Small-Caps Are Stretched

 | Nov 14, 2013 | 11:00 AM EST
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The iShares Russell 2000 (IWM) was one of the first exchange-traded funds (ETFs). The Russell 2000 is an interesting index -- mutual fund managers like to use it as their benchmark since it is full of garbage and tends to underperform its cousin, the S&P Smallcap 600 index.

Two thousand stocks is a lot to have in an index. And if you think about the mechanics of ETF trading, whereas a market maker would have to hedge ETF positions with baskets of the illiquid underlying stock, all 2,000 names, it's not difficult to imagine that in the early days, liquidity for IWM was very poor.

Nowadays, due to "high frequency trading" and statistical arbitrage, the liquidity of a fund filled with that are in and of themselves illiquid is actually amazing. (Side note: I have nothing good to say about market microstructure technophobes.)

In my ETF trading days, clients of mine liked to express a view on small-caps outperforming large-cap (or the other way around), and would buy IWM and short SPDR S&P 500 (SPY), or vice versa. I never really understood this behavior. Outperformance or underperformance on a short-term basis seemed to be completely random, but over long periods of time, secular trends would take over. In fact, style box trades, such as large over small or growth over value, can be career-makers if you get them right. I almost never get them right.

The Russell 2000 is starting to make news again because it is so overvalued on a fundamental basis. The price-to-earnings ratio (P/E) of the entire index is over 80. Now, it's not uncommon for small-cap valuation to get ahead of itself (the P/E has, at times, been infinite) but currently, the valuation is extraordinarily stretched.

IWM has been rocketing higher and attempts to short it have been fruitless (I tried, about a year ago). It's hard to believe, but the actual index value is now over 1,000 -- the Russell is up about 300% from the lows.

I have no particular desire to try to call the top. As I said before, small/large outperformance can persist for years. But I want to point out that, on a fundamental basis, small-cap stocks are extremely overvalued, and there is no margin for error. The index is priced for perfection.

As a general rule, I traffic in large, liquid names only (counter intuitively, I feel like I have more of an advantage there), so I'm not looking to place a trade. But I do think that small-cap stocks respond more to liquidity and zero rates. People who are looking for indicators that quantitative easing is perhaps causing distortions, can look no further than IWM. A broad market index with a P/E of 80 is simply abnormal.

If and when the market finally turns -- which I don't think will happen soon -- IWM will be my preferred vehicle to short. You could mark down the index a full 20% or 30% and it would still be overvalued.

I'm not a value investor, and I know that it is generally profitable to buy high and sell higher, but the Russell at an 80 P/E? I pass. The foregoing also applies to any small-cap stock I am examining on a fundamental basis.

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