Mid-Caps Should Shine If We Rally Into The Elections

by: Alan Brochstein, CFA

This weekend's Barron's has an article titled "Danger in Dividend Stocks" (subscription required) that is likely to generate some debate. The point of the article is that there has been a lot of crowding into dividend-paying stocks that has left Utilities, Consumer Staples and Telecom Services quite expensive relative to longer-term valuation ranges. While reasonable people can debate whether the recent performance of these sectors is justified or not, I think most people would recognize that these sectors are vulnerable to relative underperformance if this 11-week old rally accelerates.

Not only are these three sectors low in "beta", meaning that they tend to move less than the market, but they also all pay above-average dividend yields. Don't look now, but interest rates have started to rise. A correction of sorts of the stampede into these sectors may have already started. So far in August, with the S&P 500 (NYSEARCA:SPY) up 2.31% through 8/24, Utilities are down almost 4%. Similarly, Telecom Services are off 2%, and Consumer Staples have declined 0.33%.

While we didn't exactly storm through the "roof" last week, the S&P 500 did post new highs for the bull market that began in 2009. Surprisingly, while the index is up in price by more than 12% in 2012, higher-beta Small-Caps and Mid-Caps are lagging the market. Typically, one would expect them to be doing BETTER in a rallying market. The Russell 2000 iShares (NYSEARCA:IWM) are up about 9%, while the SPDR Mid-Cap (NYSEARCA:MDY) is up about 10%.

Two weeks ago, I suggested that buying Small-Caps, like IWM, was what made sense for those who had "sold in May" and found themselves out of alignment with their long-term asset allocations. Today, I want to demonstrate how the S&P 400 Mid-Cap index ETFs, like SPDR , iShares (NYSEARCA:IJH) or Vanguard (NYSEARCA:IVOO), should beat the S&P 500 if this rally continues.

Before I go on, let me address briefly the three ETFs. They are all extremely similar in my view and have produced almost the exact same performance over the past two years. IVOO is quite small, though it has the lowest expense ratio. With that said, they are all quite low, ranging from 0.17% to 0.25%.

For those interested in the index behind these ETFs, Standard & Poors has recently updated its website. I am quite impressed with what they have done, making it very easy to compared indices and to dive into the composition. Here is a link that will take you to the S&P 400 information.

One of the things you can get is a graphical depiction of sector exposure. Here it is for the S&P 400 Mid-Cap:

That saved me a lot of time! Here is the same graphic, but for the S&P 500:

A few things stand out, but let's start with the original point I was trying to make: Mid-Caps have minimal exposure to the three sectors cited in the Barron's article as trading rich. The Utilities exposure is actually a bit higher, while the Telecom Services is a bit lower (almost nil). The real difference, though, is in Consumer Staples, where Mid-Caps have just 3.4% exposure while Large-Caps have almost 12%.

Another big difference is the fact that the S&P 400 is almost 22% Financials. Wow. Despite all the carnage over the past five years, Financials are still the second largest part of the S&P 500, though "only" 14.7%. I actually like Financials, but I would expect in a rising rate environment that these smaller banks and financial institutions would do very well as the spreads over funding costs rose.

There are some other differences: Tech is a little smaller, Industrials somewhat larger, Energy somewhat smaller, Materials somewhat larger, Consumer Discretionary a little bigger and Health a little smaller.

This table shows the YTD price returns by sector for each index:

There are some substantial differences, as is often the case. The Energy stocks are lagging the most, but Consumer Staples is trailing dramatically. The S&P 400 doesn't have Apple (NASDAQ:AAPL)! Though that's not the sole factor, Tech leads the S&P 500 but is only slightly above average for the S&P 400. I would note that in the largest sector for the Mid-Caps, the Financials, the stocks are lagging almost 5%. The only sector where Mid-Cap performance has been better than Large-Cap performance significantly is in Health Care.

Given the sector exposures, one would think Mid-Caps would be trouncing Large-Caps this year. If one adds up the total exposure to the best four sectors for the S&P 500 (those above 16% YTD), the S&P 400 has 52.6% exposure to these four sectors, while the S&P 500 has 49.5%. Looking at the two worst sectors in the S&P 500 (those <5% YTD), the S&P 400 has 10.7% exposure, while the S&P 500 has 14.3%. More of the better, less of the worse: What gives?

The Mid-Caps are lagging big in too many sectors, but especially in the largest sectors. Financials and Technology make up 35% of the Mid-Cap index, and the differences there are large. The advantage in Health is more than offset by the disadvantages in Energy and Consumer Staples.

Going forward, I like the positioning of Mid-Caps given their sector exposures. Surely it's worth looking into valuations, and my information, which comes from Baseline, suggests that the S&P 400 is reasonably priced, with a forward PE of 14.5 compared to 13.5 for the S&P 500 but substantially higher growth. For you dividend fans, the give-up is surprisingly small, with the yield on the S&P 500 of 2.0% just slightly better than the 1.4% for the S&P 400. Another kicker could be increased M&A activity, which could benefit medium-sized companies capable of being acquired or doing a meaningful acquisition.

S&P changed the definitions last year. If you are curious how they define "Small-Cap", "Mid-Cap" and "Large-Cap", I shared the updated definitions. S&P didn't go out and do a wholesale change of the S&P 500 to get it to conform with its new $4 billion minimum, and it's worth noting how many of the S&P 400 stocks are above $4 billion (89) and how many S&P 500 stocks are below $4 billion (48). Over time, we could see more "promotions" from the S&P 400, which tend to boost the stock following the announcement of the pending change.

So, there are lots of reasons to consider Mid-Caps, especially if you think the rally will continue. The sector exposures seem favorable for MDY, IJH and IVOO, with limited exposure to low-beta and perhaps expensive higher-dividend sectors. Further, rising long-term interest rates could really help Financials (in the context of an improving economy) as borrowing demand should likely rise, enabling higher margins. I think that this would especially benefit smaller banks. Additionally, Mid-Caps offer more growth at just a slightly higher valuation. Increased M&A activity would likely be favorable. Finally, we could see continued realignment of the Large-Cap and Mid-Cap indices, which might benefit the S&P 400 as promoted stocks rally before the inclusion in the S&P 500.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.