Wealthy Retirement Contributing Analyst, Jody Chudley explains why now is the time to buy small cap stocks.

In uncertain times, history and experience are invaluable resources. What both are telling me now is that there has rarely been a better time to buy small cap stocks. This opportunity was created by an epically bad first quarter of 2020 for the small cap sector.

Small cap performance is measured by the Russell 2000 Index, the most popular index of small capitalization stocks. The first quarter decline of 30.6% in the Russell 2000 was the largest quarterly loss in the more than 40-year history of the index.

Here’s how it looked…

Chart - A Historically Bad First Quarter for the Russell 2000

The quarter was dismal, but the one-month decline between February 20, 2020, and March 18, 2020, was even worse. In just that one month, the Russell 2000 Index fell by a staggering 41.5%. Remember, that isn’t one stock dropping this much. It is an entire index consisting of 2,000 of the finest smaller publicly traded businesses in the United States that has collapsed. We need some perspective on this decline to really appreciate how rare it is.

We can get that by looking at the last two big stock market collapses, both of which ranked among the worst in history. When the internet bubble collapsed between March 2000 and October 2002, the Russell 2000 declined by 44.1%. During the bear market that started in July 2007 and ended in March 2009, the Russell 2000 had a maximum drawdown of 58.9%.

Chart - Russell 2000 During Previous Bear Market Declines

The numbers show that our total current decline in the Russell 2000 measures up with the last two major downturns. What stands out about this decline is the incredible speed at which it happened. The 41.5% decline that we just experienced is similar in size to the total decline experienced in each of the last two major market meltdowns, both of which took years to play out.

This drop in the Russell 2000 took one month!

The First Quarter of 2020 Is in the History Books – Let’s Look Forward

The Russell 2000’s first quarter was one for the history books – and not in a good way.

But while we have those history books open, it is well worth looking at what the Russell 2000 might have in store for us.

This history makes for some valuable reading because it alerts us to the fact that this looks like one of the best buying opportunities we are ever going to see.

When small caps bottomed in October 2002, the Russell 2000 rebounded with a vengeance, rocketing 60% higher over the next 12 months. That must have been fun!

The year following the bottom in March 2009 was even better, with the Russell 2000 going up 95% between March 9, 2009, and March 9, 2010. The entire index nearly doubled.

Small Cap Stocks Chart - One-Year Returns From Recent Small Cap Market Troughs

More on the Russell 2000 and Buying Small Cap Stocks

Those are pretty encouraging numbers to say the least, and it doesn’t end there…

As of March 31, 2020, the five-year annualized return from the Russell 2000 was negative 0.2%. That means that from March 31, 2015, until now, small cap stocks have not generated any return from investors. That is an incredibly rare occurrence.

Since it was formed more than 40 years ago, the Russell 2000 has completed 436 month-ends. Only 21 of those 436 month-ends have closed with the Russell 2000 sitting with a negative five-year annualized return like it has today. That is just 4.8% of the time. More important is how the Russell 2000 does after it finds itself with a negative five-year annualized return…

I’ll give you a hint – it is very, very good. With a five-year annualized negative return like we have today, historically, the Russell 2000 has produced one-year average returns of 40.8%, three-year average annual returns of 22.1% and five-year average annual returns of 18.3%.

Small Cap Chart - Average Returns Following Negative Russell 2000 Five-Year Return Periods vs. Long-Term Averages

This data is very compelling. History is telling us that buying small cap stocks today will be a very rewarding experience over the next one to five years.

When Buying Small Cap Stocks: Keep It Simple – Just Buy the Russell 2000

If the Russell 2000 is poised to have a massive run over the next five years, it doesn’t take a rocket scientist to figure out what to do…Buy the Russell 2000!

With more exchange-traded funds (ETFs) in existence today than you can shake a stick at, finding one through which to own the Russell 2000 is very easy.

The largest by far is the iShares Russell 2000 ETF (NYSE: IWM). This ETF’s assets were $34 billion as of April 9, 2020, and the fund’s expense ratio is a reasonable 0.19%. The second-largest ETF is the Vanguard Russell 2000 ETF (Nasdaq: VTWO). Assets of this ETF were $2 billion as of April 9, 2020, and the expense ratio is even lower at 0.10%.

The Vanguard ETF is much smaller and has priced its expense ratio lower to try to attract more investors. I think both ETFs are interesting opportunities today.

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