Three Reasons to Consider SMID-Caps during a Declining Rate Environment

The Fed finally began easing monetary policy, announcing a 50-basis point cut during its September meeting. While the magnitude of the first cut has been a source of debate (50 bps vs 25 bps), the main topic on the minds of advisors is how to adjust strategic asset allocations in a broader environment of declining interest rates.

Looking at previous periods of monetary easing, rate cuts have had a positive impact on small and mid-cap companies. These smaller firms typically carry more debt than larger corporations, making them more sensitive to rising interest rates. As long as the economy remains stable and avoids a recession, historical trends show that rate cuts generally provide stronger support for smaller-cap stocks compared to their large-cap counterparts.

Below we discuss three reasons why advisors should consider small- and mid- cap stocks now.

Valuations Create an Attractive Entry Point

• Small and mid-cap stocks are trading at a significant discount compared to their large-cap counterparts, presenting an attractive entry point for investors.
• Historically, valuation gaps between large and smaller companies tend to close over time, potentially paving the way for outsized gains as the market corrects this disparity and valuations revert to the mean.

Source: VanEck, Morningstar. Data as of 9/30/24. SMID cap and large cap stocks are represented by the Russell 2500 Index and S&P 500 Index, respectively.

Strong Historical Relative Performance during Past Rate Cut Periods

• Smaller companies historically benefit more during rate-cut cycles, as cheaper borrowing costs fuel growth and expansion, often leading to stronger earnings growth.
• As monetary policy loosens, investors typically rotate from safe, large-cap investments to higher-growth opportunities such as small-cap stocks.
• Data from the five previous rate-cut periods since 1995 shows that small and mid-cap stocks have consistently outperformed large-cap stocks, especially over a longer time horizon following the first rate cut.

Average Performance during Previous 5 Rate Cuts (since 1995)

Source: VanEck, Morningstar. Small caps, mid caps and large caps are represented by the S&P Small Cap 600 Index, S&P Mid Cap 400 Index, and S&P 500 Index, respectively. Periods of rate cuts start in 1995 and cover the following 5 periods: 7/6/1995, 9/29/1998, 1/3/2001, 9/18/2007, and 8/1/2019.

Winning during Election Years (and Beyond)

• Changes in government policy and fiscal initiatives can often favor smaller businesses, with many mid- and small-cap companies positioned to benefit from proposed regulatory shifts and / or infrastructure spending.
• Data from previous election years shows that small and mid-cap stocks have consistently outperformed large-cap stocks.

Average Performance during Previous Election Years (since 1996)

Source: VanEck, Morningstar. Small caps, mid caps and large caps are represented by the S&P Small Cap 600 Index, S&P Mid Cap 400 Index, and S&P 500 Index, respectively. Time period of analysis starts in 1996 and includes the month of November in the after-election returns.

Tap into the Power of Moat Investing

While the broader backdrop is favorable for the SMID-cap asset class, it’s important to remember that small and mid-cap stocks have a wide range when it comes to quality. In fact, 41% of small cap companies and 17.5% of mid cap companies are unprofitable¹. In addition, the lack of analyst coverage and research for small- and mid-cap stocks can lead to greater dispersion between a SMID-cap company’s stock price and fair value.

The VanEck Morningstar SMID Moat ETF (SMOT) can help investors gain exposure to the attractive tailwinds behind the SMID asset class and avoid the lower-quality unprofitable companies. Leveraging Morningstar’s equity research team, SMOT provides focused exposure to SMID-cap stocks, targeting companies with long-term competitive advantages and attractive valuations.

SMOT seeks to track the Morningstar^® US Small-Mid Cap Moat Focus Index^SM, which leverages Morningstar’s forward-looking, rigorous research process, driven by over 100 analysts globally. The Index applies much of the same core index methodology principles as Morningstar’s flagship Wide Moat Focus Index, but to a universe of small- and mid-cap companies. The Index targets SMID-cap companies with long-term competitive advantages, known as moats, and attractive valuations.

We believe now is a opportune time to consider SMOT because historically, the ETF has held a larger weighting to mid-cap companies versus small-caps, which could bode well in the current environment as mid-caps tend to perform better than both small and large caps following rate cuts and presidential elections.

¹ JPMorgan Guide to the Markets.