2023-11-06 13:27:32 ET
Summary
- Vanguard Russell 2000 ETF has underperformed mid-cap and large-cap peers during market turmoil.
- VTWO's fund price is more volatile than its mid-cap and large-cap peers due to the characteristics of small-cap stocks.
- While VTWO's valuation appears reasonable, an economic recession may result in lower earnings and a further decline in its fund price.
ETF Overview
Vanguard Russell 2000 ETF ( VTWO ) has a portfolio of about 2,000 U.S. small-cap stocks. The fund basically tracks the Russell 2000 Index. VTWO has typically underperformed its mid-cap and large-cap peers during market turmoil. Since we believe an economic recession is not far away, we think investors should exercise caution and wait for a better entry point.
Fund Analysis
VTWO declined to a new low recently
Like many other equity funds, VTWO had a disastrous 2022 due to the Federal Reserve's aggressive rate hike to combat inflation. The fund saw its fund price dwindled by about 26.7% from the beginning of the year to the trough in October. The fund has recovered some of its losses in the first half of 2023 but has recently lost the momentum. The rally appeared to be unsustainable and has declined by 18% from the end of July to late October 2023. VTWO has recovered some of the losses in the past week, but the fund is still in a declining trend.
VTWO’s fund price can be quite volatile compared to its mid-cap and large-cap peers
Investors of VTWO needs to beware of the characteristics of small-cap stocks. Compared to large-cap or mid-cap stocks, small-cap stocks usually do not have strong balance sheets to weather major storms. 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. Investors needs to be aware of this in times of market turmoil. As can be seen from the chart below, during the outbreak of the pandemic in 2020, VTWO declined by about 43%. In contrast, the S&P 500 index, which consists of large-cap stocks, only declined by about 35%.
Large-cap stocks also usually recover first when the market recovers. In contrast, small-cap stocks such as VTWO usually recover in the mid-stage of an economic expansion. Below is a chart that compares VTWO, its mid-cap and large-cap peers Vanguard Mid-Cap ETF ( VO ) and Vanguard Large-Cap ETF ( VV ). As can be seen from the chart, VV was the one that dropped the least among the three during the initial outbreak of the pandemic in 2020. It was also the first among the three to recover. In contrast, VTWO’s recovery was about 6 months later. In the market rally in the first half of 2023, VV was also the one to rally first. In contrast, VTWO’s fund price was only slightly higher than the trough reached in October 2022. Therefore, VTWO is more suitable for investors not before a recession. The best time to own VTWO is right before the mid-stage of an economic expansion.
Valuation reasonable
Below is a chart that shows the forward P/E ratio of the Russell 2000 Index since 1999. As the chart below shows, the forward P/E ratio of the Russell 2000 Index is currently 19.1x. This valuation appears to be reasonable compared to its historical average in the past two decades. This ratio is not as high as the peak reached during the pandemic in 2020 and 2021, but also not as low as the trough reached during the Great Recession in 2008/2009 and the initial outbreak of the pandemic in 2020. In contrast, the S&P 500 index, which consists of only large-cap stocks, has a forward P/E ratio of about 18x. Therefore, VTWO’s portfolio of small-cap stocks appears to be even more expensive than large-cap stocks.
What is the likely outcome in the next year?
While VTWO’s valuation may appear to be reasonable, investors should keep in mind that the “E” in the P/E ratio may be revised downward if an economic recession arrives. This will result in lower stock prices even if the valuations remain the same.
We believe the Federal Reserve’s policy of keeping the rate elevated for longer will eventually tip the economy over to a recession. While some people may argue that the U.S. economy appears to be resilient with strong job demands, we think investors should embrace for an eventual recession. First, it usually takes more than a year for the impact of the monetary policy to transmit fully through the economy. Therefore, we will eventually observe the damage caused by the aggressive rate hike to the economy likely in the next 6 months. Second, inflation can be quite persistent as it will lead to labors demanding higher wages. Higher wages will also lead to higher commodity and services prices. Unfortunately, the best way to prevent inflation from flaring up is to keep the rate elevated for a lengthy period. This will eventually result in an economic recession.
In an economic recession, small-cap stocks will be impacted negatively and cause earnings revision. As we have shown in our analysis, we think VTWO may underperform the S&P 500 index in an economic recession.
Investor Takeaway
VTWO’s valuation appears to be reasonable, but an economic recession will likely result in lower earnings. Therefore, we believe VTWO's fund price is vulnerable to further declines. As we have analyzed in our article, the best time to invest in VTWO is right before the mid-stage of an economic expansion, not before the recession. Therefore, we think investors should not be buying VTWO right now. Instead, it is best 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.
For further details see:
VTWO: Embrace Higher Volatility