Wall Street analysts don't always make accurate predictions, but Tom Lee from Fundstrat Global Advisors has put together a string of impressive calls over the last couple of years. He said the S&P 500 index would hit 4,750 in 2023, and it closed the year at 4,769. He then predicted the S&P would hit 5,200 in 2024, which was the most bullish target on Wall Street at the time, and it surpassed that level within the first three months.
Lee also forecast a 50% gain this year for the Russell 2000, an index featuring approximately 2,000 of the smallest companies listed on U.S. stock exchanges. The potential for falling interest rates combined with cheap valuations are two key reasons for his prediction.
The Russell 2000 hit its high point for 2024 (so far) on July 16, and Lee came out on that very day and reiterated his bullish stance in an interview on CNBC. But the index has been trading down since then, and it's sitting on a gain of just 10% for the year. That means it will have to climb by another 37.1% within the next four months to hit Lee's target.
While that seems unlikely, the Vanguard Russell 2000 ETF (VTWO +0.22%) closely tracks the performance of the index, so it's a simple way for investors to profit from Lee's prediction if he turns out to be right.
NASDAQ: VTWO
Key Data Points
The Vanguard ETF is a simple way to invest in small-caps
The composition of the Russell 2000 is very different from mainstream indexes like the S&P 500. The industrial sector is the largest in the Russell with an 18.9% weighting, followed by the healthcare sector at 15.1% and the financial sector at 15%. The largest sector in the S&P 500, on the other hand, is technology, with a sizable 31.4% weighting thanks to the rise of trillion-dollar tech giants like Apple, Microsoft, and Nvidia.
Plus, the top 10 holdings in the Vanguard Russell 2000 ETF represent just 3.2% of the total value of its portfolio, so its performance isn't beholden to a handful of stocks:
|
Stock |
Vanguard ETF Portfolio Weighting |
|---|---|
|
1. Insmed |
0.41% |
|
2. FTAI Aviation |
0.40% |
|
3. Sprouts Farmers Market |
0.36% |
|
4. Vaxcyte |
0.31% |
|
5. Applied Industrial Technologies |
0.30% |
|
6. Fluor |
0.30% |
|
7. Fabrinet |
0,29% |
|
8. SPS Commerce |
0.29% |
|
9. UFP Industries |
0.29% |
|
10. Mueller Industries |
0.29% |
Data source: Vanguard. Portfolio weightings are accurate as of July 31, 2024, and are subject to change.
Insmed is a biotechnology company that develops therapies for rare diseases. It has a market capitalization of just $13.1 billion, and as the largest holding in the Vanguard ETF, it puts the size of the Russell 2000 companies in perspective.
Sprouts Farmers Market, on the other hand, is a grocery chain with over 400 stores (and growing) across America. It specializes in healthy and organic foods. Then, there is Fluor, a construction and engineering company that builds energy and urban infrastructure.
Outside of its top 10, the Vanguard ETF also holds popular names like clothing retailer Abercrombie and Fitch, cybersecurity powerhouse Tenable, and semiconductor-service company Axcelis Technologies. Simply put, the ETF (and, by extension, the Russell 2000) is very diversified.
Falling interest rates should benefit small-caps
"The time has come for policy to adjust." Those were the words of Federal Reserve chairman Jerome Powell at the Jackson Hole Economic Symposium last month. The Fed has been locked in a battle to tame high inflation for the last two years, which saw the federal funds rate climb to a 23-year high of 5.33% in 2023, where it remains today.
But with the Consumer Price Index measure of inflation nearly back to the Fed's 2% annualized target, the central bank looks set to cut rates at its next meeting on Sept. 17 and 18. In fact, according to the CME Group's FedWatch tool, there could also be cuts in both November and December.
Lower interest rates tend to benefit small companies more than their larger counterparts. Behemoths like Apple, Microsoft, and Nvidia are sitting on so much spare cash that they each return tens of billions of dollars to shareholders every year through dividends and stock buybacks. In other words, they don't need to rely on debt financing.
Smaller companies, however, often borrow money to fuel their growth, and they tend to carry a high amount of floating-rate debt, which is highly sensitive to changes in interest rates. Falling rates will increase the borrowing capacity of small-cap companies and reduce their interest payments which will be a direct tailwind for their earnings.
Lee thinks those factors could also drive the valuation of the Russell 2000 higher. Right now, the index trades at a price-to-earnings (P/E) ratio of 17.7 (excluding companies with negative earnings), which is much cheaper than the S&P 500, which trades at a P/E ratio of 27.4.
With that said, investors pay a premium for the S&P 500 because of the quality of its constituents like Nvidia, Apple, and Microsoft, which have long-term track records of success, secure revenue streams, and fortress balance sheets. It's possible the Russell 2000 will trade at a higher valuation when interest rates fall, but I don't expect it to completely close the gap with the S&P.
Image source: Getty Images.
Will Tom Lee be right?
Lee's prediction for a 50% return in the Russell 2000 this year is ambitious. In fact, going all the way back to 1988, the index has never recorded an annual gain of 50% or more.
The Vanguard Russell 2000 ETF has delivered a compound annual return of 10.4% since its inception in 2010, so a 50% move would be highly unusual. That also represents a notable underperformance relative to the S&P 500, which has delivered a compound annual return of 13.7% over the same period.
Keep in mind that the federal funds rate was below 1% for the majority of the period between 2010 and 2022, and that wasn't enough to propel the Russell to outsized returns. The Russell 2000 could climb further in the remainder of 2024, but it's unrealistic to expect a 37.1% gain from here to reach Lee's year-end target.
With that said, small caps might be a good place to invest some money as interest rates fall, so adding the Vanguard Russell 2000 ETF to a balanced portfolio isn't necessarily a bad move.
