HH Taking The Pulse Of Small-Cap Valuations

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The summer months are upon us, and with the warmer weather comes a fresh reminder that the worst of the COVID-19 pandemic may be finally behind us. 

Here in New York, the joy of a real summer is palpable as the U.S. economy recovers from last year’s recession.

Financial markets are also brimming with optimism, so now seems like a good time to take the pulse of U.S. small-cap valuations and prepare for the next phases of the economic cycle.

That Was Then, This Is Now

This year’s hot trade has been the “reopening” trade, as investors have grown bullish on the economic revival and gotten a piece of it any way they could, from cyclical sectors, to value, to small caps. 

But as the run-up in equities persists into June, it’s prudent to examine how overvalued or undervalued markets are in a historical context.

As of May, the Russell 2000 Index is trading higher than 30 times estimated earnings; that’s more than 25% higher than its monthly historical average dating back to early 2007. To provide a sense of how high that really is, its forward price-to-earnings (P/E) ratio is ranked in the 92nd percentile over that timeframe (where a higher percentile rank indicates a higher forward P/E value, with the 100th percentile as the highest on record).

The S&P SmallCap 600 Index is a bit more subdued, trading at a negligible 4% forward P/E premium compared to its historical average. But this modest premium remains in the 70th percentile over the same period, indicating it’s not exactly a bargain by historical standards, either.

Valuation Comparison 

Figure 1_Valuation comparison

The odd man out in the universe of supercharged small-cap valuations is the WisdomTree U.S. SmallCap Fund (EES). 

It’s currently trading at an 11% discount to its historical average on a forward P/E basis since inception in February 2007. It also remains attractively priced by historical standards, ranking in the 26th percentile by the same measure.

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