What Is Going On With Small Caps?

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Before this recent volatility, major indexes hit new highs, economic numbers look good and the Federal Reserve has all but promised a continued supportive rate environment this year. Even metals were on the upswing.

Although interest rates have seemingly deigned to provide traders an ideal environment to play in, there remained a unique dark spot among the favorable market conditions that have arisen within the summer of 2019: small caps.

While the Russell 2000 caught some of the capital that flooded back to the market during the January rally, the index has largely traded sideways since then, as evidenced by the recent back-and-forth action between the Direxion Daily Small Cap Bull 3X Shares TNA and Direxion Daily Small Cap Bear 3X Shares TZA ETFs, which track the Russell 2000.

While the large-cap stocks of the S&P 500 and Nasdaq composite surged past their previous highs set in the distant past of Q3 2018, the Russell 2000 small-cap index has spent all of 2019 off its highs by anywhere from 6-20%.

The poor performance of small caps in the midst of an otherwise strong market is rare since the Russell 2000 tends to amplify the performance of broad market indexes like the S&P 500. However, the divergence does present opportunities for investors to explore strategies built around common market relationships.

The correlation between the outperforming large-cap universe versus the consolidated small caps is one that is already playing out in the thematically structured Direxion Russell Small Over Large Cap ETF RWSL and Direxion Russell Large Over Small Cap ETF RWLS, as shown in the chart below.

Chart: Yahoo Finance; Data as of 8/9/19. Past performance is not indicative of future results. Investment return and principal value of an investment will fluctuate so that an investor's shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than the performance data quoted. For standardized performance, click here

The ETFs, which incorporate a 150% long position alongside a 50% short position, reveals just how dominant the large-cap portion of the market has been through most of the year. While trend certainly supports the thesis underlying RWLS, a classic pair trading approach would suggest small caps have more room to run than the current market leaders do. All of this notwithstanding the current downdraft in markets these past few days.

Another factor in favor of a bounce in small caps is the potential interest rate cuts the market is anticipating throughout the rest of the year. While large caps have rallied on these hopes since the Fed adopted a more dovish tone in Q1, small caps have not, even though they historically benefitted the most from rate cuts.

Alternatively, a lack of rate cuts and revenue slowdown among large caps in the S&P 500 will also bring it closer to the Russell, though not in the way investors might hope.

Whatever the future holds for small caps, history indicates that the spread between the S&P and Russell will likely shorten in the coming months. It is only how that tightening will occur that market watchers are eagerly anticipating.

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