VONE - VV: Downside Risks Outweigh Upside Potential In 2023

2023-03-29 17:31:08 ET

Summary

• VV invests in large-cap U.S. stocks.
• The fund has performed quite well over the long run.
• However, the downside risk is high due to its elevated valuation.
• Earnings may continue to be revised downward for stocks in VV’s portfolio.

Introduction

Investors that focus solely on large-cap stocks have endured losses since the beginning of 2022. Will this trend continue for the rest of 2023? Will large-cap stocks win favor again? In this article, we will analyze Vanguard Large Cap ETF ( VV ) and provide our insights and suggestions.

VV tracks the CRSP US Large Cap Index. This index consists of a portfolio of market-cap-weighted, large-cap U.S. stocks. These stocks represent roughly 85% of the investable U.S. stock market. While these stocks tend to perform well over the long run, the near-term risk appears to be quite high. VV's valuation is still quite elevated, and earnings of stocks in its portfolio may continue to be revised downward. Therefore, we think investors should patiently wait on the sidelines.

Fund Analysis

Significant decline last year but long-term growth is excellent

Investors of large-cap stocks had a bad year last year, as the strong stock performance during the pandemic quickly shifted towards significant decline due to the Federal Reserve's tightening monetary policy to combat inflation. As a result, VV declined by nearly 30% since reaching the peak in the beginning of 2022 to the trough reached in October 2022. Despite its underperformance in 2022, the fund had very solid growth over the past 10 years. As can be seen from the chart below, VV delivered a total return of 203.4%. This return was only slightly behind SPDR S&P 500 ETF ( SPY ) which tracks the S&P 500 index but better than Vanguard Russell 1000 ETF ( VONE ) which tracks the Russell 1000 index. Both funds consist of large-cap stocks.

VV's exposure to technology stock is beneficial

The strong growth was due to the good growth prospect in VV's portfolio, as the fund includes many large-cap growth stocks. In fact, the technology sector represents over 27% of the total portfolio. These large-cap technology stocks include names such as Apple ( AAPL ), Nvidia ( NVDA ), Microsoft ( MSFT ), Google ( GOOG ) ( GOOGL ), and Amazon ( AMZN ). They should continue to grow at a rapid pace relative to the broader market as their businesses will benefit from several strong growth trends such as artificial intelligence, internet of things, e-commerce, digital transformation, etc.

The fund has rebounded in the past few months, but downside risk is high

Since reaching the trough in October 2022, VV has gained over 10%. While the recovery in VV's price in the past 5 months is encouraging, investors should not be too confident that we are out of the wood. Since the Federal Reserve is not ready to lower the rate due to persistent inflation, we believe this elevated rate environment will continue beyond 2023. Given that the Federal Reserve's monetary policy usually takes about 6~12 months to propagate through the economy. We may soon feel the pain caused by the policy. In fact, the recent crisis of several regional banks is a sign of some cracks in the financial system already. Therefore, the Federal Reserve's policy has a very high likelihood to tip the economy over to a recession. Since stock markets usually do not bottom before a recession, we think the market will try to test a new low during the upcoming potential recession. This decline can be significant. As can be seen from the chart below, VV declined by over 55% in the 2008/2009 recession and by over 25% in the 2020 recession.

Valuation is still expensive

Despite the significant decline last year, large-cap stocks are still expensive. Below is a chart that shows the forward P/E ratios of Russell 1000 and S&P 500 index. Since VV's portfolio has a high overlap to the S&P 500 and Russell 1000 indexes, using this chart to evaluate VV's valuation is adequate. As can be seen from the chart, despite the significant decline in 2022, the Russell 1000 and the S&P 500's forward P/E ratios are still quite elevated. The current forward P/E ratios are still significantly higher than the valuation range of 10x ~ 14x between 2008 and 2013. Therefore, we may continue to see some multiple compression, especially if there is a financial crisis.

Earnings revisions are likely just starting

Besides the risk of multiple compression, we may see earnings being revised downward for large-cap stocks. In fact, this earnings revision has already started. As can be seen from the chart below, earnings have been slightly revised downward in February 2023 for stocks in the S&P 500 index. This revision is likely just starting, as earnings were revised by more than 25% during the Great Recession and about 20% during the recession in 2020. Therefore, there is still more room for the decline in our view.

Investor Takeaway

While VV may look attractive due to the significant decline of its fund price last year, we think there may be more downside risk as its valuation still looks quite elevated. In addition, earnings revisions are probably just starting. Therefore, the downside risk appears to outweigh the upside potential. Hence, we recommend investors to wait on the sidelines.

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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