Brace For Irrational Exuberance 2.0

August 19, 2014

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.


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