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Record small-cap rally sends valuation 26% above 1990s

Mar 24, 2014 @ 10:26 am

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In one corner of the U.S. equity market, investor enthusiasm is exceeding the frenzy of the Internet bubble.

Small-cap shares tracked by the Russell 2000 Index have rallied for seven straight quarters, the longest stretch ever, sending valuations 26% above levels at the height of the 1990s rally. Gains in stocks from LogMeIn Inc. to Athenahealth Inc. have pushed the gauge up 248% since the bull market began five years ago, leaving price-earnings ratios about three times as high as for shares in the Standard & Poor's 500 Index.

Surging small-caps were cited by Federal Reserve Governor Daniel Tarullo last month as one reason policy makers should ensure they're not creating systemic risk in financial markets. While the increase in the Russell 2000 reflects speculation America's economy will expand faster than the rest of the world, investors may be getting ahead of themselves, according to Matthew Peron of Northern Trust Corp. in Chicago.

“Small-caps are all getting painted with the brush of success,” Peron, managing director of global equities at Northern Trust, said on March 19 by phone. His firm oversees about $885 billion. “The story is more nuanced than that.”

U.S. stocks rose last week, with the S&P 500 climbing 1.4 percent and the Russell 2000 adding 1%, as better-than- forecast data on jobless claims and manufacturing offset comments by Federal Reserve Chair Janet Yellen that interest rates could rise in the middle of next year. The benchmark gauge for smaller shares has risen 2.6% this quarter, compared with a 1% gain in the S&P 500.

RISK APPETITE

Small-caps, whose market value averages $1.07 billion, have led the bull market as three rounds of monetary stimulus from the Fed drove investors into riskier assets. The Russell 2000 has returned 30% a year since March 2009, compared with a 25% increase in the S&P 500. Pier 1 Imports Inc., a Fort Worth, Texas-based furniture store, and Keryx Biopharmaceuticals Inc., a developer of renal-disease treatment in New York, rose the most, each advancing about 13,000 percent during the period.

The outperformance accelerated this year even as earnings growth trailed large-caps. Profits from Russell 2000 companies climbed 6.8% in the last quarter, compared with 8.6% in the S&P 500. While bigger companies exceeded analysts' estimates by a combined 4.6%, smaller firms missed by 13%, data compiled by Bloomberg show.

“The space has undoubtedly been on fire,” Jim Russell, who helps oversee $115 billion as a senior equity strategist for U.S. Bank Wealth Management in Cincinnati, said in a March 19 interview. “Trees don't grow to the sky and you have to be wary of what you pay for that growth.”

As prices surged and earnings increased at a slower rate than analysts anticipated, smaller companies have become more expensive than they've been 86% of the time since 1995, according to data compiled by Bloomberg. The Russell 2000 is trading for 49 times reported earnings, compared with a multiple of 39 in March 2000. The S&P 500 has a price-earnings ratio of 17.2, close to its average since 1937, data compiled by Bloomberg and S&P show.

The Russell 2000 slumped 43% between March 2000 and October 2002, about 6 percentage points less than the S&P 500.

LogMeIn, which offers remote computer connectivity to mobile professionals, and Athenahealth, a Watertown, Mass., provider of online services to doctors and hospitals, are among nine companies with a P/E ratio above 1,000.

“It's a hard place to find a lot of bargains right now,” Donald Yacktman, founder of Austin, Texas-based Yacktman Asset Management, which oversees $30 billion, said in an interview on March 19. “It doesn't surprise me that this market, particularly small-caps, could be pretty highly valued and way out of whack.”

Central bankers must preserve the option of using interest rates to contain financial bubbles even as they strengthen supervisory tools to curtail systemic risk, the Fed's Mr. Tarullo said on Feb. 25 at a conference of the National Association for Business Economics in Arlington, Va.

“Valuations do appear stretched” for some small technology firms, he said. “Monetary policy action cannot be taken off the table as a response to the build-up of broad and sustained systemic risk.”

NARRATIVE CHANGE

Ms. Yellen said last week that the central bank's stimulus program could end this fall and benchmark interest rates may rise about six months later. The Fed had previously said it wouldn't raise rates for a considerable period, without specifying a time frame.

“The change in the narrative is partially to remove that speculative excess,” David Lafferty, the chief market strategist for Natixis Global Asset Management in Boston, said in a March 20 phone interview. His firm oversees about $867 billion. “When you combine the higher valuations in the small- cap world with less accommodative Fed policy, you have the potential for great volatility.”

The small-caps rally is occurring as the U.S. economy is forecast to accelerate from what has been the slowest recovery since World War II. Gross domestic product will increase 2.7% this year and reach 3% in 2015, according to the median estimates from 99 economists surveyed by Bloomberg.

China's economic slowdown and political crises from Thailand to Ukraine helped fuel demand for American small-caps as investors shunned conglomerates that are more reliant on global revenue. The average firm in the Russell 2000 gets 84% of its sales from the U.S., compared with 70 percent for the S&P 500, data compiled by Bloomberg show.

“Investors are willing to pay more for growth,” Kristina Hooper, a U.S. investment strategist at Allianz Global Investors in New York, said in a phone interview. The firm oversees $475 billion. “You do have greater sensitivity to the economic recovery so as the recovery picks up, small-caps will continue to benefit.”

Exchange-traded funds investing in small-cap shares attracted $5.73 billion this year through March 20, compared with withdrawals of $10.7 billion from those focused on large companies, data compiled by Bloomberg show.

A quarter of Russell 2000 companies didn't make any money in the last 12 months and their shares rose 7.6 percent on average in 2014, data compiled by Bloomberg show. Firms with profits trailed, rising 2.2%.

Eight stocks more than doubled this year. Among them, all but one are drugmakers that are unprofitable.

Intercept Pharmaceuticals Inc. soared 473% after saying its experimental liver-disease treatment reached its goal in an early trial. The New York-based company, whose sales were less than $2 million in 2013, won't make a profit until 2017, analysts forecast. While Chief Executive Officer Mark Pruzanski said in January that it's too early to predict when the drug will be marketed, the stock performed the best in the Russell 2000.

InterMune Inc. jumped 135% this year as its drug pirfenidone for a fatal lung disease met goals of a study expected to support U.S. approval. The Brisbane, Calif., company has reported losses every year in the past decade. Analysts surveyed by Bloomberg say it won't make any money until 2016. InterMune said in a regulatory filing in February that the timing of its profitability is “highly uncertain.”

“Biotech is the perfect example that looks a bit frothy, to say the least,” Matthew McGeary, a Stowe, Vermont-based fund manager with Eagle Asset Management, which oversees $31.3 billion, said in a phone interview on March 20. “There are clearly investors willing to take on risk and looking for hyper growth. That's what the industry is getting right now -- people flow where the momentum is.”

(Bloomberg News)

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