While U.S. small-cap stocks have historically outperformed their large-cap peers, the small- and mid-cap categories have lagged blue chips in recent years. Are small- and mid-cap stocks poised for a breakout after the projected market downturn ahead?

Steve Lowe, Chief Investment Strategist, shared how Thrivent Asset Management is positioning portfolios for the end of 2023 into early 2024. “We’ve been moderately overweight to equities all year. Our long-term default is to be more significantly overweight to equities because they outperform over the long run,” Lowe explained. “I expect we’ll turn more cautious as we get closer to 2024 in anticipation of a slower economy and earnings. And, when there is a market correction, we’ll be looking for opportunities.”

What is Lowe looking for to indicate that turn? “I think the signs to watch for are the signs that the economy is also bottoming,” he said. “Typically, things like manufacturing surveys turn in the middle of a recession—they start turning up—and we also look for indications that earnings are troughing.”

Chad Miller, Senior Portfolio Manager for Thrivent Small-Mid Cap ESG ETF (TSME), added that small- and mid-cap valuations have taken a hit compared to their large cap peers ahead of a potential slow down and provide a tailwind coming out of a slowdown.

“Currently in the market, we see a number of companies whose shares have been extremely punished due to market factors as well as interest rates” Miller said. “Within a long-term context, we know that those small- and mid-sized companies are likely to be the ones that lead the recovery on the other side of an economic downturn. With some projecting a potential recession in 2024, we will want to remain vigilant about adding to our exposure in these areas.”

“We’ve seen valuation spreads approach more normal levels,” Miller noted. “As a result, we are searching for both growth and value opportunities in the small- and mid-cap space. Valuation in the small- and mid-cap space are becoming more attractive relative to their large cap peers.”

While small-and mid-sized companies often offer solid growth potential, they often have greater price volatility, lower trading volume, and less liquidity than larger, more established companies.

Looking for opportunities

Growth has crushed value so far in 2023, with mega-cap names driving the market in the growth arena.

“You’ve seen signs of growth in cyclicals improving. But we expect quality companies to continue to outperform as earnings slow because they do have strong earnings and are supported by strong cash flows,” explained Lowe. “The small-cap segment has trailed year-to-date. It’s done a little bit better more recently; the values look attractive. But I think it’s a little early to buy because the time you want to buy small caps is into a cyclical turn or ahead of a cyclical turn, and we don’t think we’re there yet. So, that’s maybe later this year or 2024.”

“We have no way to predict what happens in the macro economy,” Miller said, “We shouldn’t be overly focused on the short-term concerns happening in the economy. But we do have a way to assess and analyze the long-term opportunity in individual stocks.”

“We believe small- and mid-sized companies certainly offer an attractive investment opportunity over the long term,” Miller added. “Assuming we will return to some type of baseline growth over the long term, we consider opportunity to invest in smaller companies with solid long-term fundamentals to create strong returns for our clients over the next five to 10 years—rather than the next one or two quarters that are inherently unpredictable.”