Let the rotation begin
Written on 2024-07-12, first published on 2024-07-16
Markets in focus
Following the CPI release on Thursday (11th July), the Russell 2000 index surged over 3% while the Nasdaq declined. This marked one of the largest intraday divergences between these two indices in history.
After a prolonged consolidation and underperformance, the Russell 2000 index broke out from a symmetrical triangle, overcoming significant resistance at approximately 2130.
The Nasdaq to Russell 2000 ratio continued its parabolic rise, exceeding the Dot-Com peak. The reversal on Thursday indicates a potential cycle top.
The U.S. 2-year yield has formed a two-year rounding top and is poised to break down from its ascending support. Anticipate the 2-year yield to decline further as rate cuts commence.
Our market views
Our initial piece of 2024, published at the start of the year, featured a relative value trade idea: shorting tech stocks represented by the Nasdaq index, while going long on small caps represented by the Russell 2000 index. At that time, the ratio between the two was just below 9, reminiscent of the Dot-Com bubble peak. To our surprise, within merely seven months, driven by the AI hype, Nvidia's price surged over 180%, reaching a market capitalization exceeding three trillion U.S. dollars. Meanwhile, small caps remained overlooked and under-owned, missing out on the tech stock rally. This pushed the ratio to an unprecedented high of 10, far surpassing the Dot-Com peak.
The landscape shifted dramatically on Thursday when a cooler-than-expected CPI print caused significant market ripples. The unexpected CPI data indicated that the disinflationary trend was back on track, leading the market to believe that the Federal Reserve might initiate the rate cut cycle in September, with one or two more possible by year-end, as CME FedWatch Tool suggested. Not only has the Short-Term Interest Rate (STIR) market started to price in rate cuts, but the 2-year treasury note market also indicates that yields are about to decline meaningfully. Following this CPI release, we observed one of the largest intraday divergences between the Nasdaq and the Russell 2000 in history. Mega tech stocks mostly declined, while other sectors, especially small caps, significantly outperformed. This divergence continued Friday, suggesting that it was more than just a knee-jerk reaction.
Fundamentally, small caps are more sensitive to the interest rate environment because these companies often lack the strong cash positions of mega caps and rely more on debt financing for operations and growth. High interest rates increase their borrowing costs, impacting their profitability negatively. Conversely, lower rates provide them breathing room, reduce borrowing costs, and improve growth prospects.
We believe that the dramatic capital rotation into small caps is driven not only by fundamentals but also by very lopsided market positioning. Firstly, small caps have been extremely under-owned in the past two years. Successful momentum strategies have favored long positions in the leaders and short positions in the laggers. The significant weight of the "Mag 7" stocks in the Nasdaq index, combined with prevalent passive investment strategies, has forced active fund managers to allocate heavily to tech stocks like Nvidia at the expense of small caps. This imbalance in allocation led to a pronounced reaction when the macro regime changed. Fund managers, realizing their underweight positions in small caps as these began to outperform tech stocks, had to quickly rotate their portfolios to avoid missing out.
Additionally, due to the enormous market caps of companies like Nvidia, even a small percentage outflow from these tech giants represents a massive inflow for smaller companies. For instance, a 1% outflow from Nvidia's trillion-dollar market cap translates to tens of billions of dollars. In comparison, the median market cap for the Russell 2000 index is only 900 million dollars. When this substantial amount rotates into small caps, it has a much more significant impact on their share prices, thereby amplifying the overall performance divergence between tech stocks and small caps.
Fortunately, the rotation we have witnessed so far has been orderly, not yet a "de-grossing," as evident from correlations between individual stocks remaining at historical lows. Such an orderly rotation refers to systematically reallocating capital between sectors without causing significant market disruption. In contrast, "de-grossing" involves rapidly reducing both long and short exposures, leading to heightened volatility and increased correlations among stocks.
However, we must remain vigilant. Past election cycles suggest that we might see the first pre-election volatility spike in July and August, with a second spike in October and November. In other words, the summer is over, and we should brace for a potentially bumpier second half of the year. If volatility continues to increase, the orderly rotation could turn into a full-blown risk-off / de-grossing event, where correlations rise significantly, and everything gets sold. Hence, we still favor the relative value trade, as even in that scenario, we believe small caps might still outperform the tech stocks by declining less. From a valuation perspective, tech stocks are much more expensive, giving them more room to fall. Conversely, small caps have been under-weighted for the past two years and are less likely to face the same selling pressure during a broad market decline. This relative undervaluation and lighter positioning should cushion them better in a downturn.
How do we express our views?
We consider expressing our views via the following hypothetical trades1:
Case study 1: Short Nasdaq / Russell 200 ratio spread
We would consider taking a short position on the Nasdaq/Russell 2000 Index ratio by selling 1 Micro E-mini Nasdaq 100 index future (MNQU4) at the current level of 20540, and buying 4 Micro E-mini Russell 2000 index future (M2KU4) at the current level of 2167, with the ratio at 20540 / 2167= 9.48. We would place the stop-loss above 10.20 for a maximum potential loss of 0.72 points. Each point move in the micro E-mini Nasdaq 100 futures contract is 2 USD, and each point move in the micro E-mini Russell 2000 index futures contract is 5 USD. Both legs have similar notional values
- Nasdaq leg: 20540 x 2 x 1 = 41080 USD
- Russell leg: 2167 x 5 x 4 = 43340 USD
We can look at two hypothetical scenarios to understand the approximate dollar amount of a 0.1 point move in the ratio.
Scenario 1: Assuming the Nasdaq 100 index stays unchanged, and the Russell 2000 index rallies to 2190, the ratio becomes 20540 / 2190 = 9.38. The overall profit, which comes from the Russell position in this case, is (2190 – 2167) x 5 x 4 = 460 USD.
Scenario 2: Assuming the Russell 2000 index stays unchanged, and the Nasdaq 100 index rallies to 20750, the ratio becomes 20750 / 2167= 9.58. The overall loss, which only comes from the Nasdaq position in this case, is (20540 – 20750) x 2 x 1 = -420 USD.
In Scenario 1, the ratio drops by 0.1 points, yielding a profit of 460 USD from the long Russell 2000 position. In Scenario 2, the ratio rises by 0.1 points, yielding a loss of 420 USD from the short Nasdaq position. There is margin offset for Nasdaq/Russell 2000 index ratio spreads.
Case study 2: Short 2-year Yield Futures
We would consider taking a short position in 2-year yield futures (2YYN4) at the current price of 4.42, with a stop-loss above 4.80, a hypothetical maximum loss of 4.80 – 4.42 = 0.38 points. Looking at Figure 4, if the rising support is broken, the 2-year yield has the potential to drop to 2.50, resulting in 4.42 – 2.50 = 1.92 points. Each point move in the 2-year yield futures contract is 1000 USD.
EXAMPLES CITED ABOVE ARE FOR ILLUSTRATION ONLY AND SHALL NOT BE CONSTRUED AS INVESTMENT RECOMMENDATIONS OR ADVICE. THEY SERVE AS AN INTEGRAL PART OF A CASE STUDY TO DEMONSTRATE FUNDAMENTAL CONCEPTS IN RISK MANAGEMENT UNDER GIVEN MARKET SCENARIOS. PLEASE REFER TO FULL DISCLAIMERS AT THE END OF THE COMMENTARY.
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