Mid-cap growth leads gains as the market adjusts to shifting macroeconomic risks, indicating a potential tactical shift toward robust value stocks

Market Overview: Diverging Factor Performance Amidst Losses

With the market down 28.0% year-to-date, the investment landscape is marked by significant disparities among equity risk factors. While broad indices remain deeply negative, certain segments—most notably mid-cap growth, as represented by the IJK ETF (IJK+0.56%)—have managed to outperform, posting a 6.6% gain so far this year. This outperformance highlights ongoing investor appetite for growth, even as recession risks remain unpriced.

However, such resilience is rare. The overall market decline is largely driven by weakness in momentum and large-cap growth factors. Both the MTUM ETF and the IVW ETF (IVW+0.54%), which tracks large-cap growth, have been the main contributors to negative returns in major benchmarks like the SPY. This raises a critical question for investors: Is the recent strength in value stocks a lasting shift toward more robust, attractively priced companies, or simply a temporary reversal within a bearish trend?

Current data leans toward the latter. Value has taken the lead for the first time since the October downturn, turning slightly positive at +0.2% year-to-date. Yet, this improvement is precarious. Defensive strategies, especially those focused on downside protection, continue to dominate. The recent tilt toward value and the broader market appears to be more of a short-term adjustment than a fundamental change in market regime. For institutional investors, this suggests a market that is probing its downside but not yet ready for a sustained risk-on rally. The durability of any factor rotation will depend on whether the macroeconomic shock from the energy crisis can be contained.

Key Drivers: Macro Trends, Valuations, and Sector Shifts

The current divergence among equity factors is a direct result of changing capital allocation priorities, shaped by improving economic fundamentals, shifting valuations, and a move away from speculative growth. Support for value and quality factors is grounded in real economic and sectoral developments, while momentum and large-cap growth are under pressure due to concerns about the sustainability of their growth and capital efficiency.

On the positive side, value stocks are benefiting from stronger earnings expectations in cyclical sectors. Sectors like financials, metals, and energy are driving value’s leadership in 2026, supported by a backdrop of resilient macroeconomic conditions and solid economic growth in the fourth quarter. This environment favors assets with tangible value and earnings power.

Case Study: IJK Value Factor Strategy Backtest

• Strategy: Long-only IJK ETF; enter when the 50-day price rank within the value sector is in the top 20%. Exit after 60 trading days or upon reaching a 15% gain or 10% loss. P/B percentile filters were not used due to data constraints.
• Backtest Results:
  • Total Return: 60.33%
  • Annualized Return: 16.77%
  • Maximum Drawdown: 11.36%
  • Profit-Loss Ratio: 2.37
  • Total Trades: 10 (8 winners, 2 losers)
  • Win Rate: 80%
  • Average Holding Period: 56.4 days
  • Average Gain: 6.87%
  • Average Loss: 2.75%
  • Largest Single Gain: 13.88%
  • Largest Single Loss: 5.23%
  • Max Consecutive Losses: 1

Although the quality factor has lagged recently, it remains attractively valued in the U.S. and is seeing improving macro trends in several regions. Its current underperformance may be more about sector-specific challenges than a fundamental loss of appeal.

On the other hand, momentum and large-cap growth face two main challenges. First, their high valuations are no longer justified by earnings growth. Second, the anticipated surge in AI-related revenues and returns on AI-driven capital expenditures has been slower than expected. This disconnect between lofty expectations and actual cash flow leaves these stocks vulnerable to a shift toward more profitable, cash-generating companies.

These trends reflect a broader, structural change in how capital is allocated. As we enter 2026, global markets are showing a renewed focus on fundamentals—profitability, cash flow stability, governance, and transparency—over pure growth potential. This shift supports value and quality factors while challenging those reliant on future growth without current profits. The outperformance of mid-cap growth and the struggles of large-cap growth illustrate the market’s evolving risk preferences, emphasizing operational strength and sustainable earnings.

Portfolio Strategy: Sector Allocation and Risk Management

The factor divergence in 2026 offers clear guidance for portfolio construction. The evidence favors a move away from concentrated growth positions toward a more balanced allocation that emphasizes risk-adjusted returns and quality.

• Overweight Value and Quality: The resurgence of value as a top performer is tied to improving fundamentals, especially in cyclical sectors like financials, metals, and energy. This is further supported by strong macroeconomic indicators and robust economic expansion. Quality, though under pressure, remains undervalued and could be poised for a rebound as macro trends improve.
• Underweight Growth and Mega-Cap Concentration: Persistent weakness in momentum and large-cap growth is a direct result of overextended valuations and disappointing earnings growth, especially as AI revenue realization lags. This makes these segments susceptible to rotation into more profitable, cash-rich businesses. The negative returns in broad equity indices are largely due to these factors, signaling the need to reduce reliance on single-factor growth exposure.
• Embrace Multi-Factor Diversification: Research consistently shows that no single factor outperforms in all environments. A diversified approach—tilting toward value and quality while maintaining exposure to other factors—offers a more resilient portfolio, better equipped to navigate changing market cycles.

Looking Ahead: Catalysts and Risks for Factor Investing

The current factor environment reflects a market in flux, with its future direction dependent on several key catalysts and risks.

• Geopolitical Developments: The ongoing conflict in Iran, and specifically the closure of the Strait of Hormuz, continues to cast a shadow over global markets. As long as this vital energy corridor remains blocked, the risk of an energy crisis and recession persists, putting pressure on momentum and large-cap growth. A resolution could ease risk premiums and shift market leadership away from defensive styles.
• AI Revenue Realization and Inflation: The slow pace of AI monetization is a significant headwind for growth and momentum factors. Persistent inflation, exacerbated by rising oil prices due to Middle East tensions, could delay monetary easing, further challenging growth narratives. For growth to regain favor, AI investments must translate into tangible, scalable revenues.
• Market Benchmarks: Institutional investors should monitor indicators like the Fama-French monthly market return for structural risk signals and the Buffett Indicator for valuation extremes. A decline in the former would support a defensive tilt, while a spike in the latter could warn of overvaluation, especially in large-cap growth.

In summary, current factor trends are driven by immediate catalysts: geopolitical risks, the pace of AI monetization, and inflation. For the rotation toward value and quality to persist, these headwinds must subside and AI must deliver on its promise. If not, the fragile leadership of mid-cap growth and value may give way, and the market could revert to its previous growth-focused stance. Active monitoring and flexible positioning remain essential in this evolving environment.