A price/earnings ratio (P/E ratio) is at first glance a very objective statistic, but it can be calculated in a few different ways. Understanding the different ways P/E can be manipulated can give us valuable insights into the markets.

Some indexes, such as the S&P 500 and the S&P Small Cap 600, explicitly state that a company must actually be profitable in order to enter the index. However, this is not true for the most famous small cap benchmark index, the Russell 2000. At February 28, 2015 the P/E of the Russell 2000 Index is a reasonable 20.3 when you only include companies with positive, real earnings (the blue area). However, when you then take all of the companies in the index and add the total positive earnings and then subtract the losses/negative earnings from the positive earnings to form the P/E ratio, the Russell 2000’s P/E jumps to 45.3 at February 28, 2015! (the red area)

Extreme Speculation and P/E Infinity

We can identify three small cap sectors where speculation has become extreme. If and when cracks appear in the small cap markets, we believe these sectors will be particularly vulnerable. The Russell 2000 Technology Index at February 28, 2015 had a very lofty P/E of 76.6, which is worrisome and eye-opening (the yellow area). As we can see from the chart, the Technology sector P/E has been over 100 in the past, so this speculative froth could continue for some time. More startling is that currently, both the Russell 2000 Energy and Health Care sectors do not in aggregate produce any earnings at all, and thus their P/E ratios are infinite! At Clark Capital, we are always mindful of managing risk in our portfolios, and we will be watching closely for what could be a sizeable reversal in some areas of the small cap universe.

Past performance is not indicative of future results. The opinions expressed are those of the Clark Capital Management Group Investment Team. The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. Nothing herein should be construed as a solicitation, recommendation or an offer to buy, sell or hold any securities, other investments or to adopt any investment strategy or strategies. This material is not intended to be relied upon as a forecast or research. The material presented has been derived from sources considered to be reliable, but the accuracy and completeness cannot be guaranteed.

Clark Capital Management Group, Inc. reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs. It should not be assumed that any of the investment recommendations or decisions we make in the future will be profitable or will equal the investment performance of the securities discussed herein.

Clark Capital Management Group, Inc. is an investment adviser registered with the U.S. Securities and Exchange Commission. Registration does not imply a certain level of skill or training. More information about Clark Capital’s advisory services can be found in its Form ADV which is available upon request.