In their latest study Citi analysts Scott T Chronert and Louis L Odette look at small and midcap stocks through the lens of earnings growth and across sectors.

“Against a backdrop characterized by valuations toward the higher end of historical ranges, but with trailing earnings growth near historically low levels, the earnings growth dynamic will become the critical variable determining SMID performance trends in 2014,” say Citi.

The authors point out that the YTD gain of 35%+ in the Russell 2000 (INDEXRUSSELL:RUT) took place against the backdrop of an expectation of 18-20% earnings growth, but the actual growth for 2013 is likely to be only 7-9%.

Heightened earnings expectations for small and midcap stocks

This “earnings expectation headwind” makes the gains achieved by the RUT appear rather impressive, but this is likely explained away by other, macro factors such as QE and improvement in the global economy on the one hand, and “heightened expectation” of earnings growth during 2014 on the other.

Using bottom-up earnings growth projections for 2014, here’s how the RUT sectors stack up for PE and PEG ratios.

1-forward-sector-pes midcap stocks

Upward 2014 earnings revisions the starting point

Interestingly, Citi chose to focus on companies and sectors that are showing earnings promise for 2014 via upward revisions to forecasts.

Sector: consumer discretionary

Citi is overweight on the sector because “it contains a compelling universe of alpha opportunities, has been an active sector for M&A, and can also be viewed as a beneficiary of lower energy prices.”

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Sector: Consumer Staples

Citi is Market Weight, as “forward PE appears stretched, with little else in the way of valuation support.”

3-consumer staples midcap stocks

Sector: Energy

Citi has a Market Weight (down from Overweight) rating on the sector given that there appears little appreciation from hereon particularly in the context of a muted commodity view.

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Sector: Financials

Citi maintains a Market Weight on this sector but notes that the percentage of upward guidance is ticking higher even while valuations appear reasonable.

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Sector: Health Care

This sector is Underweight on Citi’s radar, though there is a solid trend of upward revision and guidance. However, stretched PEs and the cloud of Obamacare implementation are a source of worry.

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Sector: Industrials

Rating: Market Weight

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Sector: Information Technology

“We are wary of the ongoing Tech Bubble influence on historical valuations. We suspect that earnings growth expectations headed into 2014 are still somewhat aggressive, but also acknowledge the sector’s inherent sensitivity to macro conditions. Further, Tech has shown very mixed performance during 2013, with Software quite strong while Hardware and Semis have been more mixed. As such, we maintain our Market Weight,” say Citi.

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Sector: Materials

Market Weight, considering its small weight in the index and sensitivity to global macro influences.

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