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The Opportunity In The Forgotten Part Of The Stock Market

As noted previously, the bull market in stocks has broadened, and small-cap stocks have outperformed after the jobs report on June 2 was mixed enough to allow the Federal Reserve to skip raising short-term interest rates last week. A more forgotten part of the stock market, midcap stocks, has also been revived recently after a moribund period. Through the end of May, midcap stocks, as measured by the Russell MidCap index, had a marginally positive total return year-to-date, while the S&P 500 was up close to 10%. Since June began, the Russell MidCap rose over 6.7% versus the S&P 500 at 5.5%.

Midcap stocks occupy the middle market capitalization between large companies and small market-capitalization stocks. Using the Russell index methodology, the 200 largest market capitalization companies comprise their large or mega-cap index. Then the following 800 companies are the Russell MidCap index. Most people are familiar with the Russell 1000, which combines those two indexes. Lastly, the next 2000 smaller companies form the Russell 2000 index.

Midcap Stock Relative Performance Versus S&P 500

Glenview Trust, Bloomberg

Despite the recent outperformance of midcap stocks, they still trail the S&P 500 by a large margin year-to-date. Most people don’t know that midcap stocks have outperformed the more talked about small-cap stocks over the last five years, ten years, and since 1994. In fact, despite underperforming large-cap stocks, as defined by the S&P 500, over the previous five and ten years, midcap stocks have outperformed them over the long term!

Annualized Return By Market Cap Index

Glenview Trust, Bloomberg

As they say, past performance does not guarantee future returns, so why could midcap stocks outperform in the future? One factor could be that midcap companies tend to be better and more stable businesses relative to small-cap stocks. The Russell 2000 has over 42% of its constituents earning no profits. Generally, these midcap stocks have ascended from the small-cap portion of the market, and at this size, the zombie companies usually have been left behind.

The mega-cap companies get the most attention from analysts, so they tend to be more fully valued than the smaller and lesser-known firms. In addition, midcap companies are large enough to benefit from scale and multiple product lines, while many still have plenty of room to grow. Again, many people might be surprised that quite a few household names are midcap companies, like Lululemon AthleticaLULU
(LULU), Yum! Brands (YUM), and CloroxCLX
(CLX). It is reasonable to argue that midcaps could be the sweet spot for investors.

Lastly, the relative valuation of midcap company stocks supports the case for outperformance versus large-cap stocks. Midcap stocks sell for 14.5 times 2023 estimated earnings, while the S&P 500 is 19.9 times. The valuation gap is near the largest since the dot com bubble in the late-1990s, which ushered in a period of massive outperformance for midcaps.

Midcap Stock Relative Valuation

Glenview Trust, Bloomberg

Federal Reserve Chair Powell followed through with his preference to pause the rate hikes last week. However, the Fed forecast calls for two more 25 basis point (0.25%) increases in short-term interest rates in 2023. Market odds favor the Fed boosting short-term interest rates only one more time at the July meeting. Despite the expected Fed funds rate creeping up after the meeting, the bond market is still pricing in that the Fed will cut rates within a year from now. This pause in rate hikes and a resultant increase in the probability that the U.S. can avoid recession supports a possible continuation of the recent outperformance of midcap stocks.

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One-Year Forward Fed Funds Futures Rate

Midcap stocks have outperformed the S&P 500 over the long term, and the current relative valuation makes an allocation more attractive. While valuation is a poor timing tool, it supports the thesis that midcap stocks could offer an attractive long-term opportunity. The relative performance has recently turned and could continue if stock market performance broadens further, but time will tell. Investors should consider an active manager in the space, or an investment in midcap stocks can be tax-efficiently and cheaply implemented using the iShares Russell Mid-Cap ETF (IWR).

 Read More  A forgotten part of the stock market, midcap stocks, has recently seen a revival after a moribund period. Midcap stocks have outperformed the S&P 500 over the long term, and the current relative valuation makes an allocation more attractive. 

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