Investors have experienced relatively few significant market corrections in the past 20 years, with notable exceptions that have shaped current investment strategies. Since the financial crisis of 2008-2009, the market has seen only brief downturns. The 2018 mini-bear market resulted in a 20% decline in the S&P 500 but was followed by a rapid recovery to new highs. The COVID-19 pandemic caused a bear market with a more severe drop of over 30%, yet this downturn was quickly followed by a rebound propelled by substantial government stimulus measures.
The most protracted market pullback came in 2022, with the S&P 500 only returning to its previous peak by the end of 2023. During this cycle, what some referred to as the “Liberation Day” correction appeared to be merely a temporary setback rather than a signal for extended turbulence. This relatively stable environment has left many investors underexposed to experiences with longer-term corrections, raising concerns as economic fears begin to emerge. Signs indicate that another downturn may be on the horizon if economic growth appears to slow.
When preparing to capitalize on a potential recovery, it’s crucial for investors to focus on historical patterns, particularly regarding which market segments are likely to lead the rebound. A common trend is that small-cap stocks often outperform their large-cap counterparts during recovery phases.
Examining historical recoveries sheds light on this assertion. During the COVID bear market, small-cap stocks experienced a steeper decline than the S&P 500, but by early September, they began to outpace larger stocks significantly. Similarly, in the aftermath of the financial crisis, small caps led the recovery for two years following their low in 2009.
As sentiment shifts and investors begin to believe the worst is behind them, a “risk-on” mentality tends to take hold, leading to increased buying activity, particularly in smaller and riskier stocks. Smaller companies typically have more agility, allowing them to bounce back more quickly than larger corporations, which can be slow to recover.
In this context, it may be tempting to favor a small-cap ETF, such as the iShares Core S&P Small-Cap ETF or the Vanguard Small-Cap ETF, during recovery cycles. However, a more balanced approach might be to consider a total market ETF, such as the Vanguard Total Stock Market ETF. While small caps may indeed offer greater return potential, large caps contribute stability and quality that smaller firms often lack.
By utilizing a total market ETF, investors can gain exposure to both small and large capitalization stocks, capturing potential upward momentum while mitigating risks associated with aggressive bets on smaller companies. This strategy is seen as a more conservative play suitable for recovery phases.
Ultimately, any of the discussed ETFs could serve as viable options for outperforming the market during a recovery cycle. Nevertheless, the Vanguard Total Stock Market ETF is perceived to provide the most balanced risk-reward profile, allowing investors to tap into various market segments without compromising on stability.
