Stocks are capping off a banner year led by AI names like Nvidia and Palantir, but as investors get ready for 2025, the market seems to be shifting.
The presidential election set off a rotation into cyclical stocks in the financial and energy sectors, and small-caps were big winners as well. The Russell 2000 jumped 5.8% on Nov. 6, though the index has been mostly flat since then.
The small-cap index, vaguely defined as companies with market caps between $300 million and $2 billion, jumped following the election as investors were hopeful that an economic expansion would give the sector a boost, and that small caps would be less affected by the tariffs that President-elect Donald Trump has promised.
Small-cap stocks also look undervalued at the moment, and have lagged behind large caps like the S&P 500 since the bull market started.
While $1,000 might not seem like much to invest, if you're looking for an ETF with high upside potential, a great way to put your money to work is in the Vanguard Russell 2000 Index Fund (VTWO -1.48%).
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Why small-cap stocks could surge
Small caps tend to be more volatile than their large-cap peers. That's because they are more vulnerable to recessions. Their balance sheets aren't as strong and they are more likely to be unprofitable since they are typically in an earlier stage of their life cycle.
Conversely, they tend to outperform in bull markets because their sensitivity to macroeconomics works both ways. However, in this bull market, small caps have lagged as the focus on AI stocks like Nvidia, which are all large-caps, has taken center stage. But that's created an opportunity for small-cap stocks.
The Vanguard Russell 2000 ETF now trades at a price-to-earnings ratio of just 14.2, which is less than half that of the S&P 500 at 29.7. Based on that gap, investors seem to expect large-cap stocks to grow more than twice as fast as small-cap peers, though small-caps have historically grown faster.
That discrepancy should lead to a rotation among investors as they sell large-cap stocks, which look overvalued based on historical measures, and buy small-cap stocks, which look undervalued and offer more opportunity than most of the market. In addition to any possible tailwinds from the incoming administration, falling interest rates are also typically a boon for small-cap stocks as they make borrowing easier, lower existing interest payments, and help grease the overall economy. The Federal Reserve has already begun lowering interest rates, and is expected to continue doing so next year.
A look at the top holdings in the Vanguard Russell 2000 ETF shows it draws from a wide range of companies, including consumer-focused stocks like Sprouts Farmers Market, industrial stocks like Fluor, and healthcare stocks like Insmed.
The biggest sector represented in the ETF is industrials at 18.9%, followed by financials at 17.7% and healthcare at 17.3%. Both industrials and financials are highly cyclical sectors, so these small caps should benefit from any economic stimulus. Investors are hopeful that tax cuts and business-friendly policies including deregulation can help stimulate the economy, in particular sectors like industrials and financials, which will favor small caps.
Tariffs may also help level the playing field for a sector that is less likely to rely on imports than multinational large-caps.
Will small-cap stocks surge in 2025?
The overall economy is the biggest risk for the Vanguard small-cap ETF because the sector needs the economy to continue to expand in order to outperform. However, based on their valuations and the broader momentum in the stock market, especially with hopes for an accelerating economic expansion, small-caps look poised to gain.
Even without help from the economy, the valuation on the small caps makes the sector attractive. It's rare for the valuation gap between the Russell 2000 and the S&P 500 to be so large. That low valuation should also put a floor on the stock if the economy struggles.
Overall, the trend that's led to the Russell 2000's underperformance should reverse because of mean reversion, falling interest rates, tailwinds from the Trump administration, and a rotation due to the valuation gap.
Investing $1,000 in the small-cap ETF could pay off significantly over the long run. With the valuation at a discount and expectations for economic expansion rising, small caps look like a smart bet.
