The investment thesis
Until December 2023, the Fed was implementing a higher-for-longer policy – meaning the Fed intended to keep the monetary policy restrictive (short-term rates higher) even if a recession was a possible outcome. The rationale was that a recession might be necessary to bring inflation down to the 2% target.
As a result, the cyclically sensitive small stocks, as proxied by a broad index Russell 2000 (IWM) were lagging the broad market – they were pricing in an imminent recession.
At the December FOMC meeting, the Fed made a major dovish pivot – it abandoned the higher-for-longer policy and signaled the beginning of the interest rate normalization policy. This means that the Fed now thinks that a recession is not necessary to bring inflation down to the 2% target, and that the restrictive monetary policy can be removed to prevent an unnecessary recession.
The point is that a recession is not in the base outlook anymore, given the Fed pivot. Thus, small stocks have to be repriced higher. This is the so-called catch-up trade – small stocks should outperform the broad market over the near term, given that they were priced for a recession, and that recession doesn’t appear to be coming, at least for now.
Of course, this investment thesis heavily depends on the Fed’s aggressive removal of the monetary policy restriction. In other words, the Fed now has to actually start cutting interest rates, words are not enough. Specifically, the lagged effects of the prior interest rate hikes could start to affect the economy, and we could still get an accidental recession, which is what the Fed hopes to avoid, especially before the election in November.
The Fed is likely to start cutting interest rates, probably in May, even though the market wants to see the cut at the March meeting. So, the timing of interest rate cuts is causing some volatility. The disinflationary process is likely to continue, as the leading indicator (the New Tenant Rent) for the shelter inflation has returned to the pre-pandemic levels, and this is important given that shelter inflation is responsible 60-70% of total inflationary spike.
Thus, assuming that the Fed follows through on the signaled interest rate normalization policy, small stocks should outperform over the near term.
The opportunity to buy
Nevertheless, small stocks (IWM) bounced strongly in November and December as some early signals of the Fed pivot already emerged at the end of October. The sharp rally into the end of 2023 opened the possibility that small stocks already priced in the pivot, and that it’s now more difficult to buy. However, the uncertainty with respect to the timing of the Fed’s interest rate cuts caused a significant 5.6% correction in 2024 YTD, and the IWM price corrected to the 50dma support level (green line). Thus, this could be an opportunity to buy.
The Small Cap Value opportunity
Within the small cap factors, the opportunity is in the small cap value stocks, and the Vanguard Small-Cap Value Index Fund ETF (NYSEARCA:VBR) seems like an appropriate investment vehicle to take advantage of this opportunity.
Here is the opportunity. The S&P 500 (SPY) earnings are expected to grow at 10.4% in 2024, while small cap stocks earnings are expected to grow at 16%, but small cap value stocks earnings are expected to grow by 26% in 2024. So, that’s the earnings story.
On the valuation side, the S&P 500 is trading at 19.9x 2024 earnings, small cap stocks are trading at 14.8x 2024 earnings, but small cap value stocks are trading at 13.6x 2024 earnings. So, that’s the valuation story.
In summary, small cap value stocks are cheap, or relatively cheaper than the rest of the market, while the earnings growth is expected to be very strong, or stronger compared to other factors in the market. So, that’s the opportunity.
What’s in the VBR?
So, looking specifically at VBR, which has about $26B in AUM, a dividend yield of 2.21%, and a low expense ratio at 0.07%, we find mostly stocks from the cyclical industries.
Industrials and financials account for around 20%, consumer cyclicals for around 14%, real estate for around 10% of the index. Technology is only around 7% of the total holdings. So, VBR is very cyclical, it is significantly affected by the domestic business cycle. Thus, it underperforms if the market expects an imminent US recession. So, that’s what happened in 2023.
Over the last 12 months, the S&P500 is up by 19%, while the IWM is up by 1.73% and VBR is up by 2.77%, so slightly better than IWM – and that’s after the end-of-the-year rally. So, the market now expects the catch-up trade, where small cap stocks catch up to the megacaps – now that a recession is not part of the outlook, given the Fed pivot.
The Fed made a surprise dovish pivot in December 2023 and this created an opportunity to buy small cap value stocks. The ETF that tracks small cap value stocks VBR is actually even cheaper compared to the S&P Small Cap 600 index, trading at a ttm PE ratio of 10.94 – this is cheap and implies basically 0% earnings growth. The reason for the low PE ratio was the expected recession – small value stocks were priced for a recession given the higher-for-longer policy outlook. But now, given the expected interest rate normalization policy, and thus, no recession outlook, the earnings for small cap value stocks should soar, CFRA predicts by 26% in 2024.
So, that is the opportunity. Now, we are waiting for the Fed to deliver, and prevent the “unnecessary” recession. And this “wait” could be volatile, but as long as the recession is avoided, the dips in VBR are buying opportunities.