SCHX - SCHA: Higher Volatility Expected In The Potential Upcoming Economic Recession

2023-10-05 12:10:15 ET

Summary

• Schwab U.S. Small-Cap ETF has a portfolio of 1,750 small-cap U.S. stocks and has been rangebound in 2023.
• Investors should be aware of the volatility of small-cap stocks, which can be more volatile than large-cap stocks.
• SCHA's valuation is reasonable but there is potential downside risk due to a possible economic recession in 2024.

ETF Overview

Schwab U.S. Small-Cap ETF ( SCHA ) has a portfolio of about 1,750 small-cap U.S. stocks. The fund has been in rangebound in 2023. SCHA typically exhibits higher volatility and suffered deeper losses in times of market turmoil and lagged in market rallies when compared to its large-cap peers. As we may be heading towards an economic recession in 2024, we think investors should remain cautious and patiently wait on the sidelines.

Fund Analysis

SCHA has been rangebound since the trough in late 2022

SCHA had a disastrous 2022 as the fund saw its fund price declined significantly by 27% from the beginning of the year to the trough in October. The fund has generally be in rangebound in 2023 and its fund price is now near the trough reached in October 2022.

Investors should keep in mind the volatility of small-cap stocks

Investors of SCHA needs to be aware of the characteristics of small-cap stocks. Small-cap stocks usually do not have a stronger balance sheet than large-cap stocks. Their business models are usually not as established as their large-cap peers. Therefore, their stock prices tend to be much more volatile than large-cap stocks. This especially needs to be noted in times of market turmoil. As can be seen from the chart below, during the initial outbreak of the pandemic in 2020, SCHA declined by nearly 45%. In contrast, the S&P 500 index, which consists of large-cap stocks, only declined by about 35%. Therefore, SCHA declined by about 10 percentage points higher than the broader market.

When the market stabilizes, it is also usually large-cap stocks that recovers first. As can be seen from the chart below, SCHA’s large-cap peer, Schwab U.S. Large-Cap ETF ( SCHX ) was the one that dropped the least among the three in the chart during the initial outbreak of the pandemic. SCHX was also the first to recover the loss after the market stabilized in 2020. SCHA lagged in the rally. The same also occurred in the 2023 rally of the stock market. SCHX recovered a lot of its losses yet SCHA’s fund price was only slightly higher than the trough reached in October 2022.

Valuation reasonable versus large-cap stocks

Investors may wonder whether SCHA’s valuation is reasonable or not. Here, we will look at the valuation of two indexes. The first index we will examine is the S&P 600 SmallCap Index. This index consists of 600 U.S. small-cap stocks. As can be seen from the chart below, the S&P 600 index’s forward P/E ratio of 12.3x is towards the low end of its historical average in the past 2 decades. However, the S&P 600 SmallCap Index may not be a good representation of SCHA as SCHA consists of 1,750 stocks. We believe a better comparison is the Russell 2000 Index, which consists of 2,000 small-cap stocks. As the chart below shows, the forward P/E ratio of the Russell 2000 Index is 20.7x. This valuation appears to be reasonable compared to its historical average. Since there are significant overlaps between the Russell 2000 Index and SCHA, we think SCHA’s valuation is also quite reasonable.

What is the likely outcome in the next year?

Now that we have learned the characteristics of small-cap stocks and the valuation of these stocks, we will look at the macroeconomic environment we are in right now and how this might evolve in the upcoming year.

We believe the Federal Reserve’s policy of keeping the rate higher and for longer will eventually bring the economy to a recession. While one may argue that the U.S. economy appears to be resilient and a soft-landing is possible if inflation can quickly come down, we do not think it is that simple. The primary reason is that combating inflation is not an easy task due to the spiraling effect of inflation. Therefore, the Federal Reserve may have no choice to keep the rate higher and for longer to combat inflation. In fact, the Federal Reserve has indicated that they will keep the rate elevated in 2024 and perhaps even longer. As the impact of this high rate propagates through the economy, it has the potential to eventually tip the economy towards a recession in 2024.

If an economic recession occurs, earnings of small-cap stocks will likely continue to be revised downwards. In addition, its valuation might be further compressed. In other words, we will witness higher volatility and SCHA’s fund price may also fall more than the S&P 500 index. Therefore, we see significant downside risk ahead.

Investor Takeaway

SCHA’s valuation may not be expensive right now, but a recession may not be too far away. As we have seen from our discussions, SCHA has the potential to drop more than its large-cap peers and SCHA is usually not the first one to recover from the market turmoil. Therefore, investors should exercise caution, and patiently wait for a better entry point.

Additional Disclosure : This is not financial advice and that all financial investments carry risks. Investors are expected to seek financial advice from professionals before making any investment.

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