- The Vanguard Small Cap ETF has performed superbly since November 2020 – but has it gone too far?
- The combination of economic fundamentals and relative valuation supports my renewed convictions on small cap for the next few months.
- Until early signs of a reversal surface, I believe that "milking" the small cap trade continues to make sense.
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"I cannot think of a better time for small cap's outperformance to kick in than right around now". This is how I summarized my bullish stance on the Vanguard Small Cap ETF (NYSEARCA:VB) back in early November 2020. Four months and 11 percentage points of outperformance over the S&P 500 later, I believe that the trade still makes sense today.
My confidence in the outperformance of the US small cap index, VB's official benchmark, slowly wanes as the Russell 2000 continues to handily beat the broad market – especially mega-cap growth stocks included in the Nasdaq (QQQ). But I believe Vanguard's ETF still has legs, as well as the best chance of producing superior returns in 2021.
Whenever I justify my bullishness towards small caps, which I have argued for since September 2020, I do so relative to an investment in the Nasdaq. At least from the perspective of capitalization size, valuation and cyclical exposure, the two groups of stocks are about as close as it gets to polar opposites.
The graph below depicts the difference in portfolio allocation between VB and QQQ across a few select sectors. In a 2021 environment of (1) economic recovery, (2) rising interest rates and (3) potential inflationary pressures, including in crude oil and other commodities, I find it hard to make a strong case in favor of an index that is light on industrials, financials, and materials plus energy, respectively.
Source: DM Martins Research, data from ETFRC
Supporting the bullish case on the Nasdaq is the upcoming fiscal stimulus package which, on the verge of being approved by the US Congress, will put money in the pockets of consumers soon. This should bode well for the discretionary sector, including Apple (AAPL), Amazon (AMZN) and Microsoft (MSFT) – which, combined, account for nearly 30% of the Nasdaq.
But this is about as compelling as it gets for the tech-heavy index this year. As the global economies restart, which they have timidly begun to, I expect to see more of a commitment from analysts to bump their earnings growth projections (see below) back to the pre-pandemic trend, which I believe will fuel the last leg higher in stocks that benefit from the reopening trade.
The elephant in the room is, of course, valuation. Isn't the expected outperformance in small cap stocks already priced in at current levels? After all, VB has topped the returns of QQQ since the end of the US Presidential election cycle (also the announcement of the first COVID-19 vaccine) by about 13 percentage points.
This is where I believe longer-term perspective is needed. I have used different versions of the graph below a few times to illustrate how, over the past twenty years, small cap has been severely discounted relative to mega-cap growth. The chart depicts a long Russell 2000, short Nasdaq play since before the bursting of the dot-com bubble.
Arrow "A" highlights a multi-year period of outperformance of QQQ over VB, partly justified by the dominance of Big Tech since just before the Great Recession of 2008-2009. Arrow "B" shows the sharp acceleration in the valuation gap, driven by the COVID-19 crisis. Finally, arrow "C" depicts the modest, partial recovery in small cap that is at least consistent with (if not understated relative to) the early innings of the upcoming expansionary cycle.
Source: chart by Portfolio Visualizer
Know when to quit
The combination of (1) economic fundamentals and (2) relative valuation that still does not look overstretched supports my renewed convictions on the small cap trade for the next few months. Yes, I believe the music will eventually stop, and a rotation back into mega-cap growth will be in order. I just do not believe that now is the right time for it.
The best course of action, in my view, is to keep an eye on price action. That is: milk the small cap play until early signs of a reversal surface. At that point, market sentiment may suggest that it is time to "sell the news", shift gears away from the Vanguard Small Cap ETF, and catch the next cyclical trend.
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This article was written by
Daniel Martins is a Napa, California-based analyst and founder of independent research firm DM Martins Research. The firm's work is centered around building more efficient, easily replicable portfolios that are properly risk-balanced for growth with less downside risk.
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Daniel is the founder and portfolio manager at DM Martins Capital Management LLC. He is a former equity research professional at FBR Capital Markets and Telsey Advisory in New York City and finance analyst at macro hedge fund Bridgewater Associates, where he developed most of his investment management skills earlier in his career. Daniel is also an equity research instructor for Wall Street Prep.
He holds an MBA in Financial Instruments and Markets from New York University's Stern School of Business.
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On Seeking Alpha, DM Martins Research partners with EPB Macro Research, and has collaborated with Risk Research, Inc.
DM Martins Research also manages a small team of writers and editors who publish content on several TheStreet.com channels, including Apple Maven (thestreet.com/apple) and Wall Street Memes (thestreet.com/memestocks).
Analyst’s Disclosure: I am/we are long AMZN, AAPL, MSFT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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