5 Small-Cap ETFs Hover Around an All-Time High: Here's Why

Small-cap stocks, as indicated by the Russell 2000 Index, have lagged their bigger peers so far this year.Small-cap exchange-traded fund (ETF) iShares Russell 2000 IWM is up 13.6% this year versus gains of 23.2% in the S&P 500, 14.2% in the Dow Jones and 21.9% in the Nasdaq-100 ETF QQQ.

Higher borrowing costs weighed on the small-cap stocks’ capital expenditure. After such a lackluster performance, can small caps turn around? Probably yes. A few small-cap ETFs have been hovering around an all-time high.

These ETFs are JPMorgan Diversified Return US Small Cap Equity ETF JPSE (up 11.2% this year), Invesco S&P SmallCap Momentum ETF XSMO (up 21.7%), Invesco S&P SmallCap Quality ETF XSHQ (up 12.3%), Vanguard Small-Cap Value Index Fund ETF VBR (up 14%) and Dimensional U.S. Small Cap ETF DFAS (up 11.9%).

In the past month, JPSE, XSMO, XSHQ, VBR and DFAS ETFs have gained 3.1%, 5%, 5.3%, 3.5% and 3.9%, respectively. Most of these returns are higher than the 3.4% returns offered by the SPDR S&P 500 ETF Trust SPY. Note that the ETF JPSE is currently in high momentum as the ETF has returned 3.9% in the past week compared with 1.1% gains noticed in the SPY ETF.

Let’s delve a little deeper.

U.S. Economy Grows Faster Than Expected in Q2

The U.S. economy grew at an annualized rate of 3% in the second quarter, surpassing Wall Street's expectations. According to the Bureau of Economic Analysis's third estimate, this growth rate remained unchanged from the previous estimate. Economists had estimated the reading to show an annualized growth of 2.9%.

The second-quarter growth marks a significant improvement from the 1.4% annualized growth seen in the first quarter. Since small-cap stocks are more domestically focused, an improving U.S. economy should bode well. Also, early indicators suggest continued growth for the U.S. economy in the third quarter.

Federal Reserve’s Interest Rate Cut

The Federal Reserve cut interest rates by half a percentage point in September. Fed Chair Jerome Powell, after the Sept. 18 decision, stated that the economy is "growing at a solid pace," while inflation is cooling and the labor market remains decent. The start of the monetary easing cycle is a great plus for small-cap stocks and ETFs.

Upbeat September Jobs Report

The September jobs report offered hopes for the U.S. markets. U.S. job gains increased in September by the most in six months, and the unemployment rate fell to 4.1%, the report showed (read: 4 ETF Investing Areas That Ruled Last Week).

Escalating Geopolitical Tensions

Tensions in the Middle East escalated in early October following an Iranian missile attack on Israel, spurring demand for safe-haven assets as investors grew anxious about the potential expansion of the conflict. Since small-cap stocks have less foreign exposure, they are not much affected by geopolitical tensions.

What Does Small-Cap Stocks Valuation Say?

Per WSJ data, the Russell 2000 is currently trading at a P/E ratio of 25.75X, slightly above the year-ago level of 23.65X. In comparison, the S&P 500 Index is currently trading at a P/E ratio of 24.68X, up from the year-ago level of 20.14X.

But then, the Russell 2000 is trading at a discount to the Nasdaq 100. The Nasdaq 100 Index is trading at a P/E ratio of 32.12X, above the year-ago level of 30.05X, per Wall Street Journal. Dow Jones Industrial Average currently trades at a P/E of 26.57X, slightly higher than that of the Russell 2000. It shows that small caps are neither too cheap nor overvalued.

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