Chart of the Day – Russell 2000, $IWM Vulnerable?

by Enis March 12, 2014 12:54 pm • Commentary

As the bubble talk continues regarding the U.S. stock market, I wanted to expand a bit on Russell 2000 in particular.  While the debate about the broader market’s valuation is more of a toss-up in my view, small caps show many more signs of a market that is driven by unsustainable speculation.

We discussed this issue in Monday’s Name That Trade post for QQQ:

Another indication that many of the small cap stocks are in bubble territory is that the median measures of valuation are near all-time highs, even as the mean measures of valuation don’t look so frothy (once again, the mega caps are not too expensive, but many stocks in the market are very expensive vs. history).  Here’s a chart from Goldman research illustrating that:

Screen Shot 2014-03-10 at 1.19.26 PM

The broader optimism in the market has led to the usual symptoms of a bubbly market – major M&A on dubious grounds (FB buying WhatsApp), large IPO issuance, and huge moves in little known sectors (marijuana, fuel cells, and small cap biotech for example).

The most active stocks in the last 2 days have been three small fuel cell companies, PLUG, BLDP, and FCEL.  Yesterday alone, PLUG opened near $12 and closed near $6, and traded more than twice its float.  The stock was trading below $1 as recently as December.  Meanwhile, Fannie Mae’s stock is down almost 50% from yesterday’s highs after concerns about Congressional action to limit future profits to shareholders.  Fannie Mae was actually a nearly $40 billion market cap company yesterday morning, and is now worth around $20 billion, an incredible move in just 24 hours.

These examples are illustrative of how stocks can move on the downside if they have had rapid, greed-inducing moves higher.  In the small cap space, many signs of froth are evident, including a willingness to ignore fundamental valuations when investing in stocks.  Here is a great chart from illustrating that willful ignorance:

Screen Shot 2014-03-12 at 11.14.23 AM

This graphic illustrates that the share of IPO’s with negative earnings issued this year is on par with the height of the tech bubble in late 1999 and early 2000.

Numerous signs of speculative fever are evident in the small cap arena in the U.S.  While the long-term chart of the S&P 500 does not look as concerning, the monthly chart of the Russell 2000 indicates the extent of the investor demand for small cap issues over the past 5 years:

IWM monthly chart, Courtesy of Bloomberg
IWM monthly chart, Courtesy of Bloomberg

The 1994 to 2000 bull run annualized about 20% per year in returns for small cap companies.  The 2002 to 2007 bull run annualized about 22.6% per year.  The current bull run since 2009 has blown those figures out of the water, with a 29% annualized return over the past 5 years.

Such a large move is very rare in a 5 year period, even in the vaunted history of the U.S. stock market.  While on its own, a big move higher is not necessarily a cause for concern, when combined with the many fundamental metrics that indicate expensive small cap equities, as well as the recent speculative euphoria, small cap stocks seem especially vulnerable to a severe correction at some point in the coming months.