Even when large-cap stocks lose, they still find a way to win.
It’s been a rocky year for the S&P 500, but the mega-cap-heavy index has still easily beaten its peers with a relatively modest 5.2% loss. For comparison, the mid-cap-dense S&P 400 and small-cap-oriented S&P 600 have sold off by 6.9% and 10%, respectively, in the first quarter.
If this performance gap holds throughout 2025, it will mark yet another year that small- and mid-cap stocks, also known as SMID caps, fail to live up to the hype. Proclamations that the long-beleaguered group’s turnaround is coming could be nearing boy-who-cried-wolf territory.
Smaller stocks may have a tough road ahead, yet some market strategists are holding out hope.
The bull case for SMID caps is simple: they’re under-owned and trade at a big valuation discount, so they’re set to take off once interest rates fall, the economy strengthens, or both. Those catalysts could be far off, but once they materialize, investors won’t want to miss out.
“All that should accrue a little bit more quickly to the earnings and revenue profiles of these small-cap companies, and therefore, they should have their day in the sun again,” Jordan Irving, a small-cap portfolio manager at Glenmede Investment Management, said in a recent interview. “And yet, we’re still waiting.”
Why smaller stocks are pricing in pain
Small- and midsize equities have made little progress in the last four years, as the S&P 1000 index designed to track those groups is up just 6% in that span.
“This has been the weakest beginning of a bull cycle for small caps on record,” Kevin Gordon, an investment strategist at Charles Schwab, recently told Business Insider. “It’s not even close.”
Those paltry returns are a product of what’s been an unusually uncertain economic backdrop. Smaller companies are often more economically sensitive than large firms with more resources, so they tend to outperform early in economic cycles and lag as growth weakens or contracts.
Once the pandemic recovery boom lost steam, so did SMID caps. The US economy was roiled by 40-year-high inflation, negative GDP growth, and recession calls that were ultimately wrong.
But although growth stabilized, smaller stocks didn’t take off since interest rates remained high. Plus, there was the looming uncertainty of the 2024 election. All of that left SMID caps in limbo.
“We didn’t go through a traditional recession, which would kind of wash out the economy, get you to a reset moment,” Gordon said. “And that’s when small caps rally.”
While SMID caps caught fire after Donald Trump won, the rally has reversed since markets are antsy about how the president’s strict trade and immigration policies will impact the economy and inflation. Gordon said tariffs and deportations would hit smaller firms hardest since they lack the resources or flexibility needed to quickly revamp their supply chains or replace workers.
Another major issue is that trade policy changes by the day, making planning nearly impossible. Gordon noted that small-business optimism just fell again, and uncertainty is near record levels.
“If businesses know what they’re facing and it doesn’t change from there, then I think that they can adjust,” Gordon said. “And that’s really what the business community is telling the administration: Just tell us what the policy is and don’t change it; then, we can adjust over time.”
Cracks could form in the economy if investment and business spending slows, Gordon warned, which may explain why smaller stocks have continued to sag this year.
A recession could be a blessing in disguise
But ironically, economic weakness could mark the beginning of the end of a multi-year dry spell for smaller stocks. The Federal Reserve would finally have a reason to cut interest rates, which Gordon said would incentivize investors to move into SMID caps — even during the downturn.
“If you do get a recession somewhat sooner, that’s probably better for small-cap outperformance after the recession,” Gordon said.
Irving from Glenmede agreed with that reasoning. And while the portfolio manager doesn’t see an imminent downturn, he said the market may be bracing for one.
“Small caps have been left out in the wilderness a little bit as we’ve had a bit of this perceived safety trade happening,” Irving said.
For patient investors, investing in smaller companies may be a win-win scenario. If the economy re-accelerates, the group should benefit most. And while a contraction would hurt, SMID caps might have less room to fall since they’re already cheap — plus they’d be closer to a recovery.
“That first move off the bottom tends to be pretty powerful from a performance standpoint,” Irving said, adding that “it doesn’t take anything heroic to see a pretty big bounce coming out of small caps here at the current valuation disparity.”
Make quality a priority
Instead of flocking to smaller stocks sight unseen, strategists agreed investors would be wise to prioritize high-quality companies, which are less risky during economic volatility.
Brian Belski, the chief investment strategist at BMO Capital Markets, wrote in a late March note that he’s prioritizing high-quality SMID caps that offer “GARP,” or growth at a reasonable price.
“Not only does this subset of stocks have a long outperformance track record, but they also currently trade at even bigger relative discounted levels and offer better growth expectations compared to the index,” Belski wrote in the note.
BMO Capital Markets
Historically, quality SMID caps that offer earnings growth at fair valuations have bested the broader market, rising 9.6% on an annualized monthly basis since early 2002 versus 8.1% for the S&P 1000, Belski noted — all while having a slightly safer risk profile.
And while that cohort hasn’t met expectations in recent years, that may be changing. The group’s key catalysts are projected profit growth of over 20% in each of the next two years, superior earnings revisions, and a double-digit valuation discount versus the long-term average.
BMO Capital Markets
“Trends may be slowly reverting to historical norms, providing an opportune time to consider these stocks,” Belski wrote.
BMO Capital Markets
Both Gordon and Irving endorsed that philosophy.
“Investing in higher-quality businesses trading at a reasonable valuation tends to work out over time,” Irving said, adding that he’d avoid companies that are unprofitable.
Avoiding landmines can be tough in the small-cap space, Gordon said, since nearly half of small-cap companies lose money. And while finding fairly valued SMID caps that are projecting confidence amid turbulence may seem like an unfair challenge, Gordon thinks it’s a worthy one.
“I would be very conscious around looking for companies or industries, if you’re at the industry level, that have strong earnings growth, strong margins, and relatively strong guidance,” Gordon said. He added: “It’s a tall order because of the uncertainty we’re in, but if you don’t have strong guidance, then you haven’t been rewarded at all by the market.”
