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The small cap Russell 2000 rose 10.4% in July, while the large-cap S&P500 (SNPINDEX: ^GSPC) has traded mainly sideways this month. According to Forbes, February 2000 was the last time in any month that the Russell 2000 outperformed the S&P 500 by so much.
Tom Lee, head of research at Fundstrat Global Advisors, believes this pattern will continue in the coming months. He recently told CNBC that the Russell 2000 could rise another 40% by the end of the summer, implying the index could top 3,100 in the not-too-distant future.
His reasoning: Small-cap companies trade at historically cheap valuations compared to large-cap companies. Furthermore, the Federal Reserve is expected to cut its benchmark interest rate soon, and lower rates should have a disproportionately positive impact on small-cap companies.
Short-term forecasts are prone to inaccuracy because the stock market can behave irrationally when performance is measured in weeks and months. Warren Buffett once described short-term market forecasts as “poison.” But Lee has been prescient in the past, such as being one of the few Wall Street analysts to predict the S&P 500’s 2023 rally.
Investors should at least consider buying a position in an index fund that tracks the Russell 2000 and the index Vanguard Russell 2000 ETF (NASDAQ: VTWO) fits the bill perfectly.
Small-cap stocks are trading at their cheapest levels in the 21st century
Small capitalization stocks have substantially underperformed large-cap stocks over the past decade. Since July 2014, the Russell 2000 has returned 126%, while the S&P 500 has advanced 232%. As a result, small-cap stocks are currently trading at the biggest discount to large-cap stocks in decades.
Michael Cembalest op JPMorgan Chase recently wrote, “Small-cap stocks are at their cheapest levels in the 21st century, with potential market and political catalysts in their favor.” He also explained how small-cap stocks ended up in this position. Russell 2000 companies are much less profitable and much more exposed to higher interest rates than S&P 500 companies.
However, futures price data shows that the Federal Reserve could cut rates three times by 25 basis points in 2024, and policymakers will make six cuts of 25 basis points before the end of July 2025. Goldman Sachs Analysts wrote in February: “In the US, 30% of Russell 2000 debt is financed on a floating rate basis, compared to just 6% of the S&P 500. This means small caps should start to feel the benefits of lower interest rates . faster than large caps.”
In addition, Republican presidential candidate Donald Trump has promised to impose new and fairly aggressive tariffs on imported goods. Certain economists believe that such a policy would worsen inflation and reduce the purchasing power of the typical American family by 2.7%. However, the tariffs tend to hit larger companies than small companies, so the Russell 2000 could outperform the S&P 500 due to a roundabout political catalyst.
To be clear, that doesn’t necessarily mean the Russell 2000 will be a profitable investment. Certain analysts have warned that higher rates could cause the stock market to fall. The Russell 2000 could simply fall less sharply than the S&P 500. Moreover, political catalysts may play little role in the short term simply because investors may react to the presidential election results. But the actual economic impact of tariffs will only become visible once these tariffs are implemented.
What Investors Need to Know About the Vanguard Russell 2000 ETF
The Vanguard Russell 2000 ETF tracks the Russell 2000, which itself measures the performance of approximately 2,000 small-cap stocks. For context, the average market cap for companies in the Russell 2000 and the S&P 500 is approximately $900 million and $35 billion, respectively.
Another important difference is the sector allocation in the stock markets. The Russell 2000 is most heavily weighted toward the industrials (19%), healthcare (15%), and financial services (15%) sectors, while the S&P 500 is most heavily weighted toward information technology (32%), financial services ( 12%). ) and healthcare (12%).
The five largest holdings in the Vanguard Russell 2000 ETF are listed below by weight.
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Submitted: 0.4%
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FTAI Aviation: 0.4%
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Abercrombie & Fitch: 0.4%
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Fabrinet: 0.4%
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Sprouts farmers market
The Vanguard Russell 2000 ETF has a reasonable expense ratio of 0.1%, meaning investors will pay $1 annually for every $1,000 invested in the fund.
The bottom line: Impending rate cuts and historically cheap valuations make the Russell 2000 look particularly attractive right now. But investors should remember that Russell 2000 companies are much less profitable than S&P 500 companies, by which I mean free cash flow margins are lower and more companies have negative earnings. So there is some rationale and rationale behind the historically cheap valuations.
Personally, I think it makes sense for patient investors to buy a few shares of the Vanguard Russell 2000 ETF now, simply because small-cap stocks have several catalysts working in their favor. However, I wouldn’t invest more than 5% to 10% of my portfolio in a Russell 2000 index fund. The S&P 500 has simply performed too well for too long for me to feel comfortable with that decision.
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JPMorgan Chase is an advertising partner of The Ascent, a Motley Fool company. Trevor Jennevine has no position in any of the stocks mentioned. The Motley Fool holds positions in and recommends Goldman Sachs Group and JPMorgan Chase. The Motley Fool recommends Sprouts Farmers Market. The Motley Fool has one disclosure policy.
Historically, this is the low-cost Vanguard index fund to buy before it surges 40%, according to a Wall Street analyst was originally published by The Motley Fool