Who is Buying Small Caps at P/E 84?

Zacks

My "Buy in May" thesis held this central idea: the much-awaited and necessary stock market correction had already occurred in the growth indexes, the Russell 2000 and Nasdaq Composite. And in May, the strong S&P 500 index which was just waiting to go higher, would lift the RUT and the Nasdaq.

On May 8, I advised Market Timers that we were starting a campaign to play a bottom in the RUT around 1100. I called it our "50/50" campaign because we were looking for support at the 50-week moving average (just below 1100) and for a bounce to ensue to retrace at least 50% of the March-April decline (rally to 1150).

We played that rally with TNA fairly well, despite a hiccup with the Tepper Tantrum on May 15 where the RUT actually went down and kissed the Feb low at 1082.

Now the RUT rally has exceeded even my expectations for how quickly it could get back to 1180. I'm sure there is a fair amount of "bear hunting" going on, but some of my favorite small caps are acting great for good reasons and I want to buy more. In fact, I did buy one today.

But, here's the number that still bothers the bears the most about the RUT: 84.

That's the 12-month trailing P/E for the index.

That is worrisome. But here's another number the bears should focus on: 19.

That's the 12-month forward P/E. Here's the data from Friday's Wall Street Journal...



Now, of course, I'm not saying that I believe the RUT will fulfill those wonderful forward estimates. But that's not the point.

The point is that many large investors are piling fresh cash into many small companies that they believe will move from a triple-digit P/E to a double-digit one, or that they believe will be doubling or tripling their sales in the next year.

Or that they believe are ripe take-over targets where the sub-$1 billion company gets taken out for 2 or 3 times that valuation, like hepatitis-C drug maker Idenix Pharmaceuticals (IDIX) this morning getting bought by Merck (MRK).

While many investors wring their hands about valuations, every week I see large portfolio managers putting money to work in growth stocks like the one I just bought today. And as long as the S&P 500 and Nasdaq 100 remain strong, the smaller growth indexes should make new highs this year, probably this summer.

Where do you stand on the valuation question for smaller companies...

Is it all too much "QE liquidity" driving us toward another bubble?

Or is this investor optimism about the economy and earnings that is justified and bound to persist into next year?

Read the analyst report on IDIX

Read the analyst report on MRK

Read the analyst report on IWM

Read the analyst report on TNA


Zacks Investment Research

View Comments (4)