mid-cap stocks being the better investment. They argue that mid-cap companies tend to have stronger balance sheets and more consistent profitability, which could provide an edge over small caps in a lower interest rate environment. In addition, the relatively attractive valuations of mid-cap stocks could give them extra momentum in the market rally that might follow a Fed rate cut.

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The MidCap S&P 400 index, which tracks mid-cap stocks, is currently valued at approximately 15 times projected earnings over the next 12 months. This figure places the index near the lower end of its historical valuation range, as noted by the Goldman team. By comparison, the S&P 500, which tracks large-cap stocks, trades at a much higher 21 times forward earnings, suggesting mid-caps are priced more attractively at this point.

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Furthermore, the Goldman team highlighted the profitability of mid-cap stocks. Over the past year, more than 90% of companies within the MidCap S&P 400 index reported positive earnings. In contrast, only about 60% of the stocks in the small-cap Russell 2000 index have been profitable over the same period, indicating mid-caps are in a stronger financial position overall.

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Despite their stronger profitability and attractive valuations, mid-cap stocks have not gained as much attention as large-caps, and both mid- and small-cap stocks have lagged behind the S&P 500 so far in 2024. As of Wednesday’s close, the S&P 400 was up by 6.4% year-to-date, while the Russell 2000 had increased by just 3.8%, according to data from FactSet. In comparison, the S&P 500 has posted a much stronger gain of 16.4% during the same period.

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The underperformance of mid- and small-cap stocks relative to large-caps is notable, but the Goldman team remains optimistic that mid-caps will take the lead once borrowing costs begin to decline. Lower interest rates can ease financial pressure on companies, and mid-cap companies, with their generally stable financial profiles, may be better equipped to benefit from this environment than their smaller peers. Their combination of more predictable earnings and lower valuations sets them up as potentially strong performers in a post-Fed rate cut rally.

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The discussion around small caps has often centered on their potential to make big gains when conditions are right, especially in times of economic recovery. These companies, by nature, can experience higher volatility but can also provide greater upside when the economy rebounds. However, the Goldman strategists caution that while small caps could see a boost from lower borrowing costs, their weaker balance sheets and higher proportion of unprofitable firms make them a riskier bet compared to mid-caps.

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Overall, Goldman Sachs believes that mid-cap stocks represent a compelling opportunity for investors in the months ahead, especially given the likelihood of a Fed rate cut and the favorable conditions it could create for the sector. Investors looking for strong returns may want to focus on mid-cap stocks as a way to capitalize on the benefits of an easier monetary policy, supported by stronger financials and lower valuations.

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In summary, the strategists suggest that while small caps might get a lift from rate cuts, mid-caps are likely to be the better bet, given their stronger financials and more consistent profitability. As borrowing costs come down, mid-cap stocks may be in a prime position to outperform both small and large caps, making them a key area for investors to consider as the Fed shifts its monetary policy.

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