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.
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