Fed rate cut could elevate S&P 500 mid-cap stocks to top trade, strategists say

Goldilocks might be onto something.

Last week, investors were busy wondering how to make the most of the Federal Reserve’s decision to cut interest rates for the first time since 2020.

I asked several strategists which stocks would benefit the most in the future. Surprisingly, this isn’t about large- or small-cap stocks – the two deals that have dominated the headlines in recent months. Rather, mid-cap stocks that are often forgotten may be best positioned for a breakout.

“Historically, mid-caps really started to outperform when the Fed actually started lowering interest rates,” Carson Group’s Ryan Detrick told me.

Detrick predicts small- and mid-cap stocks will grow 20% over the next 12 months, significantly outperforming large-cap peers. The Russell 2000 Small-Cap Index (^RUT) is up 10% since the end of June compared to the S&P 500 Index’s (^GSPC) gain of 4.7%.

A recent analysis by Goldman Sachs found that mid-cap stocks tend to outperform large- and small-cap stocks in the 12 months after the first rate cut. As confidence in a soft landing grows, investors are increasingly willing to pursue options beyond the largest companies.

“The start of the Fed’s interest rate cut cycle is a potential source of increased demand for stocks and improved investor risk sentiment,” Goldman Sachs’ Jenny Ma wrote in a note to clients earlier this month. “In the short term, mid-cap performance relative to other segments will depend on the strength of economic growth data and the pace of the Fed’s monetary easing cycle.”

The team sees low valuations and stable economic growth as catalysts for future earnings and expects a 13% return on the S&P 400 Index (^SP400) over the next 12 months.

“It’s a sentiment-driven market rotation, based on hopes for a soft landing, benefiting the riskiest areas of the market because the backdrop of returns is on another planet,” Emily Roland, John Hancock’s co-director of investment strategy, told me.

According to Jill Carey Hall of Bank of America, mid-cap companies are the “best hedge” in the near term.

“Mid-caps have recently seen better guidance and revision trends, have outperformed small-caps on average during downturns… and serve as a hedge against smaller-than-expected Fed cuts given interest rate sensitivity/small-cap refinancing risk” – wrote Hall in a note to customers

Investors have priced in cuts of about 75 basis points before the end of the year and expect the policy rate to fall to the 3.00-3.25% range by mid-2025, exceeding the Fed’s own projections.

However, it’s important to remember that this isn’t news to Wall Street, which started the year pricing in around six rate cuts in 2024.

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

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

Citi’s Stuart Kaiser is also cautious on this deal, telling me that investors should approach the group “very cautiously.”

“Even if there is a soft landing, our view is that you will still get batches of data that look worse, and when the data looks worse, the market will trade in a hard landing, just like it did earlier in early August,” Kaiser warned. “Small companies will be the eye of the storm on this issue.”

While The Street remains skeptical of small-cap stocks, I wouldn’t rush to dismiss this group entirely. Goldman’s David Kostin wrote in a note to clients this week that a positive jobs report could further increase investor risk appetite.

“A positive jobs print could prompt some investors to exit high-priced ‘quality’ stocks into less-loved, lower-quality companies as the market would likely price in a lower risk of a significant weakening in the labor market,” Kostin wrote.

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

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