Although the Russell 2000 (NYSEARCA:IWM) is down about 17% from its November highs, and its forward P/E is also compressed, it is not pricing in a recession, according to BofA.

Corrections of more than 15% have historically occurred every 1.5 to 2 years, with the last in 2023, but small caps have sold off about 35-40% around U.S. recessions.

Also, forward P/E multiples have dropped about 30% around recessions in the past 25 years, with earnings usually falling about 50% from their peaks – and 40% on average in all EPS recessions – and troughing one to two years after P/E troughs.

But Russell 2000 (NYSEARCA:IWM) earnings still haven’t troughed after the 2023 EPS recession. They currently are 38% below their prior peak, Jill Carey Hall, head of U.S. small and mid-cap strategy at BofA, pointed out.

Small caps typically trade at a higher P/E on trough earnings and the median trailing P/E has been 42x – when looking at EPS recessions since 1989 – vs. about 60x currently, which is still implying an EPS recovery.

So, small caps are discounting only a continued mild manufacturing recession with an ISM of 47.

Small caps are now trading at 14.2x, 6% below their average of 15.1x since 1985.

The Russell 2000’s (IWM) forward P/E fell to 15.4x from 16.0x, the Russell MidCap’s (IWR) P/E fell to 17.1x from 17.8x, and the Russell 1000’s (IWB) P/E fell to 20.5x from 21.5x.

Mid-caps trade 9% above their average at 16.7x vs. 15.2x, and large caps are still the most stretched at 27% above their average at 19.9x vs. 15.6x, said Hall.

P/E valuations are the most predictive long-term, she added. P/Es suggest 9% annualized price returns for the Russell 2000 (IWM) over the next decade, vs. 5% per year for the Russell MidCap (IWR) and 1% per year for the Russell 1000 (IWB).