Brace For Irrational Exuberance 2.0

Are small-cap stocks modern-day dot-coms?

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ETF specialist
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Reviewed by: Boris Valentinov
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Edited by: Boris Valentinov

Are small-cap stocks modern-day dot-coms?

Anyone who lived through the dot-com boom and bust probably got a feeling of deja vu listening to Janet Yellen’s comments a few weeks ago about “valuations for smaller firms in the social media and biotechnology industries being substantially stretched.”

They were eerily reminiscent of Alan Greenspan’s warnings about Internet companies and his famous speech on “irrational exuberance.” So, is the Federal Reserve board chair right to be concerned?

To find answers, I decided to examine the valuation of the ETF based on the marquee index for U.S. small-caps—the iShares Russell 2000 ETF (IWM | A-79). The fund is an all-inclusive benchmark spanning all sectors of the U.S. economy and reaching deep into the micro-cap space. It contains the smallest 2,000 companies in America—out of the 3,000 U.S. companies which, in sum, cover 98 percent of the investable market. 

The first thing that jumped at me was IWM’s price-earnings ratio (P/E) of 83. That’s more than four times the P/E of its sister ETF containing the top 1,000 companies the iShares Russell 1000 ETF (IWB | A-92).

It’s not unusual to see individual companies or even funds based on a limited number of holdings to display sky-high or even negative P/Es (see Understanding Negative P/E ratios For ETFs). But it is quite rare to see a broad-based fund that represents two-thirds of America’s companies with such a high P/E ratio.

Indeed, the other historical precedent I was able to find of a broad index’s P/E going anywhere this high was the Nasdaq index topping over 100 in the year 2000. But before we jump to any conclusions about whether Yellen’s concern is justified, we need to understand what’s driving IWM’s P/E and, moreover, whether the assumptions built into it are reasonable.

There are two variables that go into calculating a P/E ratio: growth rates and interest rates. Let’s look at interest rates first.

Clearly, the level of interest rates today is starkly different from the heady 1990s, and many investors and economists would point to the current low interest rates as the main reason for high valuations across all markets now. After all, interest rates are to financial assets what gravity is to physical objects: The lower they go, the higher prices can rise.

Equities in particular are extremely sensitive to the interest rates used to value them. Since equities represent a claim on an infinite series of cash flows, the required rate of return used to value them makes a huge difference.

By the same token, exactly because they are an infinite stream using today’s record low interest rates as a basis for valuing them makes no sense.

 

While it might be reasonable to accept that interest rates will stay exceptionally low for a very long time and use this to value bonds, applying such assumptions to equities would be erroneous. The proper yardstick against which equities should be measured is average long-term rates—not the current or even the forecasted medium-term level.

We recently published a white paper from Research Affiliates, ”The Moneyball of Quality Investing,” which demonstrates that historically low interest rates do indeed coincide with high P/Es, but that those high P/Es are still negatively correlated with subsequent returns. In other words, low interest rates do explain investor behavior and the current high prices of stocks, but they really don’t change their intrinsic value.

The higher price doesn’t magically make a company churn out more cash than otherwise, it just leads to poorer long-term returns.

So if the interest rates used to value today’s small-cap stocks shouldn’t be different than any other time in history, then the similar P/E ratios of the Russell 2000 now and the Nasdaq in 2000 would suggest similar growth rates as well. In other words, to justify their valuation, small-cap companies would have to grow their earnings almost as fast as what was expected of dot-com companies in the 90s.

Given that the U.S. economy is growing at around 2 percent now—half as fast as it did back then, the challenge to small-caps is twice as hard. Of course, some companies will grow at breakneck speed and fully justify their extraordinary valuations. But for every one of those, there will be scores of others that will fall by the wayside.

On average, the growth rate of small-caps is still closely tied to the economy’s growth rate.

In short, the growth assumptions currently underlying the valuations of small-cap stocks in the U.S. are not just optimistic, they are simply unrealistic. They suggest that a new mood of “irrational exuberance” is taking hold again, albeit focused on a different part of the U.S. economy this time around. And that’s not good news for a Federal Reserve that’s in charge of financial stability.

As Professor Robert Shiller reminded us in a recent piece in the New York Times, The Mystery of Lofty Stock Market Elevations, “irrational exuberance” eventually fades, and when it does, disappointment sets in. If history is any guide, the market adjustment that follows is rarely a smooth process.

Janet Yellen is right to be concerned.


At the time this article was written, the author held no positions in the securities mentioned. Contact  Boris Valentinov at [email protected].


 

Boris Valentinov is an ETF specialist at etf.com. He focuses on equity, currency and European-domiciled ETFs. Boris' previous experience includes a number of positions at various businesses within GE Capital. There, he analyzed corporate financial statements, evaluated market opportunities and developed business strategies in support of M&A activities and other investment decisions. Boris holds a B.A. in economics from Hamilton College, an M.S. in financial analysis from the University of San Francisco, and is a 2015 Level III candidate in the CFA program.