Here’s the Shocking Truth about the Russell 2000’s P/E Ratio
The comments above & below is an edited and abridged synopsis of an article by Mark Hulbert
The Russell 2000’s P/E ratio is 78.7. That means the small-cap sector is not only hugely overvalued in its own right, it is in relative terms as well. The Russell 2000’s true P/E today is higher than it was at either the top of the internet bubble or the 2007 bull market peak.
That’s important information in light of the Russell 2000 dropping below its 200-day moving average. Rather than providing a floor underneath the index, its true valuation will be exerting a force towards even more declines.
The most obvious places to look for the Russell 2000`s P/E ratio suggest that it is far lower. FTSE Russell, the company that created and maintains the index, says that the Russell 2000’s P/E ratio is 25.6. iShares, keeper of the popular ETF benchmarked to the Russell 2000 IWM, pegs the index’s P/E at 19.8 as of August 16.
What neither FTSE Russell nor iShares take into account when calculating the index’s P/E are companies with negative earnings. Since nearly a third of the companies in the Russell 2000 index are losing money, this omission has huge consequences.
Though the proper calculation takes more work, the alternative is the functional equivalent of reporting “profits before expenses.” To calculate an index’s true P/E, you divide the combined total market cap of all component companies by the sum of all those companies’ trailing 12 months earnings.
To put this in context, compare the index’s earnings yield of 1.3% (the inverse of the P/E ratio) to the 2.2% yield on the 10-year Treasury. That means a 10-year Treasury note now yields almost a percentage point per year more than the small-cap sector.
You may have other reasons for believing the small-cap sector to be undervalued right now. But don’t try to justify bullishness by claiming that the Russell 2000’s P/E is in the range of 19 to 26.