The announcement of President Trump’s “reciprocal tariff” plans certainly shook the stock market, sending it into a tailspin. While all sectors felt the impact, some were hit harder than others.
One of the most significant casualties has been the Russell 2000, a comprehensive index tracking small-cap stocks, which has now plummeted into bear market territory. Following the tariff news, the index dropped to a level that is 22% below its recent peak. Futures markets hint at potential further declines, depending on when you’re catching up on this update.
Interestingly, prior to this downturn, small-cap stocks already appeared undervalued compared to their large-cap counterparts as we approached 2025. This scenario presents a potentially golden opportunity in the small-cap arena, making the Russell 2000 an attractive option for investors eyeing long-term, market-beating returns.
Let’s delve into the current landscape of small-cap stocks and why this might be an opportune moment to consider investing in the Russell 2000.
Small-cap stocks are trading at historically low valuations compared to the S&P 500, with the disparity only getting wider. Fundstrat’s Tom Lee highlighted that entering 2024, these stocks were at their lowest price-to-book ratios relative to large caps since 1999. Since then, the gap has only widened, with the Russell 2000 underperforming the S&P 500 significantly over the past two years.
This gap is quite perplexing. The typical S&P 500 stock commands a price-to-earnings ratio of 26.8 and a price-to-book ratio of 4.8. In stark contrast, Russell 2000 components average a P/E ratio of 17.5 and a P/B ratio of just 1.9. Although large-cap stocks have indeed experienced faster earnings growth, especially tech giants, it’s hard to justify their significantly higher valuations.
Will small-cap stocks make a comeback?
Lee further notes that the last time this valuation gap was seen, small caps outperformed large caps for the next 12 years, exceeding the S&P 500 by 113 percentage points. While history doesn’t guarantee a repeat, the potential for small-cap stocks to shine again is backed by sound reasoning.
Small caps are often more sensitive to interest rate cuts, as these companies typically rely more on borrowed funds and benefit from increased investor risk appetite when rates drop. Following the tariff announcement, expectations for rate cuts have surged, with analysts now predicting five quarter-point reductions by the Federal Reserve this year, up from three previously anticipated.
While it’s uncertain how long the present market turbulence will linger or when small caps might start to close the valuation gap, their current affordability doesn’t preclude further short-term declines. However, for patient investors looking at long-term gains, the Russell 2000 presents an appealing opportunity. Investing simply in an index fund like the iShares Russell 2000 ETF (IWM) could be a wise move without needing to navigate any complexities.
