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The Fed's Valuation Concerns Put These Growth ETFs in Focus

Zacks Equity Research

It seems that the stigma of stretched valuation will not let momentum and small-cap U.S. stocks breathe easy this year. The space was hard hit in the beginning of the year thanks to overvaluation, bubble fears, the worst winter in a decade, and the possibility of a short-term rate hike sooner-than-widely anticipated.

But after a frozen Q1, spring finally sprung in the U.S. economy. Unemployment data also fell to the six-year low in June. Other data points like manufacturing and consumer confidence also favored investors’ new-found optimism.

The Fed’s decision to leave the QE-era this year also bears testimony to sustained economic recovery. As a result, the momentum space gradually returned to life in Q2.

Inside The Recent Crash

While all seems to be going well in the U.S., the Fed surprised the broader market by commenting after 14 years on overvaluation of biotech, social-media and small-cap stocks. The Fed also sounded worried over the valuation of the leveraged loan market too. The comment was strong enough to compel investors to scurry from high-growth stock sell-offs.

Thanks to this sentiment, the Nasdaq Biotechnology Index— the related index in the present context – shed 2.28% as of July 15, 2014. The Russell 2000 Index meant mainly for small-cap stocks lost 1.01% and the ETF made of social media stocks like Twitter, Facebook, Yelp and LinkedIn – Global X Social Media Index ETF (SOCL) – was off 1.10% (read: Sell-Off in Social Media Stocks Puts SOCL ETF in Trouble).

According to the Fed report, the forward price-to-earnings multiples for the concerned corner of the equity market seem elevated as compared to the historical averages. Actually, small-caps as well as tech-biotech stocks spearheaded last year’s bull market.

Investors should note that the tech boom reached such a heightened level last year that SOCL and the Nasdaq Biotechnology Index surged about 60% in 2013. Small-caps added about 33% as compared to 26% return offered by the S&P 500. The rally had to stop somewhere and 2014 marked that beginning of the correction.

ETF Impact

Needless to say, the terrible trading in the biotech and small cap stocks sent the related ETFs into the red on the day. Biotech ETFs like Market Vectors Biotech ETF (BBH), SPDR S&P Biotech ETF (XBI) and iShares Nasdaq Biotechnology (IBB) retreated, respectively, 2.34%, 3.86% and 2.20% on July 15, 2014 (read: A Comprehensive Guide to Biotech ETFs).

Small-cap ETFs including iShares Russell 2000 (IWM), iShares Core S&P Small-Cap (IJR) and Vanguard Small Cap ETF (VB) lost about 0.99%, 0.82% and 0.63%, respectively. Investors should note that at present, the S&P 500 which hit multi-year highs on several occasions this year is trading at lower P/E multiple (ttm) than IWM, IJR and VB.

The P/E multiple stands at 17 times of SPY, at 21 times for IWM and IJR, and at 19 times for VB.  Biotechs are more highly priced. XBI, IBB, and BBH had P/E (ttm) multiples of 35, 27 and 26 times as of July 15.

Bottom Line

We, like many other market participants, we believe that the U.S. market is set in motion at present, but still has to strive hard to attain last year’s peak.  The economy is far from standing on its own feet.

The Fed chair pointed at poor wage growth and sluggish housing market as major bumps in the road to recovery. Billionaire activist investor Carl Icahn also expressed concerns about a future rally in the U.S. stocks (read: Can Carl Icahn Revitalize Retail ETFs?).

However, one should not be bogged down by some pessimism in the stock markets. On a bullish note, corporate earnings are also taking a better shape than what we saw in the preceding quarter especially with the banking sector leading the way. Goldman Sachs lifted its S&P 500 price target to 2050 from 1900 for 2014.

In conclusion, “close watching" of economic indicators would be the Fed’s move to decide on the timeline of a rate hike. Whatever may be the case, Fed’s warning might drag down the high-growth stocks and ETFs in the coming days. We also suggest investors take a breather before jumping on the high-beta ETFs in the near term.

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