Is now the time to consider allocating to US small- and mid-cap growth stocks?

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Historically, small- and mid-cap growth companies in the United States have demonstrated notable outperformance relative to their large-cap peers in periods following bear markets.¹ Understandably, these bear markets tend to reflect periods of broader market concerns, and investors generally favor less economically sensitive stocks in anticipation of recessions. These dynamics appear at play today, as markets grapple with mixed economic data, rising rates and uncertainty over whether the Federal Reserve (Fed) can navigate a soft-landing and avoid recession. Over the pullback period from November 1, 2021, through September 30, 2022, the S&P MidCap 400 Growth and S&P SmallCap 600 Growth Indexes posted declines of -25.18% and -24.28%, respectively.² Year-to-date through June 30, 2023, these indexes have only just started to show positive returns (+10.44% and +7.02%, respectively, primarily due to market appreciation in the month of June), while the large cap S&P 500 Growth Index was up over 21% during the same period.³ In our opinion, overdone selling of small- and mid-cap growth stocks may provide an attractive opportunity for long-term investors today, as otherwise high-quality small- and mid-cap growth stocks are trading at what we believe to be depressed valuations despite demonstrating positive and improving fundamentals.

Small- and mid-cap growth companies can benefit from valuation re-ratings well into recoveries. When the market begins to discount a recovery, capital often returns to small- and mid-cap growth companies, as investors hope to benefit from the sensitivity of their improving earnings streams. Additionally, the cost rationalization that often occurs during times of downward volatility and recessions may produce efficiency gains for small- and mid-cap companies in the ensuing recovery period, as they often right-size their operations during periods of weakness.