We’ve been heavily focused on why we believe there is a need for a relative value rebalance in 2013. Equity markets1 have touched new record highs2, and performance has been strong. We’ve also seen in prior blog posts how two of our Indexes, WisdomTree MidCap Earnings Index (WTMEI) and WisdomTree SmallCap Earnings Index (WTSEI) have trimmed weight from some of their top-performing constituents and reallocated it to firms that did not perform as well. What we haven’t quite done as of yet is magnify the valuation impact of this rebalance.
Framing the Analysis
Price-to-Earnings Ratio (P/E) Quartiles: The first step in this analysis is defining the boundaries. For mid-caps, we will use the S&P MidCap 400 Index as the benchmark and set up the P/E ratio quartiles based on the values of its constituents as of November 30, 2013. For small caps, the Russell 2000 Index will serve in this capacity, with values measured as of the same date.
Weighting by Earnings vs. Market Capitalization (and Requiring Positive Profits): In essence, WTMEI and WTSEI weight constituents by earnings and require all their constituents to have positive profits over the four quarters prior to the annual November 30 screening date. Relative to market capitalization-weighted approaches an earnings-weighted approach has the potential to lower the P/E ratio of a similar universe of stocks.
WTMEI Pushes Weight into the Lowest P/E Quartile (as of 11/30/2013 Index Screening)
WTSEI Pushes Weight into the Lowest P/E Quartile (as of 11/30/2013 Index Screening)