Earnings have now crashed in the Russell 2000 index, to such a degree, that the trailing P/E ratio is a stratospheric 687.
Source: The Wall Street Journal.
I have noticed that IWM has been following oil (NYSEARCA:USO), down over the last half year (IWM is green bars and USO is red line).
I also downloaded, daily data, from June 1, 2015 until March 7, 2015, for both IWM and USO. I made daily returns and computed the correlation and found it to be statistically significant (source of data was yahoo finance and Gretl software).
correlation(USO, IWM) = 0.48916666
Null hypothesis of no correlation was rejected:
t-statistic = 7.75108, gives a two-tailed p-value of 0.0000
Below are the results, of an OLS regression, using daily returns, with IWM as the dependent variable and USO as independent.
Based upon the falling price of oil and well known stress in the energy sector I decided to download the net income for the last two years for all companies in the Russell 2000 index. I downloaded this data from I-metrix over the last week, or so, along with the market capitalization for each company. The list of companies in the Russell 2000 index was from Worden.com.
I was able, tediously, to get data for 1,863 companies in the Russell 2000. Some had disappeared due to acquisitions, and for others the data simple could not be drawn from I-metrix. Worden.com also gave less than 2000 stocks in the first place, at only 1,938. However, this is a very robust sample size. 1,863/2,000 = 93.2%, or 1,863/1,938 = 96.1%.
I then further filtered out stocks from the energy sector. There were 62 stocks in the energy sector, leaving 1801 stocks in the Russell 2000 Ex-energy.
All 1,863 stocks had net income of $15.077 Billion in 2015; down from $38.972 Billion in 2014. A drop of over -61%.
Total net income from energy stocks in 2014 was $2.357 Billion dollars; in 2015 this fell to -$22.139 Billion. A net decline of over -$24.497 Billion dollars.
Stocks Ex-energy earned $37.216 Billion, in 2015, up 1.64% from $36.615 Billion in 2014. These 1,801 stocks had a total market capitalization of $1,758.227 Billion dollars. Providing a P/E ratio of 47.24, and an earnings yield (E/P) of only 2.12%. This is a very high price to be paying for a group of companies that only grew net income by 1.64%.
Here is a table of statistics and distributions of the earnings yield (E/P) of the Russell 2000 Ex-energy by market capitalization.
|t statistic (mean = 0)||-2.464|
|t statistic p-value||0.014|
|lower 95% c.i.||-6.7%|
|upper 95% c.i.||-0.8%|
|# of values > 0||1,231|
|Positive Earnings Yield||68.4%|
One finds that over 68% of these companies had positive net income. However, the remaining companies skew the whole distribution to the left, since they have very large losses compared to their market cap. Indeed, the statistics show that it is very likely that the average earnings yield of these 1,800 companies is negative; since, there is a 95% confidence interval between -6.7% and -.8%.
I already alluded to the overestimation of forward earnings in my first article concerning the Russell 2000's valuations. These 1,800 stocks also appear to be overbid by investors. We can see how much the required return is by using the justified trailing P/E ratio formula.
Source: Financial Exam Help
From the WSJ data, I assume the dividend payout is still 1.72%. It would be better if I got the dividends paid for all these companies, but it was very difficult just to get the net income data from I-metrix. Then one just plugs in the data to find the required return on common equity for these companies. If I have done the algebra and calculation correct, it is only a risk premium of 3.39%, which is required by investors.
Where is the company size and liquidity premiums that are supposed to come from investing in small companies?
Damodaran shows that the 2006-2015 geometric equity risk premium, over T-bills, for the S&P-500 was over 6%!
I conclude that even Ex-energy the Russell 2000 is still over valued. Currently the direction of oil prices still has a large effect upon the movement of this index. Portfolio and risk managers be aware of the oil price "factor" upon your portfolio. You might have more risk based on this factor then your realize. Remember in a bear market to sell those rips, if you ignored that recommendation last summer.
Since June of 2012, growth stocks in the Russell 2000 have outperformed valued stocks, based on capital gains (Growth is green bars & Value is red line).
If you have a mandate to be invested in the Russell 2000, look to "tilt" towards value vs growth stocks. It appears the trend of growth outperformance has begun to reverse.
Remember that over the very long term value stocks have been shown to outperform growth stocks.
- The Russell 2000 is still overvalued, even Ex-energy.
- The Russell 2000 is tracking the movement in the price of oil, be aware of this risk.
- There are profitable stocks within the Russell 2000 constituents; active investors should concentrate on these stocks, and those stocks which have value metrics.
- Hedge funds and speculators could attempt a long/short strategy of being long the Russell 2000 Value ETF (NYSEARCA:IWN), and short the Russell 2000 Growth ETF (NYSEARCA:IWO).
- Trading speculators should remember in bear markets to buy the "dips" and sell the "rips". We just had a "rip".
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.