Market Correction: This Bargain ETF is Down Almost 20%

The S&P 500 index has recently dipped into correction territory after experiencing a decline of about 10% from its recent highs. However, other segments of the stock market have faced even steeper losses.

One significant area that has struggled during this market sell-off is small-cap stocks. The Russell 2000 small-cap index has decreased by over 18% from its peak late last year. This decline can be attributed to rising concerns about a potential recession, which usually affects smaller companies more severely.

Despite the recent downturn, small-cap stocks were viewed as a compelling investment opportunity at the start of the year, and they appear even more appealing now. This is why the Vanguard Russell 2000 ETF (VTWO) is currently at the forefront of many buy lists.

Understanding the Vanguard Russell 2000 ETF

As indicated by its name, the Vanguard Russell 2000 ETF is an index fund that mirrors the performance of the Russell 2000, which is broadly recognized as a reliable gauge of small-cap stock performance.

Companies within the Russell 2000 have a median market cap of around $3.3 billion. This is a weighted index, meaning that no single stock comprises more than 0.6% of the fund, which is in stark contrast to the large-cap-dominated S&P 500. The ETF’s leading holdings include Sprouts Farmers Market, Insmed, and Vaxcyte. If these companies sound unfamiliar, that’s part of the benefit of investing in a broad small-cap ETF like this one; it provides exposure to a diverse array of smaller firms without requiring extensive research into individual investments.

This Vanguard ETF is also known for its low expenses, with an expense ratio of just 0.07%. This means that for every $10,000 you invest, you'll incur a minimal annual cost of merely $7, which is not a fee paid directly but rather reflected in fund performance.

A Notable Valuation Gap

The Vanguard Russell 2000 ETF was already considered inexpensive a year ago, and its value has only decreased further. Early in 2024, small-cap stocks traded at their lowest price-to-book valuations compared to large-cap stocks since the late 1990s. The recent surge in mega-cap tech stocks, driven by advancements in artificial intelligence, has only widened this valuation gap. In fact, the Russell 2000 has underperformed even further this year, even as the S&P 500 entered correction territory.

This underperformance has led to significant disparities in valuations between small-cap and large-cap stocks. Here are some key metrics illustrating this gap:

Metric	S&P 500 Median	Russell 2000 Median
P/E ratio	27.5	17.8
P/B ratio	5.0	2.0
Earnings growth rate	18.9%	14.3%

The data here is based on information from Vanguard at the end of January. This valuation gap has only increased further amid the recent market correction. It’s important to note that while S&P 500 companies are generally seeing faster earnings growth, this difference is insufficient to rationalize such a wide valuation disparity.

While the gap between these indices might not completely close, there's a valid point in that the S&P 500 contains a significant number of high-growth tech stocks that warrant a premium compared to small caps. Nevertheless, the difference in valuations is currently at its broadest in a long time, indicating that small caps may have room for recovery.

Small-Cap Stocks Might Shine in a Rally

While small-cap stocks have been hit hard due to fears of recession and economic uncertainty, a turnaround in these situations could work in their favor.

Moreover, expectations for interest rate cuts from the Federal Reserve have notably risen in recent weeks, with projections now indicating three to four quarter-point cuts, escalating from a previous expectation of just one.

Small-cap stocks often benefit when interest rates decline, as they generally rely on external financing. Lower rates can ease their borrowing costs. Additionally, as rates drop, investors might shift funds from more secure assets like Treasury securities into equities, supporting “riskier” investments such as small-cap stocks.

Furthermore, potential governmental moves regarding tax cuts and regulatory changes, if beneficial, could significantly enhance prospects for smaller companies.

It’s essential to acknowledge that the current market turbulence and correction could still worsen before stabilizing. Straining economic data or escalating trade tensions may lead to further impacts. Yet, from a long-term investment standpoint, the Russell 2000 ETF presents a compelling opportunity right now, and long-term investors may find this an advantageous time to invest.

Author has interests in the Vanguard Russell 2000 ETF. Recommendations are made purely for informational purposes.

Market, Stocks, ETF