How To Play An Interesting Small-Cap Phenomenon

Recent equity market turbulence is proving to be a headwind for small-cap stocks. Over the past 90 days, the small-cap Russell 2000 Index is lower by 1.70 percent while the large-cap Russell 1000 Index is higher by 3.70 percent.

The small-cap index has also been nearly 500 basis points more volatile than its large stock counterpart, but investors may want to acknowledge an interesting phenomenon as it pertains to small caps following market volatility.

What Happened

Historical data confirm that after significant volatility spikes, small-caps outperformed their larger counterparts. That could bring opportunity with the Direxion Russell Small Over Large Cap ETF RWSL.

RWSL tracks the Russell 2000/Russell 1000 150/50 Net Spread Index, which essentially takes a 150 percent long position in the Russell 2000 and a 50 percent short position in the Russell 1000 to deliver 100 percent net long exposure to investors. In other words, if small caps start outperforming large caps again, RWSL could be a rewarding bet for investors.

Why It's Important

RWSL's near-term relevance can be explained as follows. Three months after volatility spikes, large caps historically gain almost 10 percent, well below the 14 percent gained by small caps, according to Direxion data. Six months later, the gap is 20 percent to 14.88 percent in favor of small stocks.

“Using the date of the peak level of the VIX in June 2016, October 2016, February 2018 and December 2018, this study highlights how buying the dip has paid off for investors over the last 3 years,” said Direxion in a recent note. “In fact, it has paid to buy Small Caps over Large Caps. In the 3 months following these spikes, Small Caps outperformed by 4.16%. Throughout the 6 months following a volatility spike, Small Caps outperformed by 5.12%. While returns heading into these events were mixed with some positive and others negative, Small Caps outperformed in all 4 of the subsequent periods.”

What's Next

An end to the China trade flap could be just the elixir RWSL needs to run higher. Should that not materialize, the thesis outlined here could prove faulty.

“The impact that further tariffs would have on increasing inflation further complicates the idea that the US Federal Reserve would cut rates as opposed to needing to increase them,” said Direxion. “Of course, much of this is speculative as there remains time for a deal to be completed that would limit the negative impacts and make buying the dip a continued winning move. Investors should watch how the market balances the quality that Large Caps tend to provide relative to the lower exposure that Small Caps may have to international trade.”

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