The Small Cap Bubble

The Russell 2000 index reached new highs but price action is confined in a slowly rising channel in past six months. The trailing 12-month P/E ratio of the index is at 82. The top 20 holdings of the IWM ETF indicate a bubble formation and irrational exuberance.

The iShares Russell 2000 ETF (IWM) daily chart below shows the channel formation in the last six months.

A parabolic move above the upper trendline of the rising channel is possible. Given the irrational exuberance in this market such a scenario cannot be discounted.  Although this is already a bubble market, irrational exuberance can persist for many months, or even a few years, as the dot com bubble has taught us.

Below is a list of the 20 top holdings of IWM:

Financials and to a lesser extent a few other sectors save the day otherwise the picture would be a lot worse. I summarize the findings below based on the top 20 holdings:

  • Three stocks have negative EPS
  • Eleven stocks have P/E > 30
  • Eight stocks have P/E > 70
  • Average year-to-date return of overvalued stocks: +69.9%
  • Average year-to-date return of with P/E < 30 stocks:: +1.8%

It may be seen that year-to-date return is inversely proportional to valuations. This is indicative of a speculative market driven by greed and not by attention to value. Forecasts are impossible and in this market most technical indicators are not useful. This bubble could inflate for much longer and no one can estimate when it will burst. A bear market can start even today or after a couple of years. The 50/200 golden cross is still in bullish mode but a correction could quickly erase all gains from this signal since it was triggered in May of last year and before a death cross reversal occurs. Protection in the form of put options may be a good choice here but there is an associated high cost.

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Charting and backtesting program: Amibroker

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