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IWM Divergence: Small Caps Are Still Overpriced Nov. 20, 2014 1:27 AM ET | About: iShares Russell 2000 ETF (IWM), Includes: QQQ, SPY by: Fred Piard
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article. (More...)
Summary- Some analysts think that small caps underperforming is a bad omen.
- But this metrics shows that they have been flying too high.
- What you can expect if the historical balance is restored.
Between 03/04/2014 and 11/18/2014, the SPDR S&P 500 ETF (NYSEARCA:SPY) has gained almost 10%, whereas the iShares Russell 2000 small caps ETF (NYSEARCA:IWM) has lost close to 3%. A divergence between risky segments and the broad market is often seen as a bearish sign. But in this case, the divergence is not confirmed by the largest and most liquid risky segment represented by the PowerShares Nasdaq-100 ETF (NASDAQ:QQQ).
(click to enlarge)
(chart: FreeStockCharts)
Moreover, a short historical valuation study shows that small caps have been, and are still overpriced relative to large companies.
MethodologyMy indicator is the price-to-earnings ratio, excluding extraordinary items, trailing twelve months. As its average is sensitive to outliers and gives extreme readings at some points in time, my evaluation is based on the median value in two universes: the S&P 500 and the Russell 2000 indices. Rather than comparing the values for both universes, I prefer comparing each of them to its historical average, staying in the same universe. Doing so, I want to take into account the bias created by the different risk and reward expected by investors for small caps and large caps.
ResultsUniverse
| median PE (Nov.15th)
| 15-y average of median PE
| Deviation
| S&P 500
| 20.97
| 19.05
| +7.7%
| Russell 2000
| 21.59
| 18.63
| +15.9%
| Because of the calculation mode (median value instead of capital-weighted average), the deviation of large caps PE relative to its historical average may not be sufficient to conclude that the S&P 500 index is overpriced. Based on other metrics (equal-weighted average of the net profit-to-price), I wrote in a recent article that S&P 500 companies are not overpriced, and that is still my opinion.
However, it makes sense to compare the two universes.
Based on the price-earnings historical data in each market capitalization segment, small-cap companies still have an unjustified premium compared with large-cap companies. The divergence between SPY and IWM may go 8% further in the next weeks or months, it would just rebalance the situation to the 15-year average ratio.
My next article will explore specific industries to figure out which ones are overpriced and underpriced from a historical perspective. Feel free to follow me if you don't want to miss it.
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