The Standard & Poor’s 500 Index ended August trading at a P/E ratio of 24.6 according to the website multpl.com. In August 2011, the P/E of the S&P 500 bottomed out at 13.8, and the climb since then to the current valuation is evidence of investors’ optimism in the large-cap market.
While the broad market is still below the heady days of the 1990s when the S&P 500 P/E exceeded 33, valuations are still at levels not seen prior to the ‘90s in modern stock market history.
That’s not to say that there aren’t valid reasons for investors to like equities. Low bond yields and meaningless interest rates on savings vehicles have pushed investors into stocks as one of the few investments that can actually earn them money.
Corporate earnings have been strong, and economic indicators have regularly (if not consistently or resoundingly) been positive enough to demonstrate that the country is in generally good shape.
So what about small-cap valuations? FTSE Russell reports that the P/E ratio of the Russell 2000 Index ended July 2016 at 25.58. That seems to compare well with the P/E of the S&P 500.
Or at least that’s what you might think at first.
Mark Hulbert published an article on MarketWatch.com on August 19, 2017, entitled “Here’s the shocking truth about the Russell 2000’s P/E ratio." In the piece, Hulbert explained that the P/E ratio as published by FTSE Russell is actually the “P/E Ex-Neg Earnings”—that is, the P/E is calculated by throwing out all the companies in the index that have negative earnings, and then calculating the P/E with only the remaining companies.
About one-third of the Russell 2000 companies are thus eliminated. According to Vincent Deluard, head of global macro strategy at financial services firm INTL FCStone, a better way of calculating the P/E of the index is to add up all the earnings—and losses—of companies in the index, and use that aggregate figure for the denominator.
In fact, this is what the Wall Street Journal does on its website, and the P/E of the Russell 2000 Index at the end of August was 87.82. That’s more than three times the “PE Ex-Neg Earnings P/E”!
Deluard then goes on to compare the Russell 2000’s “true” P/E to a few peak periods of the past. Today’s Russell 2000 P/E is higher than it was at either the top of the internet bubble in 1999 (around 55) or the 2007 bull market peak (around 60).
Hulbert concludes his article by advising, “You may have other reasons for believing the small-cap sector to be undervalued right now. But don’t try to justify your bullishness by claiming that the Russell 2000’s P/E is in the range of 19 to 26.”
Needless to say, all of the companies tracked by the SmallCap Informer have positive earnings, and the average P/E of all covered companies was 20.3 as of July 31, 2017. This makes sense because we skew towards lower P/E stocks and try to avoid the roller coaster ride that high P/E equities often deliver.
As always, though, we buy stocks, not the market. But sensible stock selection in the small-cap segment seems more prudent now than ever.
- DOUGLAS GERLACH