Market Correction: This Dirt Cheap ETF Is Down by Almost 20%

The benchmark S&P 500 index has recently entered correction territory, marked by a drop of 10% from its recent highs. However, some areas within the stock market have faced even steeper declines.

One significant segment experiencing underperformance during this market downturn is small-cap stocks. The Russell 2000 small-cap index has plummeted more than 18% from its peak in late 2024. This downturn can be attributed to rising recession fears, which tend to have a more pronounced effect on smaller companies compared to larger ones.

At the beginning of the year, small-cap stocks seemed like a great opportunity for long-term investors. The current situation makes them even more appealing. This is why the Vanguard Russell 2000 ETF (VTWO 2.44%) is high on my list of recommendations right now.

What is the Vanguard Russell 2000 ETF?

The Vanguard Russell 2000 ETF is an index fund that tracks the Russell 2000 index, which is widely regarded as one of the best indicators of small-cap stock performance.

The average market capitalization of a Russell 2000 company is $3.3 billion. Although it is a weighted index, no single stock accounts for more than 0.6% of the fund, which is a significant contrast to the S&P 500, which is dominated by mega-cap stocks. The fund's top holdings include Sprouts Farmers Market, Insmed, and Vaxcyte. If you are not familiar with these companies, that underscores the benefit of investing in a broad small-cap ETF, as it provides exposure to a diverse range of smaller firms without necessitating extensive research.

This ETF has a low expense ratio of just 0.07%. To put it in perspective, if you invest $10,000, your annual costs amount to only $7. This is not a fee that you have to pay directly; rather, it is reflected in the fund's overall performance over time.

A wide valuation gap

The Vanguard Russell 2000 ETF was already considered inexpensive a year ago, and it has only become more so since then. At the beginning of 2024, small-cap stocks were trading at their lowest price-to-book valuation compared to large-cap stocks since the late 1990s. This valuation gap widened further due to the surge in mega-cap tech stocks driven by artificial intelligence (AI) trends last year. Even with the S&P 500 now in correction territory, small-cap stocks from the Russell 2000 have declined even more.

This situation has led to a substantial valuation gap between small-cap and large-cap stocks. Consider some key metrics:

Metric	S&P 500 Median	Russell 2000 Median
P/E ratio	27.5	17.8
P/B ratio	5.0	2.0
Earnings growth rate	18.9%	14.3%

This data is as per Vanguard's latest information available at the end of January. Notably, the gaps are believed to have widened even more in the current market correction. While the average S&P 500 company is demonstrating quicker earnings growth, this growth is insufficient to justify the significant valuation disparity.

It is essential to acknowledge that this gap may never completely close. The S&P 500 includes a larger share of high-growth (and high-valuation) tech stocks, which might warrant a premium. Nevertheless, the valuation gap between these two indexes is the widest it has been in a long time. As discussed in the next section, small-cap stocks may have the potential to recover significantly.

Small-cap stocks could be big winners in a rebound

While small-cap stocks have been adversely affected by recession fears, uncertainties around tariffs, and disappointing economic data, these factors could work in their favor once conditions improve.

There have also been rising expectations regarding Federal Reserve interest rate cuts this year, with the current median forecast suggesting three to four quarter-point cuts compared to just one anticipated at the year’s start.

Lower interest rates could benefit small-cap stocks significantly, as these companies typically rely more on borrowed funds. Additionally, as rates decline, capital could shift from safer investments like Treasury securities and CDs into the stock market, providing a boost to riskier assets like small-cap stocks.

Moreover, prospects for tax cuts and regulatory reforms, part of policy discussions by the current administration, could provide additional support for smaller companies once uncertainties around tariffs are resolved.

It is crucial to note that the current market fluctuations and corrections may not be over. If economic conditions worsen or tariff uncertainties escalate, things could deteriorate before they get better. However, from a long-term perspective, the Vanguard Russell 2000 ETF represents an excellent opportunity right now, and long-term investors who choose to invest at this moment are likely to find satisfaction in their decisions.

This article is meant for informational purposes and reflects general insights about the market.

market, stocks, etf