Small-Cap ETFs: Are the Stars Aligning?

Broader small-cap benchmarks are trailing large-cap rivals this year. That lethargy could give way to opportunities with smaller stocks and the related small-cap ETFs because macroeconomic conditions could turn for the worse.

Historically, slow growth environments have been hospitable to smaller stocks. While many investors aren’t aware of that fact, ETFs such as the Invesco NASDAQ Future Gen 200 ETF (QQQS) could be worth examining over the next several months if, as expected, economic growth slows.

“We project economic growth will stagnate in the second quarter, constrict in the third, and only begin a sluggish recovery in the fourth,” noted Morningstar strategist Dave Sekera. “A weak economy will pressure earnings growth and likely lead to negative sentiment in the markets. We expect that the markets will be looking for an upswing in leading economic indicators in order to begin the next move higher toward our long-term, intrinsic valuations.”

Other QQQS Benefits

The potential perks offered by QQQS extend beyond possible positive (or less bad) responses in sluggish economic environments. For example, as noted by Morningstar’s Sekera, small-cap stocks are currently undervalued relative to larger counterparts.

On a related noted, value stocks are offering value relative to other styles, and that value proposition is particularly noticeable in the small-cap ETFs space. That could highlight potential advantages with QQQS because nearly a third of its holdings are classified as value. Meanwhile, less than 27% have the growth label.

“By market capitalization, small-cap stocks remain the most undervalued, trading at a 27% discount to fair value, whereas large- and mid-cap categories remain closer to the broad market valuation. The single most undervalued category is small-cap value, trading at a 40% discount to our fair value,” added Sekera.

As for sectors with currently appealing valuations, that label applies to the consumer cyclical and materials sectors, which combine for about 10% of the QQQS portfolio. Tech and communication services stock are slightly undervalued today. Those sectors combine for roughly 30% of QQQS.

“Although we expect the economy to be relatively stagnant over the remainder of this year, we see the best values across the cyclical sectors. These were the worst-performing sectors in 2022 and we think the market has pushed prices down too far as compared with our long-term intrinsic valuations,” concluded Sekera.

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The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.