Small and mid cap stocks are looking much more attractive, says Northwestern's Matt Stucky

Key Concepts

• Russell 2000: A small-cap stock market index, currently outperforming the S&P 500.
• Market Concentration: The disproportionate influence of a small number of large-cap stocks (particularly the “Magnificent Seven”) on overall market performance.
• Valuation Spread: The difference in valuation metrics between small-cap and large-cap stocks.
• Earnings Revisions: Changes to analysts’ forecasts of a company’s future earnings.
• Monetary Policy: Actions undertaken by a central bank (like the Federal Reserve) to manipulate the money supply and credit conditions.
• CPI (Consumer Price Index): A measure of the average change over time in the prices paid by urban consumers for a basket of consumer goods and services.
• Deflation Data: Measures indicating a decrease in the general price level of goods and services.
• Mag 7: Refers to the seven largest US technology companies (Apple, Microsoft, Alphabet, Amazon, Nvidia, Tesla, and Meta).

Small Cap Outperformance and the Shifting Market Landscape

Matt Stuckey, Chief Portfolio Manager at Northwestern Mutual Wealth Management, discusses the recent outperformance of the Russell 2000 index compared to the S&P 500, and outlines his firm’s investment strategy in light of evolving economic conditions. He argues this trend is “certainly been overdue” given the historically narrow market leadership of the past three years.

Historical Market Narrowness & The Impact of Monetary Policy

Stuckey highlights that between 2023 and 2025, only 20-30% of S&P 500 constituents outperformed the index, a significantly narrower range than the historical average of 40-45%. This narrowness, he attributes to the previous monetary policy environment of higher interest rates, which disproportionately impacted certain segments of the economy. The infrastructure buildout was a key driver of growth during this period. However, with rates potentially coming down and a broader economic recovery taking hold, Stuckey believes the conditions are ripe for small-cap outperformance.

The Recipe for Small Cap Success

The key catalysts for continued small-cap outperformance, according to Stuckey, are consistent upward revisions to earnings estimates and a compression of the valuation spread between small and large-cap stocks. He states, “You want to see consistent earnings revisions up. And that valuation spread between small and large continue to compress. And that’s the recipe for outperformance.”

Navigating Rate Cut Expectations and Inflation Risks

Stuckey acknowledges the risk that a reacceleration of the economy, driving earnings higher, could be offset by a reduction in the number of expected rate cuts this year – currently below two. He notes that historically, market corrections are triggered by rising rates or rising unemployment. However, he points to a surprising downward trend in inflation as a potential catalyst for the Federal Reserve to maintain a more dovish stance.

He specifically mentions a “growing downside wedge between the daily deflation data and the overall CPI year on year numbers,” drawing a parallel to 2021 when this metric foreshadowed rising inflation. He suggests this could now signal a potential decline in inflation, potentially leading to further rate cuts. “If that was a precursor to the upside, maybe it’s perhaps a precursor to the downside,” he posits.

Portfolio Strategy: Shifting Away from Mega-Cap Concentration

Stuckey outlines his firm’s portfolio strategy, which involves a shift away from concentrated positions in mega-cap stocks towards mid and small-cap companies, investment-grade fixed income, and international stocks. While acknowledging the “quality profile” and “impressive earnings growth” of mega-cap tech companies, he emphasizes the unusual level of market concentration and the associated risk.

He explains, “It is somewhat unusual to have the market as concentrated as what it is, and that just increases the risk profile.” He suggests that companies utilizing the products developed by the “Magnificent Seven” (Mag 7) may represent the next phase of growth. He also points out that small and mid-cap companies are generally more labor-intensive, and therefore stand to benefit more from productivity gains unlocked by new technologies. “Certainly the ones that are using these products to unlock the productivity seem to me to be where some of this earnings leverage might be.”

The Future of the Federal Reserve

Stuckey also briefly touches on the upcoming change in Federal Reserve leadership when Chair Powell’s term expires, suggesting this could also contribute to a continuation of rate cuts.

Data and Statistics

• 20-30%: Percentage of S&P 500 constituents that outperformed the index between 2023-2025.
• 40-45%: Historical average percentage of S&P 500 constituents that outperform the index.
• 9%: Peak CPI inflation rate reached in recent years, as referenced in the discussion of deflation data.
• Below 2: Current market expectation for the number of rate cuts in 2024.

Conclusion

Matt Stuckey presents a bullish outlook for small-cap stocks, driven by a combination of improving economic conditions, potential rate cuts, and a shift away from the historically narrow market leadership of mega-cap tech companies. He emphasizes the importance of monitoring earnings revisions and the valuation spread between small and large-cap stocks as key indicators of continued outperformance. His firm is strategically positioning its portfolio to capitalize on this trend, while acknowledging the risks associated with inflation and potential shifts in Federal Reserve policy.