Biggest Bargains in ETFs

But bargain-hunters should think twice. Small- and mid-cap stocks are still considerably more expensive than the large-cap S&P 500: the S&P 400 MidCap SPDR (MDY Quote) is trading at over 18 times expected 2007 earnings per share, compared with just 15.6 times for the S&P 500, while the small-cap stocks in the iShares Russell 2000(IWM Quote) ETF are still trading at almost 24 times expected 2007 EPS.

These lofty valuations are a headwind on future appreciation.

In any case, the two indices are likely to suffer the most during an eventual recession (whether this is brought on by a credit crunch or not), since they are heavily concentrated in the very cyclical consumer discretionary sector.

Therefore, investors using a "buy on the dips" strategy should probably focus instead on large-cap stock ETFs such as the S&P 500 SPDR.

However, it seems odd that the two foreign-stock ETFs in our study should have fallen as much as they did, since the companies they hold are not only less exposed to any credit crunch here but are also, as the chart shows, cheaper than their large-cap counterparts here in the U.S. (using the S&P 500 as a proxy).

I think that both of these funds (or more specifically the stocks held by these funds), which are still big winners on the year, were sold by nervous traders who needed to raise cash.

At any rate, this looks like an excellent opportunity to buy the iShares MSCI Emerging Markets ETF, one of the biggest losers during the recent correction, even if shares have already recovered some lost ground. Not only are these stocks perhaps most removed from our subprime problems, they are also the cheapest at just 13.9 times expected 2007 EPS, despite earnings growth rates roughly double those of the S&P 500, both this year and next!

We're a little less sanguine about the developed-economy stocks in the iShares MSCI EAFE ETF. (EAFE stands for Europe, Australasia and the Far East.) Though somewhat cheaper than the S&P 500 in terms of price-to-earnings ratio , companies in this Japan-heavy index are also consistently less profitable than their U.S. counterparts -- and therefore will likely grow earnings at a slower rate in the future. That implies the discount is at least in part deserved. Still, I am not negative on EFA and believe that investors following a "buy on the dips" strategy should include this fund. However, we would not "back up the truck" to add more than you're adding in the S&P 500.

Small-, Mid-Cap Valuations Still Lofty Price-to-earnings ratio on estimated 2007 EPS