Goldilocks might be onto something.

Over the past week, investors were busy figuring out the best way to play the Federal Reserve’s decision to lower interest rates for the first time since 2020.

I asked a number of strategists which stocks stand to benefit the most going forward. Surprisingly, it’s not large or small caps — the two trades that have dominated market headlines in recent months. Rather, mid-cap stocks, an often forgotten trade, may be best positioned for a breakout.

“Historically, midcaps really start to outperform once the Fed actually starts cutting rates,” Carson Group’s Ryan Detrick told me.

Detrick sees small and mid caps surging up to 20% in the next 12 months, far outperforming large-cap peers. The Russell 2000 (^RUT) — the small-cap index— has soared 10% since the end of June, compared to the S&P 500’s (^GSPC) 4.7% rise.

Recent analysis by Goldman Sachs found that mid caps typically outperform large and small cap stocks in the 12 months following the first rate cut. As confidence for a soft landing grows, investors are becoming more comfortable reaching for options outside of the biggest companies.

“The start of the Fed rate cutting cycle is a potential source of incremental equity demand and boost to investor risk sentiment,” Goldman Sachs’s Jenny Ma wrote in a note to clients earlier this month. “In the short term, mid-cap performance relative to other segments will hinge on the strength of economic growth data and the pace of the Fed's easing cycle.”

The team sees low valuations and resilient economic growth as catalysts for future gains and expects a 13% return for the S&P 400 (^SP400) index over the next 12 months.

“This is a sentiment-driven market rotation based on soft landing hopes, benefiting the riskiest areas of the market, as the earnings backdrop is on another planet,” John Hancock investment management co-chief investment strategist Emily Roland told me.

Mid caps are the “best hedge” for the near-term, per Bank of America’s Jill Carey Hall.

“Mid caps have seen better recent guidance and revision trends, have outperformed small caps on average in Downturn regimes… and serve as a hedge against fewer-than-expected Fed cuts, given small caps' rate sensitivity/ refinancing risk,” Hall wrote in a note to clients

Investors have priced in roughly 75 basis points of cuts before the end of the year, and see the policy rate falling to the 3.00% to 3.25% range by mid 2025, exceeding the Fed’s own projections.

Remember though, this isn’t new for Wall Street, which started the year pricing in roughly six interest rate cuts for 2024.

Risk of a slower Fed rate-cutting cycle and lingering recession fears are key factors behind the recent shift from favoring small-cap stocks to mid caps, as small caps tend to have weaker balance sheets and are less profitable.

Annex Wealth Management chief economist Brian Jacobsen told me the small-cap trade may “get challenging before it gets more compelling,” and a “fear about slower growth will likely outweigh the benefits of lower borrowing costs.”

Citi’s Stuart Kaiser is also cautious on the trade, telling me investors should approach the group “very carefully.”

“Even if you get a soft landing, our view is you're still going to get batches of data that look worse than that, and when the data comes in looking worse than that, the market's going to trade a hard landing like it did in early August,” Kaiser warned. “Small caps are going to be the eye of the storm on that.”

While the Street remains skeptical on small caps, I wouldn’t rush to dismiss the group entirely. Goldman’s David Kostin wrote in a note to clients this week that a positive jobs report could further increase investor appetite for risk.

“A positive jobs print could prompt some investors to rotate out of expensive ‘quality’ stocks into less -loved lower quality firms as the market would likely price lower odds of substantial labor market weakening,” Kostin wrote.

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