The main U.S. small cap index, the Russell 2000, is hitting all-time highs, yet the CBOE Volatility Index (VIX) is also elevated. It's not supposed to happen this way, which means we are likely looking at a sign of significant market froth.
This chart depicts the long-term inverse relationship between the Russell 2000 and the VIX. When the VIX rises in year over year terms, this is a sign of increased market fear and lower investor risk tolerances. Small cap stocks, more volatile than their large-cap counterparts, have historically performed poorly during periods of rising investor anxiety. In short – VIX up, small caps down.
The recent divergence can be interpreted a few ways. In one reading, the VIX is rising because of a political problem that will soon be fixed with a debt ceiling agreement. Small-cap investors are merely looking ahead.
But investors adopting this optimistic view will be hard pressed to explain the severely stretched valuations in the Russell 2000. The trailing 12-month price earnings ratio for the Russell 2000 is 40 times, well above the three year average of 31 times.
Forward earnings using analyst estimates (which are often overly hopeful) tell a similar story. The Russell is currently trading at 27 times forward earnings relative to the three year average of 22 times.
U.S. small caps are trading at lofty valuations at a time when the broader corporate earnings environment is deteriorating. There's no equivalent data for the Russell 2000, but the S&P 500 saw a record number of negative earnings surprises ahead of the current reporting season.
The Russell 2000 is, on average, trading at lofty valuations during a time of elevated risk and a weakening profit growth environment. I wouldn't expect these record high stock prices to last long.
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Scott Barlow