SLY - SLY: Earnings May Still Be Revised Downward

2023-03-29 03:03:31 ET

Summary

• SLY owns a portfolio of U.S. small-cap stocks.
• The fund’s forward P/E ratio is relatively low to its historical average.
• However, the fund’s price may decline in a recession if its estimated earnings are being revised downward.

ETF Overview

The broader equity market has been in a decline since the beginning of 2022. Many stocks have seen their valuations compressed substantially in the past year. Should investors be focusing their attention on large-cap stocks, mid-cap stocks, or small-cap stocks? In this article, we will analyze SPDR S&P 600 Small Cap ETF ( SLY ) and provide our recommendations and suggestions.

SLY invests in stocks in the S&P 600 index. This index basically selects 600 small-cap stocks in the United States. Following the decline last year, SLY’s valuation appears to be very reasonable and perhaps even cheap relative to its historical average. However, our base case is that a recession will likely arrive in the second half of this year. Downward revision of the earnings of many stocks in SLY’s portfolio may just be starting. Therefore, there is still substantial downside risk owning SLY right now. In this uncertain macroeconomic environment, investors should exercise patience and wait on the sidelines.

Fund Analysis

SLY experienced significant decline since 2022

Like other major indexes, SLY has not performed well last year. As can be seen from the chart below, the fund has delivered a loss of 18.63% since the beginning of 2022. The result was inferior than the 16.68% loss of the SPDR S&P 500 ETF (SPY), and the 15.30% loss of the SPDR S&P MidCap 400 ETF (MDY).

Thanks to the significant decline last year, SLY’s valuation is not expensive right now

Investors may wonder whether this drop makes these ETFs attractive or not. Let us now look at their current forward P/E ratio. As can be seen from the chart below, SLY, MDY and SPY currently have forward P/E ratios of 12.8x, 12.9x and 17.2x respectively. Like its peer MDY, SLY’s forward P/E ratio of 12.8x is now towards the low end of its historical range in the past 20 years. We have only seen these low valuations for both SLY and MDY in two occasions, once during the Great Recession in 2008/2009, and another time during the recession caused by the pandemic in 2020. Therefore, we do see both SLY and MDY's valuations attractive at current level. This also means that in general, small-cap and mid-cap stocks are now relatively cheap. In contrast, SPY which owns solely large cap stocks still has an elevated valuation despite the significant decline last year. Its current forward P/E ratio of 17.2x is comparable to its historical valuation between 2015 and 2020 but still much higher than the historical valuation between 2009 and 2014.

However, downward earnings revision is likely just starting

We know that the price of a stock is equal to the P/E ratio multiply by its earning. Therefore, we need to take into consideration both P/E ratio and earnings to understand where the the price of the stock will go. While we have experienced major multiple compressions in the past year in SLY’s forward P/E ratio, we have only seen a slight downward earnings revision in stocks in SLY’s portfolio. As can be seen from the chart below, SLY’s earnings estimate has been revised slightly to about $88.6. However, we think this is just the beginning of an earnings revision. In an economic recession, earnings can be revised downward significantly. As the chart below shows, during the 2008/2009 Great Recession and the 2020 recession, earnings have been significantly revised.

We believe a recession may not be too far away as the Federal Reserve’s policy to keep the rate elevated for a lengthy period may eventually trigger a recession in the second half of 2023. In this recession, we think estimated earnings of SLY will likely be significantly revised downward. Given small-cap stocks usually do not weather a storm much better than large-cap stocks, the impact on the earnings of small-cap stocks will be significant in a recession. If earnings is being revised downward, we expect SLY’s fund price to also drop proportionally. Hence, there is still substantial downside risk and investors should not neglect this risk.

Investor Takeaway

Although SLY suffered tremendous decline last year and its valuation appear to be attractive right now, there is still substantial downside risk as we anticipate a recession to occur in the second half of 2023. As the economy enters a recession, stocks in SLY’s portfolio may experience downward earnings revision and this will cause SLY's fund price to decline. Therefore, we think it may be better for investors to wait on the sidelines.

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