If we’re long-term buyers, what ought to we be shopping for?
That’s how often I’ve seen these market slumps, tumbles and crashes during the 25 years I’ve been writing about this stuff. At least.
This includes slumps in 2010 and 2011 that were as bad as this one, and which I bet you’ve totally forgotten about even if you lived through them. But it also includes the memorable dramas of 2000-3 and 2007-9, when share prices halved, and March 2020, when they fell by a third in a few weeks.
If you were underinvested in stocks when the market was falling you felt smug about it, as you probably do now.
If you were still underinvested coming out…not so much.
After all of these crashes came and went, $1 invested 25 years ago in a broad stock market fund like the Vanguard Total Stock Market Fund VTSMX, -3.49% would be worth $8.30 today. The bears lost.
With markets starting their sixth week in the red, it raises a couple of urgent questions. One is unanswerable: How low are we going to go? Nobody knows. Flip a coin. Take a guess. Go to Salem, Mass., and ask a “licensed” tarot card reader. Their guess will be as good as anyone else’s.
Another question is more useful and probably easier to answer: If we’re long-term investors, what should we be buying?
A number of market strategists say that at this point there is one area of the market that is looking particularly cheap, especially in relation to everything else. That area isn’t the S&P 500 index SPX, -3.20% of large-company stocks, the usual go-to for 401(k) and IRA investors. It’s small company stocks. Especially boring, higher-quality, so-called “value” small companies.
The broad Russell 2000 small cap index RUT, -4.21% has already plunged 25% since its peak last November. This is one of the sharpest, biggest falls on record. This index, the general benchmark for smaller US companies, is now lower than it was when Joe Biden became president 16 months ago.
And it’s left them cheap. “Small caps are [in] the bottom 3% of their historical ‘relative’ valuation range versus the S&P 500, and small cap value stocks are in the first percentile,” Doug Ramsey, chief investment strategist at Leuthold Group, tells me.
“On a price-to-earnings (PE) basis small-cap stocks remain ‘on sale’ in relation to large cap,” reports Will Nasgovitz, portfolio manager of Heartland Value Fund, a value-oriented stock fund. “This is only the third time in the last 42 years small-caps have sold at this large of a discount.” Within small-caps, he adds, “value seems to be at a decided advantage over small-cap growth.”
Nasgovitz, reached at his Milwaukee, Wis. offices, says that he typically follows the narrower S&P 600 small cap index SML, -2.84% rather than the Russell 2000. (The S&P index excludes many riskier or more speculative companies.)
He says that at the moment the S&P 600 trades at less than 12 times forecast earnings for the next 12 months, compared to nearly 18 times for the S&P 500. That discount is very big by historical measures, he points out.
I’ve run a longer-term chart, showing the Russell 2000 index in relation to the S&P 500 going back to 1987. This is a comparative chart, showing one divided by the other. As you can see, over the long term they have tended in the same direction, but at different points in time one was more in fashion than the other. The smart play seemed to be to bet on whichever was cheaper.
Russell 2000 vs S&P 500 (price only), 35 years
Even if small-caps are an opportunity, they are not a freebie. Small-cap stocks are usually more volatile than large-company stocks (though not always). Leuthold’s Ramsey warns that even though small-caps are cheaper today, that probably won’t help you in the short term.
“The history of small-caps is that they will fully participate in an equity bear market regardless of their comparative valuations,” Ramsey says. He adds: “I do believe, though, that they will greatly outperform the S&P 500 over the next 3-5 years.”
There are multiple ways of dipping your toe in the small-caps pond. They include through an actively managed fund such as Heartland Value HRTVX, -2.97% (It has fees of 1.1% a year, and has outperformed the Russell 2000 Value index over 1 and 5 years, though not over 10.) Or through a low -cost passive fund that doesn’t try to pick winners. Among low-cost exchange-traded funds, the Vanguard Russell 2000 ETF VTWO, -4.22% has fees of just 0.1%. The SPDR S&P 600 Small Cap ETF SPSM, -2.85%,
which follows the narrower, higher-quality index, has fees of 0.05%. The value-oriented equivalent, the SPDR S&P 600 Value ETF SLYV, -2.55%,
An important research note published seven years ago by hedge fund company AQR argued that if small-caps have done better over time than large-caps, that outperformance has been concentrated among better quality stocks. If they’re right, it’s a case for preferring the better quality S&P 600 index over the broader, less discriminating Russell.
Wall Street number crunchers continue to debate whether there is a so-called “small-cap effect,” meaning whether small-caps over time have outperformed large-caps. But the advantage of the current situation is that you don’t need to care. So long as the long-term performance is at least in line with large-caps, the current discount offers an opportunity.