The market’s latest milestone has sparked concerns about the sustainability of the rally. Despite the S&P 500’s impressive 20% year-to-date gain, some investors are wary of the index’s lofty valuations. The Vanguard S&P 500 ETF’s price-to-earnings ratio has reached 28.7, a level only seen during the dot-com bubble, the Great Recession, and the pandemic – all of which were followed by bear markets.
A closer look at the “Magnificent Seven” stocks, which dominate the S&P 500, reveals that most are trading at valuations above 30, typically associated with smaller growth stocks. While large-cap stocks have led the charge, their outperformance may be nearing its end. Historically, bull markets tend to broaden over time, with mid-caps and small-caps eventually catching up.
The Vanguard Russell 2000 ETF, which tracks small-cap stocks, offers a compelling alternative. With a P/E ratio of 17, it trades at a 40% discount to the S&P 500. This disparity is unlikely to persist, especially as the Federal Reserve’s interest rate cuts favor smaller companies. Over the long term, small-caps have traded at a premium to large-caps, and a reversion to the mean could lead to significant gains for the Vanguard Russell 2000 ETF.
As interest rates decline, the gap between small-caps and large-caps is likely to narrow, making the Vanguard small-cap ETF an attractive option. While it’s unlikely to double in price overnight, the math suggests that small-cap investors could reap significant rewards in the coming years.
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