In general, the S&P 500(SNPINDEX: ^GSPC) is the preferred stock market barometer for large-cap companies, while the Russell 2000 is the preferred stock market barometer for small-cap companies. Specific details are provided below:
S&P 500: Includes 500 large-cap companies that cover about 80% of U.S. equities by market value. The median market capitalization is $37 billion.
Russell 2000: Includes nearly 2,000 small-cap companies that cover about 5% of U.S. equities by market value. The median market capitalization is about $1 billion.
Tom Lee, head of research at Fundstrat Global Advisors, told CNBC during a recent interview that small-cap stocks may outpeform large-cap stocks by a wide margin in the near term. “I think small caps, in the next couple of years, could outperform by more than 100%,” he said, citing interest rate cuts and historically cheap valuations.
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Should that prediction prove accurate, the Russell 2000 would run circles around the S&P 500 in the next few years, perhaps even doubling its return as Lee suggests. Investors can position themselves to benefit by purchasing shares of the Vanguard Russell 2000 ETF(NASDAQ: VTWO).
Read on for the important details.
Image source: Getty Images.
Tom Lee highlighted two reasons small-cap stocks could outperform in the coming years. First, the Federal Reserve recently started cutting interest rates, and small-cap companies usually benefit from rate cuts more than large cap companies because the former usually have more floating-rate debt. Second, small-cap stocks currently have historically cheap valuations relative to large-cap stocks.
Importantly, Lee is not the only Wall Street pundit to make those points. In July, JPMorgan Chase strategist Michael Cembalest wrote, “Small-cap stocks are at their cheapest levels in the 21st century with potential market and political catalysts in their favor.” The catalysts he referenced include falling interest rates, as well as the tariffs proposed by President-elect Donald Trump. Tariffs usually hurt large-cap stocks more, according to Cembalest.
Likewise, Goldman Sachs strategists Hania Schmidt and Jen Nusser addressed interest rate cuts and small-cap valuations in a recent blog headlined: Time to Shine? A Small Cap Reversal of Fortune. The key points are detailed below:
The Russell 2000 has historically outperformed the S&P 500 by an average of 12 percentage points during the 12-month period following the end of a rate-cutting cycle.
Since 1985, the P/E ratio of the median Russell 2000 stock has been (on average) 2% below the P/E ratio of the median S&P 500 stock. But the discrepancy is currently 28%.
Investors should bear in mind that the current rate-cutting cycle started in September, and will likely persist for several months. So, the first point above will only become relevant once the current cutting cycle reaches its conclusion. That said, the relative valuation of the Russell 2000 versus the S&P 500 is 26 percentage points below its average over the last four decades.
The Vanguard Russell 2000 ETF tracks the performance of roughly 2,000 small-cap companies. The index fund includes value stocks and growth stocks from all 11 market sectors, though it’s most heavily weighted toward the industrial, financial, and healthcare sectors. The five largest position in the Vanguard Russell 2000 ETF are listed by weight below:
FTAI Aviation: 0.5%
Sprouts Farmers Market: 0.5%
Vaxcyte: 0.5%
Insmed: 0.4%
Mueller Industries: 0.3%
Importantly, the Russell 2000 offers much less exposure to technology stocks than the S&P 500. Specifically, the former has just 11% of its market value in technology stocks, while the latter has 32% of its market value in technology stocks. That discrepancy is noteworthy because the technology sector was the best-performing market sector over the last five, 10, and 20 years.
Consequently, the Vanguard Russell 2000 ETF underperformed the S&P 500 during those periods. In fact, while the Vanguard Russell 2000 ETF advanced about 125% over the last decade, the S&P 500 surged about 245%, essentially doubling the return of the small-cap benchmark.
The last important point is the expense ratio. The Vanguard Russell 2000 ETF carries a modest expense ratio of 0.1%, meaning investors will pay $1 annually on every $1,000 invested. Comparatively, the Vanguard S&P 500 ETF has a lower expense ratio of 0.03%.
Here’s the bottom line: Fundstrat analyst Tom Lee thinks interest rate cuts and historically cheap valuations will help the small-cap Russell 2000 outperform the large-cap S&P 500 by more than 100% in the next few years. Investors can position themselves to benefit from that outperformance by purchasing shares of the Vanguard Russell 2000 ETF.
However, the S&P 500 has crushed the Russell 2000 in recent history because it has more exposure to the technology sector. That trend could continue in the future as the artificial intelligence boom unfolds. So, I think the most sensible move is to own an S&P 500 index fund and a Russell 2000 index fund, but I would prioritize the former over the latter.
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JPMorgan Chase is an advertising partner of Motley Fool Money. Trevor Jennewine has positions in Vanguard S&P 500 ETF. The Motley Fool has positions in and recommends Goldman Sachs Group, JPMorgan Chase, and Vanguard S&P 500 ETF. The Motley Fool recommends Sprouts Farmers Market. The Motley Fool has a disclosure policy.
