With major indices like the S&P 500 and Nasdaq hovering near all-time highs, many investors are finding it challenging to identify value in the current market. The valuations of many large-cap technology stocks, which dominate these indices, have stretched significantly, leaving fewer apparent bargains.
However, certain segments of the market have not participated in the recent rally to the same extent, creating potential opportunities for those with a long-term perspective. Two areas that appear relatively undervalued are small-capitalization stocks and real estate investment trusts (REITs), both of which could benefit from shifting economic conditions.
Key Takeaways
- Major stock indices like the S&P 500 are trading near record highs, making value difficult to find.
- Small-cap stocks and Real Estate Investment Trusts (REITs) are two sectors that appear undervalued compared to the broader market.
- A significant valuation gap exists between small-cap and large-cap stocks, the widest since the late 1990s.
- A potential decline in interest rates could disproportionately benefit both small-cap companies and the real estate sector.
The Search for Value in an Expensive Market
The current investment landscape is characterized by high valuations, especially among the largest companies. The S&P 500, a benchmark for U.S. large-cap stocks, is trading at a significant premium compared to historical averages. This rally has been largely driven by a handful of mega-cap technology firms, concentrating both gains and risk.
This environment can be difficult for investors looking to deploy new capital. Paying a high price for assets can limit future returns and increase downside risk. As a result, many are looking beyond the most popular stocks and funds to find areas that may have been overlooked during the recent market surge.
A Tale of Two Markets
The valuation disparity is stark. The average S&P 500 component trades at nearly 29 times earnings and 5.2 times its book value. In contrast, the average Russell 2000 component trades for just 18.3 times earnings and 2.0 times book value, highlighting a significant discount.
Spotlight on Small-Cap Stocks
One area that stands out is the small-cap segment of the market. These are smaller companies that, while potentially more volatile, also offer significant growth potential. The Vanguard Russell 2000 ETF (VTWO) is one vehicle that provides diversified exposure to this asset class.
Understanding the Opportunity in Small Caps
The Russell 2000 index, which VTWO tracks, is composed of 2,000 smaller U.S. companies. The median market capitalization of these firms is around $3.4 billion, a fraction of the size of the giants in the S&P 500. This diversification is a key feature; no single stock makes up more than 0.74% of the fund's assets, reducing single-company risk.
Currently, the valuation gap between small-cap and large-cap stocks is at its widest point since the late 1990s. History shows that following that period, small-cap stocks went on to outperform their large-cap counterparts for more than a decade. While past performance is not a guarantee of future results, the historical precedent is compelling for long-term investors.
The Case for Real Estate Investment Trusts (REITs)
Another sector that appears attractively priced is real estate, specifically through Real Estate Investment Trusts (REITs). These are companies that own and often operate income-producing real estate, such as apartments, warehouses, data centers, and retail properties. The Vanguard Real Estate ETF (VNQ) offers broad exposure to the U.S. REIT market.
What Are REITs?
REITs are required to distribute at least 90% of their taxable income to shareholders in the form of dividends. This structure makes them a popular choice for income-focused investors. VNQ, by holding a basket of these companies, currently offers a dividend yield of nearly 4%.
The fund holds over 150 different REITs, though it is more concentrated than the small-cap ETF. Its top 10 holdings account for about 39% of its total assets, reflecting the presence of several very large players in the REIT industry.
Why Now Could Be the Time for Real Estate
The performance of REITs is closely tied to interest rates, and the prospect of falling rates presents several potential benefits for the sector.
- Lower Borrowing Costs: Real estate companies often use debt to finance property acquisitions and development. Lower interest rates reduce their cost of borrowing, which can improve profitability and support growth.
- Higher Property Values: Commercial real estate valuations are often benchmarked against risk-free interest rates like the 10-year Treasury yield. As these rates fall, property values tend to rise, increasing the net asset value of REITs.
- Increased Investor Demand: In a lower-rate environment, the relatively high dividend yields offered by REITs become more attractive to income-seeking investors. This increased demand can drive up share prices.
A Long-Term Strategy
While the current market dynamics suggest that now could be an opportune time to consider these ETFs, they are best viewed as long-term investments. Market timing is notoriously difficult, and short-term volatility is always a possibility, especially in the small-cap space.
Buying assets at an attractive valuation and holding them for the long term is a proven strategy for building wealth over time. The key is patience and a willingness to look beyond the most crowded trades in the market.
For investors feeling that they have missed the rally in large-cap stocks or are concerned about high valuations, adding exposure to undervalued sectors like small caps and real estate could be a prudent move. By regularly investing in diversified, low-cost funds like VTWO and VNQ, investors can position their portfolios to potentially benefit from a broadening of market leadership in the years to come.
