U.S. equity markets have been strong thus far in 2013, and small-cap stocks particularly so. Recently, we have focused on the WisdomTree SmallCap Earnings Index, with particular emphasis on strong performance—a focus that we reiterate here.

When market movements reach this level, it’s important to ask whether these moves are justified in each case.

Are share prices moving more than their underlying fundamentals? A focus on valuation becomes increasingly important when equity markets move at such a speed.

Below, we will discuss the process the WisdomTree SmallCap Earnings Index employs to manage the valuation risk inherent in gains of nearly 38% over the prior year.

What we see (in this case on a sector basis) is that WTSEI delivered a nearly 38% return over the period, with strong returns spread across all 10 sectors, ranging from 22% at the low end for Utilities to over 52% at the high end for Consumer Discretionary stocks.

Consumer Staples and Cyclical Sectors Lead: The two Consumer sectors (Consumer Staples and Consumer Discretionary) lead the way within WTSEI over this period. Much has been made of the potential for the Federal Reserve to alter its policy due to a perceived strengthening of the U.S. economic picture. Other cyclical sectors—Materials, Industrials and Financials—also had returns of nearly 40% or more.

Are Valuations Getting Stretched?

Strong performance is well and good, but a potential issue with market capitalization-weighted indexes is that they tend to simply hold what has run up in price instead of rebalancing based on any metric of relative value. In essence, there is no mechanism employed with a disciplined regularity that attempts to shift weight from what has performed strongly in the past to what may have potential to perform strongly in the future.

How WTSEI Delivers a Disciplined Rebalancing Process

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