Overtaking on the curve? The Fed cuts interest rates, mid-cap stocks are expected to outperform the market significantly!

Over the past week, investors have been busy looking for the best way to deal with the Federal Reserve's first rate cut since 2020.

Surprisingly, when asked which stocks are most likely to benefit the most in the future, several strategists said it's neither large-cap stocks nor small-cap stocks - both of which have dominated the headlines in recent months. Instead, the often overlooked mid-cap stocks may be in the best position for a breakthrough.

Ryan Detrick of Carson Group said, " History shows that once the Federal Reserve truly starts cutting rates, mid-cap stocks tend to significantly outperform the market."

Detrick expects that over the next 12 months, small-cap and mid-cap stocks could rise by as much as 20%, far outperforming large-cap stocks. Since the end of June, the small-cap Russell 2000 index has surged by 10%, while the S&P 500 index has only risen by 4.7%.

A recent analysis by Goldman Sachs found that in the 12 months following the first rate cut, mid-cap stocks typically outperform large-cap and small-cap stocks. As confidence in a soft landing increases, investors are increasingly willing to look beyond large companies for investment opportunities.

Jenny Ma of Goldman Sachs mentioned in a report to clients earlier this month, "The start of a Federal Reserve rate-cutting cycle may be a potential source of new stock demand and increase investors' risk appetite. In the short term, the performance of mid-cap stocks relative to other sectors will depend on the strength of economic growth data and the pace of the Federal Reserve's easing cycle."

The team believes that undervaluation and strong economic growth will be catalysts for future returns, and expects the S&P 400 MidCap Index to gain 13% in the next 12 months.

Emily Roland, Co-Chief Investment Strategist at John Hancock Investment Management, said, "This is a sentiment-driven market rotation based on hopes for a soft landing, which is favorable for boosting the most adventurous areas of the market."

According to Jill Carey Hall of Bank of America, mid-cap stocks are the "best hedge tool in the near term".

Hall pointed out in a report to clients, "Mid-cap stocks have had better performance guidance and revision trends recently, outperforming small-cap stocks on average during recessions, and considering the sensitivity of small-cap stocks to interest rates and refinancing risks when the Federal Reserve cuts rates less than expected, they can serve as hedge tools."

Investors expect the Federal Reserve to cut rates by about 75 basis points by the end of this year, and anticipate that by mid-2025, the policy rate will fall to between 3.00% and 3.25%, exceeding the Fed's own forecasts.

However, for Wall Street, this is nothing new as it had already anticipated about six rate cuts by 2024 at the beginning of the year.

The slower pace of Federal Reserve rate cuts and ongoing recession concerns are key factors driving investors from favoring small-cap stocks to mid-cap stocks, as small-cap stocks often have weaker balance sheets and poorer profitability Brian Jacobsen, Chief Economist of Annexus Wealth Management, stated that the market for small-cap stocks may become "challenging before becoming more attractive," and that "concerns about slowing growth are likely to outweigh the benefits of low borrowing costs."

Stuart Kaiser of Citigroup also expressed caution about this trade, advising investors to "proceed very carefully" with this group.

Kaiser warned, "Even in the event of a soft landing, we believe there will still be a batch of data worse than expected. When data underperforms, the market will trade like a hard landing as it did in early August, at which point, small-cap stocks will be at the center of the storm."

Despite Wall Street's skepticism towards small-cap stocks, there is no need to rush to completely dismiss this group. David Kostin of Goldman Sachs mentioned in a report to clients this week that positive employment reports may further enhance investors' interest in risk assets.

Kostin wrote, "Positive employment data may prompt some investors to shift from expensive 'quality' stocks to less favored low-quality companies, as the market may price in a significant deterioration in the labor market."