Looking past the Mag 7: Why mid- and small-caps could outperform going forward

For a lot of investors, the idea of a broader risk rally outside of the ‘Magnificent Seven’ (Apple, Microsoft, Alphabet, Amazon, Nvidia, Meta Platforms and Tesla) requires clearing a few mental hurdles. After all, we’re not long removed from a pronounced late summer sell-off and the macro climate still feels temperamental with potential landmines still lurking. Nevertheless, given current valuations, those who choose to increase allocations to small and mid-caps at this point in the monetary policy cycle may expect to be rewarded.Below, we’ll go over the main reasons why investors should consider increasing satellite positions in small- and mid-cap stocks.

1) Macro backdrop isn’t as bad as you might think

For all the talk of an incoming ‘recession’ in the United States, forward-looking growth indicators don’t show anything of the sort. For instance, both the Federal Reserve Banks of New York and Atlanta have GDPNow models¹ that provide high frequency updates on the health of the U.S. economy with minimal tracking errors. Both now show an annual growth rate above 2.5% (quarter-over-quarter)² on a seasonally adjusted basis. That’s around trend for the world’s largest economy and suggests that slack is building at a slower pace than perhaps the market expects. It is quite remarkable when you consider how restrictive the real policy interest rate has been for some time now.True, there are signs of strain in the labour market. But for now, those are consistent with the slower backdrop you’d expect at this point in the economic cycle, as opposed to anything more nefarious. Monetary policy remains very tight (i.e. interest rates remain high relative to recent history) and rate cuts should cushion the backdrop against any residual risks that may be building in the system from here. While the ‘soft landing’ scenario has lost some shine of late, it’s still the most likely base case scenario.³

2) Small- and mid-caps are cheap relative to the S&P 500

An easy way to gauge this is by looking at the forward price-to-earnings ratio for small-cap US equities relative to the S&P 500.⁴ Using Bloomberg’s estimates, we see that the forward P/E ratio for small caps was 0.80x that of the S&P 500. For mid-caps, that ratio is 0.78x.⁵The cheaper valuation is only part of the story though. The length of time by which both indices have been undervalued matters here, as well. For instance, both ratios have been below 1.0x for the past three years—the longest such timeframe since the turn of the century. The ratio has been remarkably steady for an unusually long span, and there’s a decent case to be made that it should push higher as investors consider the relatively cheap valuation for small, and mid-caps.

Chart 1 – Small and Mid-Cap indices: ‘Cheap’ vs. broader gauge for some time

3) Valuation matters amid Fed rate cuts

From prior Fed rate cut cycles, we observe that small/mid-cap valuation relative to the S&P 500 tends to have predictive value over the following six months. For instance, if the P/E ratio for small/mid-caps is above that of the S&P 500, then the former will usually underperform over the course of the next six months (see Table 1). However, given that P/Es for both have been below that of the broader index ahead of the first Fed rate cut, the closest parallel would be with the 2000-2001 cycle – which saw both small/mid-caps outperform to a meaningful degree.

Table 1 – Valuation ahead of first Fed rate cut tends to be predictive

4) Fundamentals matter

As the Fed eases interest rates, small and mid-cap stocks should benefit since the cost of debt servicing is going down. Consider the chart below, which indexes debt growth since the Great Financial Crisis. We see an over six-fold increase in the level of short-term and long-term debt carried by firms that qualify as small-cap. For mid-caps, that figure is closer to four-fold—which is still noticeably larger than the near two-fold increase for the broader market.That result also compares to what we’ve seen in total debt-to-equity ratios⁶—as small cap firms have been relying a lot more on debt financing for a while now. Given that a significant portion of these names likely don’t have access to bond markets, it stands to reason that there’s been a lot more reliance on bank lines which are generally floating rate.⁷ Lower float rates imply lower debt servicing costs for these names. That provides a clearer path to potentially improved income scenarios and ultimately, share price growth.

Chart 2 – Growth in short- and long-term debt