Are the Shorts Right? Is a Correction Coming?

According to The Wall Street Journal, the iShares Russell 2000 Index is the most heavily shorted ticker in the U.S. markets -- by a huge margin. This at a time when, again according to the Journal, "short positions are at record levels."

There are more than 300 million shares shorted of the small-cap ETF. In a distant second is Ford, with 213 million shares shorted, followed by the S&P-tracking SPDRs, the Nasdaq 100-tracking Cubes (NASDAQ:QQQQ), Level 3 Communications (NASDAQ:LVLT), Motorola, Comcast (NASDAQ:CMCSA), Charter Communications (NASDAQ:CHTR), and Microsoft (NASDAQ:MSFT).  

Forecast: Cloudy, chance of thunderstorms
Now, in previous columns, we've pounded the table for small caps -- something about them being hands-down the market's best performers. And they've certainly had a nice run. So nice, in fact, that a lot of smart money -- much of it from hedge funds, no doubt -- is shorting the major small-cap index, betting not only that the small-company bull run is in its final days but also that a "correction" is nigh.

We're not 12-month market prognosticators. We don't know whether the Russell 2000 will continue its torrid run, if it's dead money, or if it's going to drop substantially in the near term.

We also don't really care.

The past does not repeat itself, but it rhymes
Last year, fellow Fools Tom Gardner and Bill Barker examined the various price-to-earnings ratios of the major Russell indexes as part of their work with our Motley Fool Hidden Gems small-cap investing service. If the smaller-cap P/Es were out of whack with the larger-cap P/Es, the reasoning went, there might be something to this "correction is nigh" theory.

But that wasn't the case last year, and it doesn't seem to be the case this year. Here are the data as of July 31:

While small caps are trading for a slight premium to large caps, the gap is neither shocking nor well outside of the historical norm.

Another handy (and oh-so-quick-and-dirty) test
Tom and Bill also revisited a Peter Lynch theory from Lynch's book Beating the Street. Lynch wrote that investors could, as a handy reference, compare the P/E ratio of T. Rowe Price New Horizons Fund (PRNHX), a small-cap growth fund (whose top holdings include NII Holdings (NASDAQ:NIHD) and Henry Schein), against the P/E ratio of the S&P 500 (whose top holdings include ExxonMobil and General Electric (NYSE:GE)). If the ratio falls between 1.0 and 1.2, it's time to load up. If the ratio is above 2.0, be very afraid.

Last April, Tom and Bill found the ratio to be around 1.6. Today, it's closer to 1.17.

In other words, using master investor Peter Lynch's test, rather than shorting small caps, now might actually be the time to start buying some. Why is that so? Because small-cap earnings have been growing rapidly in this healthy economy without the small-company stocks outperforming their larger (and slower-growing) counterparts over the trailing-12-month period.

Earnings don't tell the whole story
Of course, the market's performance going forward isn't at all governed by what's happened in the trailing 12-month period. Our guess is that these heavy short bets are less bets against the valuations of small-cap stocks but rather based on the theory that the confluence of rising interest rates and rising energy prices will thwack consumer confidence, sending the whole economy into a downturn.

And when that happens, earnings that have been growing rapidly will cease doing so -- and stocks will fall. Previously fast-growing small caps will likely get hit hardest. But while that may be true for the index, it's absolutely not true across individual stocks.

Don't stop ... thinking about tomorrow
We continue to believe that investors who are looking will find compelling small-cap opportunities in the current market environment. After all, while an index can track general market sentiment, truly great small companies will continue to be the best stocks that investors can buy to hold for the next decade or more.

That's our outlook at Hidden Gems, anyway, and our recommendations are currently beating the market by 35 percentage points on average. If you'd like to join our growing community of investors and take a look at the stocks we're recommending, click here to try the service free for 30 days. There is no obligation to subscribe if you're not absolutely satisfied.

This article was first published July 19, 2007. It has been updated.

Brian Richards owns shares of Microsoft. Tim Hanson does not own any companies mentioned in this article. Microsoft is a Motley Fool Inside Value recommendation. T. Rowe Price New Horizons is a Champion Funds pick. The Fool's disclosure policy wishes to alert its fans that this is the 40th anniversary of the "Summer of Love."