ETF Focus Rewind: Small-Caps Looking Attractive Both in the Short-Term and Long-Term
Conditions look good for a rebound from last week and that means adding risk makes sense.
2 ETFs To Consider Buying (And 1 To Avoid) This Week
Stocks took a bit of a bearish turn last week, but if history as any guide, that could be a good sign for this week. Most of last week's damage was done during the second half, including Friday afternoon's steady sell-off across the board. It was an ugly finish to the week, but it also sets up the scenario where dip buyers could show up again on Monday after having the weekend to review conditions. With stocks not experiencing a 5% pullback in 10 months, it seems like a solid bet that at least the first part of the coming week features some gains.
There are a few hints of building volatility here, but nothing I'd consider significant at this point. The S&P 500 has fallen for five straight days, but the index is still less than 2% from its all-time high (although small-caps are 5% below theirs). The VIX ticked up to around 21 at the end of the week, matching similar minor spikes that occurred in both July and August. This in and of itself doesn't indicate that the markets are becoming noticeably riskier, but it's worth keeping an eye on.
St. Louis Fed president Jim Bullard may have caught investors a bit off guard with his comments about central bank tapering plans. He basically dismissed concerns about the labor market citing that the unemployment rate is still low and jobs are plentiful even if workers are still on the sidelines. He wants to maintain a tapering schedule that starts sooner rather than later. As I discussed last week, I think the markets may have priced in a modest delay in the launch to tapering following the weak August jobs report, but Bullard's comments may assist in reversing that notion. I imagine any comments the Fed makes throughout the next month will be very delicate in order to avoid any kind of tantrum in the markets.
I suspect that traders are going to view this week as an opportunity to buy shares at a discount this week following last week's pullback. Economists and brokerage houses have been downgrading their economic growth forecasts due to the spread of the delta variant, but buyers have been a constant presence in this market despite any negative news. I think the one catalyst that could affect stock prices is a rise in interest rates. We saw that a bit last week, but a 10-year yield of 1.34% isn't going to come close to shocking the system. I think conditions are still favorable for buying equities here.
With that being said, here are three ETFs I'm going to be watching this week and the narratives that go along with them.
Vanguard Small Cap Growth ETF (VBK)
The upcoming debt ceiling debate remains the one thing that I believe could shake up the markets, but that probably doesn't become a risk until October or even November. In the meantime, risks seem relatively low in the short-term and I'm expecting that buyers will return to the markets to take advantage of U.S. stocks' recent losing streak.
In that case, riskier stocks make sense. With the exception of a short period of underperformance in early August, it's been all growth over value in the small-cap market since June. High beta has also outperformed low volatility, so investors have definitely shown a preference for risk even though small-caps have bounced around relative to large-caps.
Overall, VBK has been stuck in that $250 to $300 range and lags the S&P 500 by about 12% year-to-date. But it's trying to break through that $300 ceiling and conditions look favorable for that to finally happen.
ProShares S&P Mid Cap 400 Dividend Aristocrats ETF (REGL)
Over the past four months, dividend ETFs of every style have significantly lagged the S&P 500. Of those, dividend growth strategies have generally done the best. Even though the economic recovery narrative, which dominated during the first half of the year, should have boosted high yield dividend ETFs, but that wasn't really the case. Now that the recovery is slowing, the Fed is getting ready to take its foot off the accelerator and inflation is still above 5%, more conservative dividend strategies, such as those focused on the aristocrats, should do comparatively well.
The ProShares S&P 500 Dividend Aristocrats ETF (NOBL) and the ProShares Russell 2000 Dividend Growers ETF (SMDV) would be options for large-caps and small-caps, respectively, but I'm favoring the middle ground of REGL. If it's going to make a run though, it's going to need a good week from cyclicals. More than half of the portfolio is dedicated to the combination of financials and industrials. Banks have bounced around between outperformer and underperformer for several months, but interest rates might be trending a little higher, which would provide a boost for financials if it continues. Industrials, on the other hand, have been a consistent underperformer since May. There are some hills to climb in terms on breaking some trends, but I like the mid-cap growth potential coupled with the return of dividend growth here.
Acruence Active Hedge U.S. Equity ETF (XVOL)
XVOL is a relatively new and small fund, but its strategy deserves to be on your radar. It's essentially an S&P 500 index fund with a VIX hedge overlaid on top of it. The fund purchases VIX options contracts in different quantities, expirations and strike prices based on a proprietary algorithm that anticipates volatility levels. It's an interesting fund that could provide an alternative to a core S&P 500 by taking advantage of risk mitigation strategies.
As I've mentioned already, however, I'm thinking this is going to be a risk-on week. If it's a risk-on week, then risk mitigation strategies might prove to be less than optimal. At $87 million in assets, it's becoming more investable, but it's just not there yet. High trading spreads make it to costly to own right now, but keep this one on your radar because it's an intriguing new fund.
Chart of the Week
If you’ve read this far, you’re probably sensing a theme. While this week’s ETF picks focus on the short-term opportunity I see in riskier stocks, the chart focuses more on the long-term potential in the more attractively valued segment of equities. Small-caps have not been a sexy area of the market to invest in going back more than 10 years, but if you pull back on your view, you’ll see that this group hasn’t been this cheap relative to large-caps since the tech bubble.
The S&P 600 Small Cap Index is trading at a forward P/E ratio of just under 15 right now. That’s roughly 30% cheaper than the 22 multiple of the S&P 500. If you’re looking for a long-term entry point into small company stocks, you may not find a better time than right now. I think the short-term could get a little bumpy considering this is the point where it looks like the Fed might begin easing its support of the financial markets and the strength of the economic recovery is in some question, but there’s a roadmap for above average gains over the next 10-20 years.
I do want to note that the S&P 600 looks quite a bit different than the S&P 500. It’s much more balanced from a sector standpoint than the large-cap index and is more exposed to the cyclical areas of the economy. It has 10%+ allocations to industrials, financials, healthcare, technology and consumer discretionary stocks, while allocating another 8% to real estate. Tech is only the 3rd largest sector holding in the S&P 600 compared to it accounting for nearly 30% of the S&P 500 today.
From a pure valuation perspective, I think you have to like small-caps here. Whether the narrative will play to allow this sector to recapture some of that value remains to be seen, but it’s an attractive long-term set-up.
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