Is Small Cap in Correction? | Tactical Investment Insights 05-19-2014

Is Small Cap in Correction?

Last week, the Russell 2000 Index had fallen 8.75% from recent peak of 1,208.65 reached on March 4. On May 15, the index once fell below 1,087.79 during intra-day trading, the 10% threshold of the widely-used definition of correction, two days after the Dow Jones industrial average and the S&P 500 closed at record highs. The Russell 2000 index is also trading below its 50-day and 200-day moving averages. The technical analysts normally consider the index is in a downward trend territory. Is small cap in correction? We think that small cap stocks might go lower in the near term, but the bull market sentiment, solid economic performance and monetary stimulus will continue moving the small cap stocks and the stock markets in general higher this year. There are a few factors that have contributed to the recent pullback of small cap stocks.


Source: Yahoo

(1)   Stretched Valuation 

After a blistering rally last year, the valuation the of small cap stocks has moved above historical averages. At the end of 2013, the forward P/E ratio of Russell 2000 Index stood at 30, higher than the 18-year historical average of 26 since 1996, according to Bloomberg data. The Price-to-Book ratio was 2.33, which was much higher than the historical average of 2.1 as well. After the earnings were revised up in 2014, the current forward PE and PB are 24.9 and 2.4, respectively. Although the valuation is not over-stretched, some correction in small cap stocks is inevitable, and healthy.

Source: Bloomberg

(2)   Weak Q1 Earnings Reports 

On the earnings side, the most recent quarter has seen some disappointed earning reports. The Thomson Reuters index of nearly 2,000 companies in the small- and mid-cap space showed 44 % have missed earnings forecasts so far, according to StarMine data. For comparison, the large cap companies had a better earning season. Just 25 % of S&P 500 components have missed expectations for per-share earnings in the first quarter.

The market technical and valuation suggest that the correction in small cap stocks may go a little further. However, the bull market in U.S. equities isn’t over yet. The positive trends in the broader markets are continuing, and the Federal Reserve keeps stimulus in place with a slow unwinding of quantitative easing. Fed Chair Janet Yellen stated that the central bank must continue to spur economic growth as indicators for inflation and employment remain far from the central bank’s goals. Most the economic indicators are pointing to the direction of an expanding economy. As the economic growth continues, corporate earnings growth will pick up. As a result, the valuation in the small cap stocks may not seem so expensive. We expect small cap stocks to be higher by the end of year.