This is our final question that has been the main objetive of our last five publications. As the valuation of Russell 2000, as any other index, can not provide an exact figure we have use our trading algorithm to calculate a range of confidence trying to mesure the probability to obtaing a fair value above diferent price levels.
Below we can see the histogram of the values obtained for Russell 2000, making 1000 iterations. This has been done using random values for the described variables, centered on our main expectations and forcing the random iterations to follow the standard deviations of different variables. On the right, you can see a table with the values and their respective percentiles.
On the 5th of March, 2018 the Russell 2000 index quotation was 1532. According to our calculations, the fair value of Russell 2000 is below the current prices with a probability of 94% and below 567 points with a probability of 50%.
Russell 2000 is overvalued almost in every considerable scenario.
We summarise the impact of the above estimations in our valuation of Russell 2000, considering the following stress scenarios:
|Scenario Description||Value (Median)||Comments|
|Increase of 1.2% growth (up to 2.9% in real terms) from year 2018 and the terminal growth at the same level, in line with the Treasury’s Office of Tax Policy expectation.
The increase of 1.2% is divided in 0.7% increase because of the tax reform and 0.5% because of the impact of infrastructure investment using a very optimistic fiscal multiplier of 0.7x .
|783||· Long term economical tendency growth at 2.9% is even much higher than the last two decades’ average (2.3%). It is against the historic tendency as Chart 17 shows, and it is unlikely that demographic issues that were not an impediment in the past are taken into account.
· The growth tendency is one of the most aggressive if we compare it with other estimations like those of Federal Reserves or the Tax Foundation’s ones.
· Even if the economic growth for the next decade could be stimulated, reaching a level of around 3% in real terms, there is no reason to increase our baseline estimation for long term tendency above 1.7% in real terms, after 2027.
· Only in the most optimistic case expected by Treasury’s Office of Tax Policy that considers no public debt increase after the fiscal stimulus, could no reduction in economic growth be considered after the stimulus period. On the other hand, if according to the Joint Committee on Taxation the public debt will increase by $1.0 trillion in 10 years, the economic growth during the second decade could be reduced by 0.6% below the tendency (according to our calculations) if Government has to relieve the mentioned debt burden in the next 10 years from 2027.
· 0.7% impact of Tax reform is also one of the most optimistic estimations if we compare it with the estimation of Joint Committee on Taxation of 0.8% throughout the ten year period, or 0.29% annually projected by Tax Foundation.
· The infrastructure investment plan is expected to end in 2027, so there is no reason to expect fiscal stimulus beyond that year. In this sense, terminal growth should be below 2.9%, or the average growth of the period between 2018-2027.
|· GDP growth above our baseline estimation in 1.2% (up to 2.9% in real terms) from year 2018 to 2027
· Terminal growth at 2.9% in real terms, in line with Treasury’s Office of Tax Policy expectation.
· Small caps growing annually 1% above the economy over 10 Years.
|872||· Even though the small caps could benefit the tax reform more than the large caps, we think a long term growth above the USA economy will be very unprovable. Russell 2000 is a good company sample of the USA’s economy, and its performance has been historically very close to the evolution of the GDP in the USA, as Chart 5 shows.
|Increase the GDP growth from year 2018 to 2027 by 1.2% growth and maintain terminal growth without changes compared to our baseline estimation.||600||· Although this scenario is more realistic, it still expects the highest positive impact of tax reform in GDP growth for the next ten years.
· This scenario does not consider any negative effect on GDP growth beyond 2027, nor any tax increase to relieve the debt burden that could be generated between 2018 and 2027
|Scenario that the current price (1550) is discounting:
|1550||· This scenario is based on:
o Increase of the baseline GDP growth from year 2018 to 2027 by 0.7%.
o EPS of small caps growing 1.5% above the economy for 10 years.
o Russell 2000 EPS up front increase of 135% based on a significant part of the 30% of companies which are in losses to get in profits. This last assumption is the hardest to admit.
According to our calculation, Russell 2000 is overvalued with a probability of 94% and there is a probability of 50% to obtain a return of 64% or higher, holding a short position in the index.
Neither tax reform, not infrastructure investments plans nor protectionism can justify the extremely high valuations of Russell 2000. We estimate the currents levels are discounting a huge increase in EPS especially of the 30% of the index companies that today are not yet generating profits. Even assuming an increase of 135% of EPS of the index, it is still necessary to suppose other previously mentioned optimistic hypothesis to raise the fair value to the level of the current prices.
As we are pretty sure that the fair value of Russell 2000 is below the current level, we can account with a good safety margin and say that Russell 2000 is a good investment opportunity to hold short position.