After lagging behind the broader market for 6 years, U.S. small and mid-cap stocks launch a strong comeback! JPMorgan: The next 3-6 years may see 30%-60% excess returns.

After several years of significant underperformance versus the broader market, U.S. small and mid-cap stocks are now at a key market turning point, set to benefit from both a valuation rebound and macro-driven tailwinds.

According to Wind Chasing Trading Desk, Eduardo Lecubarri, JPMorgan's global small and mid-cap strategy chief, stated in a research report on the 21st that over the next 3 to 6 years, U.S. small and mid-cap stocks are expected to generate 30% to 60% excess returns (Alpha). He emphasized that since their 2021 peak, the Russell 2000 index's performance versus the S&P 500 has declined by 60%, marking the largest relative drop in history outside the tech bubble era. This extreme divergence has led to a near-historic level of valuation discount.

The core driver behind this optimism lies in a dramatic macro shift: the previous headwinds of soaring interest rates and wage inflation, which had restrained small and mid-cap profitability, have now hit a turning point and turned into tailwinds. Meanwhile, the promise of domestic tax cuts for U.S. manufacturers and potential tariff policy impacts have created a unique policy environment favoring domestically oriented small and mid-sized enterprises.

As capital costs are no longer cheap and large-cap corporate buybacks lose steam, the market landscape is being reshaped. JPMorgan believes that, given this asset class has suffered from negative sentiment for four consecutive years and tends to show resilience in downturns, the current moment offers outsized upside potential for small and mid-caps.

Historic Valuation Discount

According to JPMorgan data, U.S. small and mid-cap stocks have vastly lagged large caps in recent years, and this performance gap is extremely rare in history. Lecubarri noted that, apart from the tech bubble era, this is the largest lag he has ever seen.

Specific data shows that since the 2021 peak to now, the Russell 2000 index, representing small and mid-caps, has underperformed the S&P 500 by 60%. This prolonged slump has led to a severe valuation discount, currently close to the historical high.

The report suggests that the fundamental factors serving as clear obstacles for small and mid-caps from 2021 to 2023 have now become positive growth drivers, mainly in the areas of interest rates and wage inflation.

First is the shift in interest rate environment. Rising interest rates previously hit small and mid-caps quickly by increasing interest expenses, since these firms often hold more floating-rate debt and have to revalue interest costs more rapidly. Now, the market expects rates to fall rather than rise, which will significantly reduce financial burdens for small businesses.

Second is the cooling of wage inflation. As a sector much more labor-intensive than large caps, small and mid-caps were hit hard by wage inflation in 2023. However, U.S. hourly wage growth has dropped from a 5.9% peak in 2022 to the latest 3.7%. With these two inhibitors now in the past, profitability outlooks for small and mid-caps will substantively improve.

Policy Dividend: Tax Cuts and Tariff Exemptions

Looking ahead to next year's policy environment, JPMorgan highlights a unique equation favoring small and mid-caps: the dual impact of tax cuts and tariffs.

On one hand, promised tax cuts for domestic manufacturers mean firms primarily operating in the U.S. stand to benefit more than multinationals, and U.S. small and mid-caps are fundamentally more domestically oriented. On the other hand, U.S. mid-caps are better shielded on the tariff front, not only because their revenue exposure is more local, but also because their sourcing is more domestic.

Lecubarri explains that if a company's exports exceed its imports, profit margins are negatively correlated with the dollar's performance. Given small and mid-caps' low reliance on overseas markets, they are better positioned than large caps to avoid the shocks of tariffs and currency fluctuations. This combination of "tariff immunization" and "tax cut benefit" gives them an edge in the new policy cycle.

In addition to fundamentals and policy, market capital dynamics are also shifting, especially regarding stock buyback trends. In recent years, buyback activity has been strong, mainly driven by U.S. large cap companies.

However, as base rates rise and money is no longer "free," coupled with profit growth slipping to single digits, corporate buyback capacity is constrained. According to JPMorgan, the proportion of companies doing buybacks will decline for the second consecutive year in 2025. This trend means that the advantage large caps previously enjoyed in supporting stock prices via massive buybacks is waning, further balancing the contest between large and small/mid caps.

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The above content comes from Wind Chasing Trading Desk.

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