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Small Caps: Downward Correction Ahead

|Includes: iShares Russell 2000 ETF (IWM), SLY

Russell 2000 as an index which combines 2000 companies with low and medium market capitalization represents approximately 9 % of total market capitalization of American companies.

In the periods of economic recovery, it is known that smaller companies will have tendency to achieve better results in stock prices than for example 500 the biggest American companies. This occurred in the last 5 years, when the index S&P 500 has only 192 % net yield in comparison to Russell 2000 which has a 233 % net yield. But a look into the valuation ratio does not explain such growth of the market capitalization of smaller companies.

Current average P/E ratio of companies of Russell 2000 index stands at extended 54.23, which is even higher than at the end of 2007.

Source: Bloomberg

It has to be taken into consideration that 610 companies out of 1957 all together are non-profitable and that they make up for 31 % of all companies comprised in this index. Including these companies in the calculation would make the real P/E ratio even higher. The reason why some financial websites report about P/E being around 21 is that they use a different method than the one used for S&P 500 index, therefore making such calculations questionable. These methods do not include non-profitable companies or the P/E amounts that are higher than a certain value (e.g. iShares Russell 2000 ETF) some even use estimated forward earnings.

Additionally, the average P/B ratio in Russell 2000 index is higher than in 2007. Namely, among 1957 companies which comprised the index in the end of August in 2014 average P/B stood at 6.21. This is definitely a good reason for a careful deliberation of further purchasing stocks of smaller market capitalizations.

High values of P/E and P/B ratios would be justifiable if there were any signs of stronger business growth and proportional growth of profit but the profitability ratios paint a different picture.

Source: Bloomberg

ROE, with which we can calculate the profitability of the capital, would stay at the same level with rising market capitalizations and proportional growth of the profits. The ratio in the Russell 2000 index has lowered in the last five years from 6.21 to 3.68 and is therefore lower as it was in the 2007 when the ROE fell to 4.04.

Even more concerning is ROA ratio, which is used to calculate the profitability of assets, which has fallen in the last 5 years from 1.61 to 0.97 and is also lower as it was in 2007, when the ROA stood at 1.06.

Source: Bloomberg

Rising stock prices and consequently market capitalization of Russell 2000 index resembles the growth of stocks in the previous stock market bubble and does not follow disproportional lower growth and profitability of companies. Of course the bull trend can persist a lot longer, but there is a strong possibility that the Russell 2000 index will suffer a strong correlation downward. One of the catalysts could most certainly be the rise of the rates of interest in America which has been along with the better employment data and rising inflation on the horizon for quite a while.

Disclosure: The author is short IWM.