Welcome to RBC’s Markets in Motion podcast, recorded March 12th, 2021. I’m Lori Calvasina, Head of US Equity Strategy at RBC Capital Markets. Please listen to the end of this podcast for important disclaimers.
The big thing you need to know today: we think Mid Caps – stocks in the Russell Mid Cap and S&P 400 indices – are intriguing, particularly for investors normally focused on the Large Cap space.
If you’d like to hear more, here’s another 5 minutes.
While you’re waiting, a quick reminder that you can now subscribe to this podcast on Apple, Spotify, Google and Stitcher. If you like the podcast, please rate and review it to help other listeners find the show.
Now, the details.
Mid Caps have outperformed Large Caps since the March 2020 mid recession lows in the US Equity market. They haven’t been quite as strong as the Russell 2000 Small Caps, but they have beaten the S&P 500.
We think Mid Caps can continue to outperform for three reasons.
Reason number 1: At the index level, Mid Caps have more exposure to cyclicals, which have been outperforming strongly, than Tech, Internet, Media and Telecom – otherwise known as TIMT.
- We see this very clearly in terms of market cap weightings.
- In both the Russell Mid Cap and the S&P 400 indices, the two primary mid cap benchmarks, there’s more weight in cyclical sectors such as Financials, Energy, Materials, Industrials, and Consumer Discretionary ex Internet than there is in TIMT.
- Over time, the Russell Mid Cap benchmark has generally had more than 50% of its weighting in cyclical sectors. That’s fallen to 46% as TIMT’s representation has grown in recent years. But the bias to cyclicals is still very high.
- The bias similar for the S&P 400, another widely used Mid Cap benchmark.
- We also seen a bias towards new cyclical leadership in the Russell 2000 Small Caps.
- But that’s not the case for the S&P 500.
- In the early 1990s, cyclicals made up over 50% of the S&P 500, making it relatively aligned with US economic trends, while TIMT accounted for less than 20%.
- But by 2019, these biases had flipped, transforming the S&P 500 into more of a secular growth basket.
- Their cyclical bias gives the Mid and Small Cap indices an inherent advantage over the S&P 500 as market leadership moves away from secular growth and back towards value oriented cyclicals and commodities.
Reason number two: Mid Caps aren’t over owned yet.
- Our work suggests that Mid Caps still have plenty of runway from a positioning perspective.
- In the futures market, Mid Cap positioning hasn’t been close to past extremes either on a dollar value basis or the number of contracts owned.
- There’s been an uptrend in positioning – a catch up trade of sorts – that’s basically remained intact in recent weeks.
- This stands in contrast to Nasdaq, where futures market positioning has been retreating for the past five weeks, with downtrends from post 2014 peaks on both dollar value and the number of contracts owned in place.
- We think this helps explain why the Growth trade has been hit so hard recently, and the fact that positioning hasn’t yet returned to 2018 lows suggests that the unwind isn’t finished yet.
- This also stands in contrast to S&P 500 futures positioning, which has been at or above pre 2020 highs on a dollar value basis.
- Positioning in that segment has started to trend lower in recent weeks.
- Interestingly, current levels of Russell 2000 futures positioning look more like that of the S&P 500 than Mid Caps today.
Our third reason: like the reflation trade generally, we still see valuation opportunity in Mid Cap.
- Relative forward P/E comparisons indicate that Mid Cap valuations remain very attractive vs. Large Cap despite recent outperformance of Mid Cap.
- Mid Caps are also starting to look more reasonably valued relative to Small Cap. The relative multiple is still a wee bit above average on a relative basis, but has improved dramatically.
- Additionally, within the Russell 1000, a broad universe that many institutional investors who specialize in Large Cap use consider to be their relevant universe, stocks in the bottom two quintiles of market cap currently offer the most reasonable P/E’s.
- Right now those bottom two quintiles includes stocks in that index under $10 billion market cap.
One last thought: Mid Caps are also a backdoor way for Large Cap investors to combat the low quality trade.
- The question about whether Mid Caps look interesting has been coming up in our discussions with long-only investors about how they can mitigate the impact of the low quality bent to market performance on their portfolios.
- Since last March, stocks in the Russell 1000 with low ROE, high debt, and high short interest, along with low market cap, have been outperforming.
- This is something that has typically been seen coming out of past recessions.
- But high quality on the ROE, leverage, and short interest factors is seen over time, and many institutional investors are reluctant to move into lower quality parts of the market because of that.
- Things are different when it comes to market cap. In the Russell 1000, low market cap has actually performed best over time, making a post recession trade that makes sense to chase.
That’s all for now. Thanks for listening. Please reach out to your RBC representative with any questions.