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

Goldilocks may be onto something.

Last week, investors were busy figuring out how best to play the Federal Reserve's decision to cut interest rates for the first time since 2020.

I asked several strategists which stocks will benefit the most going forward. Unsurprisingly, it's not large or small caps — the two businesses that have dominated market headlines in recent months. Rather, mid-cap stocks, an often-forgotten trade, may be the best position for a breakout.

“Historically, midcaps really start to outperform when the Fed actually starts cutting rates,” Ryan Detrick of the Carson Group told me.

Detrick sees small and mid caps rising up to 20% over the next 12 months, outperforming large-cap peers. 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 Goldman Sachs analysis found that mid-caps generally outperformed large- and small-cap stocks in the 12 months after the first rate cut. As confidence grows for a soft landing, investors are becoming more comfortable with options outside of the biggest companies.

“The start of the Fed rate cut cycle is a likely source of rising equity demand and heightened investor risk appetite,” Goldman Sachs' Jenny Ma wrote in a note to clients earlier this month. “In the short term, mid-cap performance relative to other sectors 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) index over the next 12 months.

“It's a sentiment-driven market rotation based on soft landing expectations, benefiting riskier areas of the market because the earnings backdrop is on another planet,” Emily Rowland, co-chief investment strategist at John Hancock Investment Management, told me.

According to Bank of America's Jill Carey Hall, mid-caps are the “best hedge” for the near term.

“Mid caps have seen recent directional and correction trends, outperforming small caps on average in bearish regimes… and small caps act as a hedge against lower-than-expected Fed cuts given rate sensitivity/refinancing risk,” Hall wrote in a note to clients.

Investors priced in roughly 75 basis points 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 the Fed's own projections.

Keep in mind, though, that this isn't new for Wall Street, which started the year pricing in about six interest rate cuts for 2024.

The risk of a slower Fed rate-cutting cycle and fears of a prolonged recession are key drivers behind the recent shift from small-cap stocks to mid-caps, as small-caps have weaker balance sheets and are less profitable.

Brian Jacobsen, chief economist at Annex Wealth Management, told me that the small-cap trade “may be challenging before it becomes more compelling” and that “fear of slower growth will likely outweigh the benefit of lower debt costs.”

Citi's Stuart Kaiser is also cautious on the trade, telling me investors should approach the group “very carefully.”

“Even if you get a soft landing, our view is you're still going to get batches of data that look worse than they look, and when the data looks worse than it looks, the market is going to trade a hard landing as it did. Early August,” Kaiser warned. “Small caps are going to be the watchers of the storm on this one.”

While the Street remains skeptical on small caps, I wouldn't be too quick to dismiss the team entirely. Goldman's David Kostin wrote in a note to clients this week that a positive jobs report could increase investors' appetite for risk.

“A positive jobs print could prompt some investors to shift from expensive 'quality' stocks to less-loved low-quality companies because the market is unlikely to experience significant labor market weakness,” Kostin wrote.

Sean Smith An anchor in Yahoo Finance. Follow Smith on Twitter @SeanaNSmith. Tips about contracts, mergers, staffing situations, or anything else? Email seanasmith@yahooinc.com.

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