Will SMidCaps continue to underperform?

Investing.com — Technology, semiconductor, and the Magnificent 7 stocks saw notable gains on Monday, driving the 0.5% higher to 5,975.

The uplift in semiconductor stocks was largely attributed to Foxconn (SS:)’s announcement of a 15% year-over-year revenue increase, which led to a 3.4% rise in Nvidia (NASDAQ:)’s stock price.

Following a good day on Wall Street, analysts at Yardeni Research reiterated their recommendation to overweight the LargeCap S&P 500 Information Technology and Communication Services sectors.

On the other hand, the firm said it is not as keen on the and the – collectively called SMidCaps – as well as the SmallCap , citing their continued underperformance relative to the S&P 500. All three indexes fell on Monday.

According to Yardeni, the relative underperformance of the SMidCaps since mid-2022 is linked to the flat trends in their forward earnings, in stark contrast to the S&P 500’s forward earnings, which have been climbing to record highs since mid-2023.

“This divergence is unusual,” Yardeni notes. “Our theory is that the profitable SMidCap companies with the most potential to become LargeCaps are getting acquired by LargeCap companies before they can do so.”

Moreover, the forward revenues of the S&P 500 and S&P 400 have been reaching record highs since mid-2022, while the S&P 600’s forward earnings have stagnated.

The forward profit margins of the S&P 500 have also been on the rise, reaching new highs, whereas the S&P 400 and S&P 600’s margins are still below their early 2022 peaks and significantly below the S&P 500’s margins.

The firm’s analysis indicates that the forward price-to-earnings (P/E) ratios of the S&P 400 and S&P 600 increased from approximately 14.0 to 16.0 last year. “That multiple expansion accounted for most of last year’s rally in both price indexes, as their earnings were disappointing,” the report states.

Yardeni raised questions about the widespread use of the Russell 2000 as a benchmark index for SmallCaps, noting that over 30% of the companies in the index are unprofitable. This has resulted in the Russell 2000’s forward P/E being much higher than that of the S&P 600, which Yardeni prefers as a benchmark for SmallCap stocks.