The Russell 2000 Index is trading at about 21 times forward earnings, well above the 10-year average of roughly 17. Small-cap stocks continue to offer attractive growth — with five-year estimates of 11.6% for the asset class as a whole — but at 21 times earnings, the price is steep.
Using this valuation level as a starting point, the opportunity for returns in the next five years is muted at best. Given small caps’ volatility, this indicates an unfavorable risk-reward profile for anyone committing new cash to the asset class today.
The other issue to consider is the general froth currently being exhibited within the small-cap space. According to ETF.com, the ProShares Ultra Russell 2000 ETF (UWM) has pulled in more than $1.1 billion in assets year-to-date — ninth-highest among all ETFs in the United States.
That’s an unusually large amount of money for a leveraged (2x) ETF within such a short period of time, indicating that investors are tripping over themselves to take on risk here.
It’s also worth noting that the surge in biotechnology stocks has played a huge role in small caps’ outperformance, a trend that reflects an extension of investors’ search for domestic names with organic growth and high beta.
However, the sector is getting extremely bubbly here. Yesterday, Michael Ide of ValueWalk reported that the pharma/biotech component of the Russell 2000 Index is up 24% year-to-date. As a result, the year-to-date return for the overall index (3.8% as of March 5) has surged well above the 0% median return for all stocks in the index.
As the table below shows, nine of the top ten year-to-date performers in the Russell Index are pharma/biotechs. If this sector loses its luster, small-cap stocks will quickly cough up their performance advantage.
The Bottom Line
Small caps still have a lot going for them, and investors may be hesitant to sell in a market that has left anyone but the most ardent bulls behind. Still, with valuations where they are and such strong gains already in the books, it’s time to take a more cautious approach to this space.
As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.