Small cap companies have been struggling for most of this year, so when Federal Reserve chair Janet Yellen warned investors about stretched valuations last week it sent them even lower, now down 1% YTD. While value investors often see sell-offs as an opportunity to pick up some good stocks that got caught up in the mix, Goldman Sachs analyst David J. Kostin warns that the Russell 200 looks like it still has room to fall.
“Russell 2000 earnings and performance are highly levered to the US economy, which we expect to grow at an above-trend 3% pace in 2015,” writes Kostin in a report with Goldman Sachs analysts Stuart Kaiser, Amanda Sneider, and Ben Snider. “But large downward EPS revisions YTD have inflated small cap valuations, which remain significantly above historical averages both in absolute terms and relative to the S&P 500.”
Small cap stock prices aren’t falling as fast as EPS forecasts
Even though small cap stock prices have tumbled recently, EPS forecasts have fallen even faster, especially when compared to the modest downgrades for the S&P 500 (INDEXSP:.INX). As of the end of June, consensus downgrades were well into negative double-digit territory for the year.
While Kostin et al don’t expect the Russell 2000 (INDEXRUSSELL:RUT) to keep falling, they do expect it to underperform the S&P 500 (INDEXSP:.INX) 4% to 6% over the next 12 months as valuations fall back to normal levels. The current average of 1.3x EV/sales is still more than a full deviation of the average 1.0x multiple, on par with 2007 levels, and really only surpassed by the dot com bubble.
Analysts still bullish on small caps for 2015
Even with the EPS downgrades, the consensus forecast is still for Russell 2000 EPS growth to hit 30% in 2015 compared to about 12% for the S&P 500. The Goldman Sachs report mentions that these estimates ‘may be revised lower,’ and it does make you wonder if this years outsized EPS downgrades are partially due to such optimistic initial estimates last year.
Small caps still have lower margins than the S&P 500 (INDEXSP:.INX), 2.2% versus 8.9% on average, and nearly 20% of the Russell 2000 (INDEXRUSSELL:RUT) companies have negative earnings, so there is plenty of reason to be skeptical that the index will have such a great year. The one big advantage they may have is that small caps are less sensitive to small interest rate changes and won’t face the same headwinds as large caps if the Fed policy rate ticks up next year.