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Citigroup Capital Markets analyst Lori Calvasina says she gets queasy just thinking about second quarter results. After all, a disappointing earnings season would surely be a blow to the small and mid cap space that she covers.

Unlike Q1, she says investors won't be satisfied by mere positive surprises this time around. But should clear signs unfold over the next few weeks that profits are stabilizing and the economy is improving, the next leg up in the rally could be close at hand.

She said in a note to clients:

If things unfold as we think they need to, we expect small/mid cap stocks to react positively. But if this higher bar isn’t cleared, further weakness seems likely.

Despite her very real near-term concerns, Ms. Calvasina says she remains a buyer of small/mid caps and reiterated her year-end target of 550 on the Russell 2000 and 640 on the Russell 800 mid cap index.

Fuelling her optimism is the fact that valuations in the space remain low by historical standards. She noted that when the Russell 2000 has traded at a price-to-book ratio of 1.45x as it was Tuesday, an average 29% gain has followed over the next 12 months, 92% of the time.

The fact that small and mid cap indices have recently pulled back is also viewed positively.

She wrote:

Since 2003, when the small and mid cap indices have fallen in the 6 week period leading up to earnings seasons, they have usually rebounded during earnings season.

Ms. Calvasina added that third quarters during recovery trade years have on average tended to be positive ones and once GDP trends start to turn positive, M&A activity also typically picks up.

Finally, she said sell-side ratings upgrades have only just begun.

She told clients:

If company guidance improves, analysts could start to upgrade stocks. Though analysts have started to take up earnings estimates, ratings have not show the same rebound.

Source: Citigroup Nervous About Q2 Earnings for Small and Mid-Caps