Russell 2000 Breakout, Until Proven Otherwise, Deserves Benefit Of Doubt

The Russell 2000 has broken out. There are many reasons to doubt the breakout – ranging from elevated valuations to falling profit estimates to several soft economic data points. But as long as the breakout remains intact, bulls deserve the benefit of the doubt.

It is a potentially dangerous combination – falling profit estimates and rising stock prices. Yet, this is what major US equity indices are in the midst of currently.P/E multiples across the board have risen – some uncomfortably so.

Chart 1 presents the operating P/E for S&P 500/400/600 companies going back to 2008. Of this, years up to 2018 use trailing estimates, while 2019/2020 are based on forward estimates. With one quarter to go this year, the multiple is higher for all three indices this year versus last year. Noticeably, the P/E multiple for the S&P 600 small cap index has risen from 21.6x last year to 25.9x this year.

As far as 2020 is concerned, two facts are worthy of attention. One, multiples across the board go down significantly for next year. This is because the sell-side has penciled in very high growth rates for next year – 11.3 percent for S&P 500 companies, 14.5 percent for 400 and 52.6 percent for 600! And two, the revision trend in these estimates is not very encouraging.

In March this year, 2020 estimates for S&P 500 companies were $186.36; as of last Thursday, they had been revised downward to $176.42.Similarly, estimates for S&P 400 companies went from $136.71 in January this year to $113.32, and for S&P 600 companies from $67.63 in February this year to $59.06. Next year’s estimates for S&P 600 companies in particular suddenly fell through the roof; as recently as November 11, the sell-side expected $65.70 for next year.

Amidst this, the Russell 2000 small cap index broke out two weeks ago, joining mid-caps which staged a range breakout five weeks ago. Both small- and mid-caps were otherwise lagging their large-cap cousins. The S&P 500 large cap index (3145.91) surpassed its July high six weeks ago; its all-time high of 3154.26 from seven trading sessions ago is a stone’s throw away. In contrast, both the Russell 2000 (1633.84) and the S&P 400 mid cap index (2021.98) reached their highs in August last year, at 1742.09 and 2053.06 respectively.

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