Trailing PEs Near Historic Highs; Earnings Growth Questions Loom

Trailing PEs for the Russell 2500 (INDEXRUSSELL:R25I), Russell 2000 (INDEXRUSSELL:RUT), and Russell mid-cap are all approaching historic highs. Even the Russell Top 200, while not near a historic high, is above its historic average and rising steadily. After so much multiple expansion, these high valuation levels shouldn’t be a surprise, and they are further proof that companies will need to justify further price increases with earnings growth.

Trailing PEs near the higher end

“Several valuation metrics remain near the higher end of historical ranges. This implies increased reliance on earnings growth drivers as a market trigger during 2014,” writes Citi analyst Scott T. Chronert. And while rising/falling estimate ratios and positive surprise trends both improved recently, “both remain near the lower end of historical ranges and underscore an ongoing lack of conviction in forward growth.”

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Michael Mauboussin: Here’s what active managers can do

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Small cap valuations gain on large caps

Small cap valuations gained on large caps in the fourth quarter (large caps still look cheaper right now), while small and mid-cap valuations remained comparable.

“A combination of falling growth expectations, low rising/falling estimate ratios and positive surprise trends over the past few months has left earnings growth expectations toward the low end of historical ranges,” writes Chronert. “During Q4, there have been early signs of improvement in many of these metrics.”

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Value outperformed growth in Q4

Chronert found that value strategies edged out growth in the fourth quarter, though growth was still up for 2013 as a whole. Also, internal correlations fell, indicating that more investors are engaging in stock picking strategies than they had been earlier in the year. “This indicates a positive sentiment shift and more stock specific differentiation,” writes Chronert.

Put another way, investors are no longer content to make gains off a bull market that is lifting every company that isn’t obviously in trouble. Stock picking strategies are on the rise, as many analysts have been predicting, and even investors who are bullish on the recovery have to know that companies who can’t demonstrate strong performance will be punished by the market this year. Even though the Relative Strenghth Index (RSI) is still currently neutral (meaning recent gains and losses are comparable), that could change in the near future as dispersion grows.