Are the Shorts Right? Is a Correction Coming?

According to The Wall Street Journal, the iShares Russell 2000 Index is the second-most heavily shorted ticker in the U.S. markets. What's more, it's been either No. 1 or No. 2 on the short list since July.

There are more than 251 million shares shorted of the small-cap ETF. The S&P-tracking SPDRs, with 261 million shares shorted, is first. Ford, Micron (NYSE: MU), and beaten-down financial sector stocks E*Trade Financial (Nasdaq: ETFC), Wells Fargo (NYSE: WFC), and Wachovia (NYSE: WB) are also near the top of the list.

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. Yet the money that's been shorting them since July has done very, very well ... and it seems like they expect this "correction" to continue.

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

We also don't really care.

The past does not repeat itself, but it rhymes
Back in 2006, fellow Fools Tom Gardner and Bill Barker examined the various price-to-earnings ratios of the major Russell indices 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.

Although that wasn't the case last year, the stocks still got rocked. In other words, those same small caps have gotten cheaper:

While large-cap multiples have stayed pretty constant, small caps are clearly more compelling values today than they were last summer.

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 (representative major fund holding: Roper Industries (NYSE: ROP)), against the P/E ratio of the S&P 500 (representative major holding: Procter & Gamble (NYSE: PG)). 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.

Today, that ratio is 1.3.

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 past 12 months. Our guess is that these heavy short bets are not so much 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 22 percentage points on average despite recent volatility. 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.

Neither Brian Richards nor Tim Hanson owns shares of any companies mentioned in this article. T. Rowe Price New Horizons is a Champion Funds pick. The Motley Fool owns shares of SPDRs. The Fool's disclosure policy thinks it's appropriate to wear shorts to the store where the creatures meet.