Investors should add to small- and mid-cap stocks because of valuations, Fed’s outlook – analyst

The valuation backdrop for small-caps and mid-caps continue to look compelling for investors looking to add exposure, said Brian G. Belski, chief investment strategist at BMO Capital Markets, in a note.

Small caps (SP600) are still trading at a discount relative to their 20-year average, while mid-caps (SP400) trade only at a slight premium, according to BMO Capital Markets data. The S&P 500 (SP500), on the other hand, trades at a significant premium relative to their 20-year average.

In addition, when looking at history, small caps (SP600) have benefited once the Federal Reserve began lowering rates.

Both the S&P 600 (SP600) and S&P 400 (SP400) have averaged double-digit gains in the one-year following initial rate cuts by the Fed since 1995, at 12.8% and 10.7%, respectively, said Belski. The S&P 500 (SP500) has averaged 6.7%.

Then, average returns go over 20% for both mid caps and small caps when these rate cuts happened in economic growth, avoiding a recession.

However, currently relative performance for both cap groups is in “deeply oversold levels,” after delivering one of their best monthly performances in July. But, “from our perspective, it is only a matter of time before these trends reverse if history is any sort of guide,” he said.

This weakness has typically been followed by fast rebounds over the past 30 years, with an average outperformance of 3.1% for small-caps and 3.9% for mid-caps for all monthly rolling one-year periods.

Also, blended growth rates for small and mid-caps accelerated sharply from 2021 to 2022, with peak growth rates of 26.1% and 19.7%, respectively.

“We believe peak pessimism is in place making a rebound even more likely and recent trends have begun to show some improvement,” said Belski, and advised investors to increase exposure to the group, arguing that “it is only a matter of time before the fortunes of this group take a turn for the better.”

He said that a “highly selective approach” is necessary, and name the following outperform-rated stocks are ones fitting the theme:

• Bunge Global SA (BG)
• Constellation Energy Corporation (CEG)
• Criteo SA (CRTO)
• Dayforce, Inc. (DAY)
• Digital Realty Trust, Inc. (DLR)
• Entegris, Inc. (ENTG)
• Expand Energy Corporation (EXE)
• Exelixis, Inc. (EXEL)
• Restaurant Brands International, Inc. (QSR)
• Rubrik, Inc. (RBRK)
• Ross Stores, Inc. (ROST)
• RPM International Inc. (RPM)
• Snap, Inc. (SNAP)
• Trade Desk, Inc. (TTD)
• Take-Two Interactive Software, Inc. (TTWO)
• US Foods Holding Corp. (USFD)
• Vistra Corp. (VST)