In general the S&P500(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 can be found below:
S&P500: Includes 500 large-cap companies covering approximately 80% of US equities by market value. The average market capitalization is $37 billion.
Russell 2000: Includes nearly 2,000 small-cap companies covering approximately 5% of U.S. stocks by market value. The average 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 could easily outperform large-cap stocks in the short term. “I think small caps can outperform by more than 100% in the coming years,” he said, citing rate cuts and historically cheap valuations.
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If this prediction is correct, the Russell 2000 would continue to orbit the S&P 500 for years to come, perhaps even doubling its returns, as Lee suggests. Investors can position themselves to benefit by buying shares of the Vanguard Russell 2000 ETF(NASDAQ: VTWO).
Read on for the important details.
Image source: Getty Images.
Tom Lee highlighted two reasons why small-cap stocks could outperform in the coming years. First, the Federal Reserve recently started lowering interest rates, and small companies tend to benefit more from rate cuts than large companies because the former tend to have more variable-rate debt. Second, small-cap stocks currently have historically cheap valuations compared to large-cap stocks.
Importantly, Lee is not the only Wall Street expert making these 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 was referring to include falling interest rates, as well as those proposed by newly elected President Donald Trump. Tariffs tend to be more damaging to large-cap stocks, according to Cembalest.
Likewise, Goldman Sachs Strategists Hania Schmidt and Jen Nusser discussed rate cuts and small cap valuations in a recent blog headline: Time to shine? A reversal of fortune for small businesses. The main points are described below:
The Russell 2000 has historically outperformed the S&P 500 by an average of 12 percentage points over the twelve-month period following the end of a rate-cutting cycle.
Since 1985, the price/earnings ratio of the average Russell 2000 stock has been (on average) 2% below the price/earnings ratio of the average S&P 500 stock. But the difference currently stands at 28%.
Investors should remember that the current rate cutting cycle started in September and is likely to continue for several months. So the first point above will only become relevant once the current cutting cycle has reached its end. That said, the Russell 2000’s relative valuation to the S&P 500 is 26 percentage points below the average over the past four decades.
The Vanguard Russell 2000 ETF tracks the performance of approximately 2,000 small-cap companies. The index fund includes value and growth stocks from all eleven market sectors, although it is most heavily weighted in the industrial, financial and healthcare sectors. The five largest holdings in the Vanguard Russell 2000 ETF are shown below by weight:
Importantly, the Russell 2000 offers much less exposure to technology stocks than the S&P 500. Specifically, the former has only 11% of its market value in technology stocks, while the latter has 32% of its market value in technology stocks. This discrepancy is notable because the technology sector has been the best-performing market sector over the past five, ten and twenty years.
As a result, the Vanguard Russell 2000 ETF underperformed the S&P 500 during those periods. While the Vanguard Russell 2000 ETF is up about 125% over the past decade, the S&P 500 is up about 245%, outpacing the small-cap benchmark’s returns. has actually doubled.
The last important point is the expense ratio. The Vanguard Russell 2000 ETF has a modest expense ratio of 0.1%, meaning investors will pay $1 annually for every $1,000 invested. For comparison: the Vanguard S&P 500 ETF has a lower expense ratio of 0.03%.
The bottom line: Fundstrat analyst Tom Lee thinks 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 coming years. Investors can position themselves to take advantage of this 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. This trend could continue in the future as the artificial intelligence boom unfolds. So I think the wisest thing to do is 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 Jennevine holds positions in Vanguard S&P 500 ETF. The Motley Fool holds 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.
1 Vanguard Index Fund Could Beat the S&P 500 by 100% in the Next Years, a Wall Street Analyst Says, originally published by The Motley Fool
