Bargains Prevail in U.S. Small Caps

Articles From: WisdomTree U.S.
Website: WisdomTree U.S.

By:

Investment Strategy Analyst

When I last wrote about U.S. small capsvaluations had reached historic lows after immense springtime volatility. Unfortunately for bulls, small caps have yet to rebound, but attractive valuations remain.

Though recessionary fears are top of mind, we believe those with a contrarian view or the confidence to remain invested amid the volatility can still benefit from small-cap allocations. Their future may be brighter than the grim forecasts suggest.

Historically Low Valuations Remain

U.S. small caps are notoriously a “junky” market, with a preponderance of unprofitable companies that have historically ranged around 20% for the Russell 2000. But even when unprofitable companies are removed from the Index, the P/E and forward P/E ratios of the small-cap market are historically discounted.

Both measures are currently trading well below long-term averages and have remained more than two standard deviations below that average amid the summertime and early fall volatility. Even after a “dead cat bounce” from June to July, small-cap valuations have fallen two straight months to reach their lowest level since the depths of the global financial crisis.

Historical P/E (ex. Negative Earners) of Russell 2000

Historical P/E (ex. Negative Earners) of Russell 2000

Historical Forward P/E (ex. Negative Earners) of Russell 2000

Historical Forward P/E (ex. Negative Earners) of Russell 2000

In percentage terms, both multiples are about 35%–40% discounted from their long-term average and are nearing single-digit territory.

Value and growth styles haven’t fared much better, trading roughly 35%–44% (and about two standard deviations) below their long-term averages.

Value and growth styles haven’t fared much better, trading roughly 35%–44% (and about two standard deviations) below their long-term averages.

Recessionary Fears Causing Undue Pain

Historically, small-cap forward P/Es commanded about a 4% premium to large caps, though this relationship has steadily broken down in the last few years. After the summertime volatility, the forward P/E of the Russell 2000 relative to that of the large-cap-centric Russell 1000 remains more than two standard deviations below its long-term average.

Russell 2000 Fwd. P/E (ex. Negative Earners vs. Russell 1000

Russell 2000 Fwd. P/E (ex. Negative Earners vs. Russell 1000

Their relationship with mid-caps is similar, reflecting investors’ fears that a recession will disproportionately affect smaller companies heavily dependent on the local economy.

Russell 2000 Fwd. P/E (ex. Negative Earners) vs. Russel Mid Cap

Russell 2000 Fwd. P/E (ex. Negative Earners) vs. Russel Mid Cap

History Suggests a Promising Outlook

For those who believe the Fed may tip the U.S. into a recession with its aggressive rate hike agenda, it is understandably counterintuitive to dignify an asset class notoriously sensitive to economic growth amid expectations of reduced earnings and profit margins. But for the intrepid small-cap investor, we believe the future has historically looked bright after similar periods.

Over the past two decades, small-cap valuations have breached a 20% discount to their long-term average forward P/E on nine occasions (using monthly data). For eight of these nine observations, small caps subsequently outperformed large caps over a two-year period by roughly 5% on average.

Forward Returns When Forward P/E Exceeds 20% Discount from LT Average

Forward Returns When Forward P/E Exceeds 20% Discount from LT Average

Many of these observations occurred in the wake of historical economic disasters, such as the global financial crisis and the onset of the COVID-19 pandemic. Although 2022 has looked similar to those timeframes from a market performance standpoint, history suggests a rosy outlook for small caps in the aftermath of a severe downturn.

For the most recent SEC standardized performance and month end performance, please click the respective ticker: EESDESDGRS.

Originally Posted November 2, 2022 – Bargains Prevail in U.S. Small Caps

Important Risks Related to this Article

There are risks associated with investing, including the possible loss of principal. Funds focusing their investments on certain sectors and/or smaller companies increase their vulnerability to any single economic or regulatory development. This may result in greater share price volatility. Dividends are not guaranteed, and a company currently paying dividends may cease paying dividends at any time. Please read the Fund’s prospectus for specific details regarding the Fund’s risk profile.

Disclosure: WisdomTree U.S.

Investors should carefully consider the investment objectives, risks, charges and expenses of the Funds before investing. U.S. investors only: To obtain a prospectus containing this and other important information, please call 866.909.WISE (9473) or click here to view or download a prospectus online. Read the prospectus carefully before you invest. There are risks involved with investing, including the possible loss of principal. Past performance does not guarantee future results.

You cannot invest directly in an index.

Foreign investing involves currency, political and economic risk. Funds focusing on a single country, sector and/or funds that emphasize investments in smaller companies may experience greater price volatility. Investments in emerging markets, real estate, currency, fixed income and alternative investments include additional risks. Due to the investment strategy of certain Funds, they may make higher capital gain distributions than other ETFs. Please see prospectus for discussion of risks.

WisdomTree Funds are distributed by Foreside Fund Services, LLC, in the U.S. only.

Interactive Advisors offers two portfolios powered by WisdomTree: the WisdomTree Aggressive and WisdomTree Moderately Aggressive with Alts portfolios.

Disclosure: Interactive Brokers

Information posted on IBKR Campus that is provided by third-parties does NOT constitute a recommendation that you should contract for the services of that third party. Third-party participants who contribute to IBKR Campus are independent of Interactive Brokers and Interactive Brokers does not make any representations or warranties concerning the services offered, their past or future performance, or the accuracy of the information provided by the third party. Past performance is no guarantee of future results.

This material is from WisdomTree U.S. and is being posted with its permission. The views expressed in this material are solely those of the author and/or WisdomTree U.S. and Interactive Brokers is not endorsing or recommending any investment or trading discussed in the material. This material is not and should not be construed as an offer to buy or sell any security. It should not be construed as research or investment advice or a recommendation to buy, sell or hold any security or commodity. This material does not and is not intended to take into account the particular financial conditions, investment objectives or requirements of individual customers. Before acting on this material, you should consider whether it is suitable for your particular circumstances and, as necessary, seek professional advice.