SMIDs Face ‘Valuation Versus Earnings Growth’ Reckoning

SMID Volatility index

Last week, the Russell 2000 (INDEXRUSSELL:RUT) was down 3.1% while the Russell Midcap (INDEXRUSSELL:RMCC) and Russell 2500 (INDEXRUSSELL:R25I) lost 1% and 2.2% respectively. As SMID sector highlights, Consumer Discretionary was the best performing sector while Health Care was the worst performing on the week.

The sell-off caused a huge spike in volatility as shown in the chart of the CBOE Russell 2000 Volatility Index (INDEXCBOE:RVX) below.

Performance YTD

The following table shows the YTD sector-wise performance for the Russell 2000 (INDEXRUSSELL:RUT) and Russell Midcap (INDEXRUSSELL:RMCC):


Will earnings growth catch up with valuations?

“Our ‘early cycle showdown’ theme is now coming into play! Against a high valuation backdrop, SMID earnings growth needs to improve to offset valuation concerns,” says the latest SMID Cap “Rap” note from Citi analysts Scott T Chronert and Louis L Odette. “With EM and weather issues affecting the macro set up, the burden of proof should unfold as we enter the spring months.”

Citi point out that as small and mid cap companies stepped out of a recession the market recognized this by assigning high valuations, but ultimately these valuations much also be justified by better earnings growth – and the day of that reckoning may be nearing.

SMIDs: Stock picking the new focus

SMIDs are likely to also become a stock picker’s playground in 2014, say the Citi analysts. This is because the focus will move from economic recovery and sensitivity to company growth, and the “bias shifting away from positive revisions and quality to more traditional absolute and emerging growth metrics.”

Stability on the horizon

The Citi analysts observe from the RSI and Advance/Decline technical indicators that both are near oversold or previous-low levels and that this suggests “near term stability.” In particular the A/D line is at a level from where it has typically rebounded on previous instances.


Uncanny correlation between the RVX and leveraged ETF volumes

In the chart of the week, the Citi analysts draw our attention to the close relationship between the aggregate volumes of leveraged ETFs and the spikes in the CBOE Russell 2000 Volatility Index (INDEXCBOE:RVX).


However, the analysts point out the current macro concerns around emerging markets and the US economic data are factors to be watched. Inclement weather across the US may likely also impact economic performance, but this would be better quantified around March.

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About the Author

Saul Griffith
Saul Griffith is an investor in stocks, commodities and forex, writing under a pen name. Saul has top accounting qualifications and extensive experience in industry and the financial markets. He also has an abiding interest in breaking news that could be a harbinger of new trends and give insight into an instrument’s potential for providing value, growth or yield.

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