Believe it or not, the stock market is on a roll. The S&P 500 has jumped by nearly 14% from its recent cyclical low point. The Dow Jones Industrial Average is up almost 19%. Even the shell-shocked Nasdaq Composite Index has vaulted 13% higher.
We're not quite in a bull market just yet. However, it looks like one is coming. Here's why buying a small-cap index ETF would be a smart move in the current environment.
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Why a new bull market is likely
Let's first take a look at why a new bull market is likely in 2023. The most obvious reason is that stocks have risen enough to put the threshold at which one begins within reach.
The S&P 500 only needs to gain another 6% or so to enter a new bull market. The Dow Jones Industrial Average needs to rise less than 2%. The Nasdaq Composite would require a 7% move.
History is also on the side of the bulls. The S&P 500 has fallen by 19.4% or more during only seven years since 1923, including last year. Three of those cases were before the index existed in its current form with 500 companies. In four of the six previous cases, the S&P soared by more than 20% in the year that immediately followed the one that featured the steep decline.
Investors who follow technical indicators also have a reason to be optimistic. The S&P 500's 50-day moving average could soon rise above its 200-day moving average. This so-called "golden cross" frequently precedes a period of solid gains.
Think small
If the stock market is indeed poised to begin a new bull market, there's a group of stocks that can be expected to perform exceptionally well. Historically, small-cap stocks have outperformed during the early stages of bull markets.
Buying individual small-cap stocks is one way for investors to profit from this trend. However, investing in individual small-cap stocks can be riskier than buying shares of larger companies. That's where two exchange-traded funds (ETFs) come into play.
The Vanguard Small-Cap ETF (VB 0.29%) tracks the performance of the CRSP US Small Cap Index. The ETF allows investors to buy nearly 1,488 small-cap stocks in one fell swoop.
On average, the companies in the Vanguard Small-Cap ETF's portfolio have delivered annual earnings growth of 14.5% over the last five years. They're also attractively valued, in general, with an average price-to-earnings multiple of 12.3.
The iShares Core S&P Small-Cap ETF (IJR 0.86%) is designed to track the performance of the S&P SmallCap 600 Index. It holds positions in 679 small-cap stocks. These stocks have, on average, valuations that are a little higher than those in the Vanguard Small-Cap ETF, with an average price-to-earnings multiple of nearly 13.7.
One key advantage both of these small-cap index ETFs offer investors is a low cost. The expense ratio of the Vanguard fund is only 0.05%, while the iShares ETF's expense ratio is 0.06%.
Playing devil's advocate
Let's play devil's advocate for a minute, though. What if a new bull market doesn't begin soon? Would investors have made a big mistake buying either of these small-cap index ETFs in this scenario? Not at all.
Small-cap stocks don't just tend to outperform large-cap stocks in the early stages of bull markets. They also generally outperform over the long term. This is partially due to small-cap stocks commanding higher risk premiums compared to large-cap stocks. Also, small-cap stocks often aren't followed as closely, which means they can sometimes be undervalued.
Buying the Vanguard Small-Cap ETF or the iShares Core S&P Small-Cap ETF should set up investors to profit in the early stages of a new bull market if one materializes soon. And if it doesn't, you can still reap great returns by holding these investments for the long term. That's a win-win scenario, making investing in either of these small-cap index ETFs a really smart move right now.
