Small-Caps Getting Too Tempting to Ignore | ETF Trends

Temptation isn’t a valid investment thesis. Still, when it’s supported by more credible factors, it can be hard to ignore and arguably useful. The above could accurately describe the current state of affairs with small-cap stocks and the related exchange traded funds. In recent months, an increasing number of analysts and market observers have highlighted discounted valuations across small-caps. Alone, that could prompt investors to evaluate ETFs such as the Invesco NASDAQ Future Gen 200 ETF (QQQS).

There’s more to the story, including the point that those valuations are reaching historically low levels. This potentially provides fuel for a small-cap rally. That would be a welcomed relief for wary investors that have been disappointed by year-to-date losses by standard small-cap gauges.

QQQS Valuation Opportunity

QQQS follows the Nasdaq Innovators Completion Cap Index. While that’s not the run-of-the-mill small-cap benchmark, old guard indexes can be an indicator. Currently, it’s indicative of the valuation opportunity that’s afoot with smaller stocks, including QQQS components.

“Today, stocks in the Small Cap Index carry an average price/fair value estimate ratio of 0.78, while the average stock in the Morningstar US Large Cap Index has a ratio of 0.93,” noted Morningstar analyst Sarah Hansen. “This means stocks in the small-cap index are relatively cheaper than their larger counterparts. Ratios over 1.00 indicate a stock is overvalued, while ratios below 1.00 mean it’s undervalued. The further away from 1.00, the more over- or undervalued the asset.”

Nearly 40% of QQQS’s 199 holdings are classified as value stocks. This confirms that the ETF has considerable leverage to the small-cap valuation theme. That’s meaningful at a time when small-caps are historically cheap and as a some bond market observers believe the Federal Reserve could lower interest rates in 2024, potentially providing tailwinds for smaller equities.

“Over the past 18 months, the Fed has embarked on the most rapid interest-rate-hiking campaign in its history to combat sticky inflation and a dangerously hot labor market,” added Hansen.

Interestingly, the Fed’s rate hikes were designed to engineer a soft landing and avoid a recession. Those are relevant points to small-cap investors because smaller companies are typically highly sensitive to goings on in the domestic economy, but with recession expectations having been dialed back, assets such as QQQS aren’t yet reflecting that good news.

Looking ahead to 2024, if economic data cooperates and the Fed indicates rate cuts are possible, today’s small-cap deals could prove worthy of the attention they’re currently receiving.

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