We’ve seen some historic moves in the last three weeks when it comes to small-caps. After getting utterly decimated, small-cap stocks have — seemingly out of nowhere — surged relative to the S&P 500. In fact, when we look at the price ratio of small-caps to large-caps, the last three weeks have undone nearly the entire year’s worth of relative underperformance. Absolutely stunning to witness.
This was set off by a softer consumer price index (CPI), which became the catalyst for a massive short-covering unwind in small-caps. I’ve talked about this dynamic before here on InvestorPlace. Given how poorly small-caps had underperformed large-caps, many hedge fund managers took on spread trades, whereby they would short small-caps and simultaneously go long on large-cap tech. Since March of last year, the trade has worked well due to the crisis playing out among regional banks (that is, because regional banks are primarily small-caps). The idea behind the trade was to neutralize market risk by being long and short at the same time, playing the relative underperformance and outperformance for profit.
The spread trade by its nature is not as volatile as just owning the S&P 500 outright, due to the short hedge. This means traders were free to leverage up the spread trade bet. The more the spread widened, the more leverage was taken by investors doubling down on large-cap longs outperforming small-cap shorts. This, of course, works until something gets sparked and the leveraged trade needs to be de-risked.
A Cycle of Self-Fulfilling Momentum
That’s largely what’s happened over the last three weeks. We’ve seen a multi-standard-deviation shock in the relative performance of small-caps to large-caps. Hedge funds have been caught off side and are in the process of deleveraging as a result. That deleveraging begets more deleveraging as it implies covering shorts, putting even more upward pressure on small-caps. The cycle of self-fulfilling momentum catches even more steam and we see even more liquidations of that positioning.
Now, I don’t know for sure, but this is the kind of stuff you tend to see prior to major hedge funds blowing up. Why? Because of that very leverage I just mentioned. Spread traders take on leverage under the assumption that what we’ve seen over the last three weeks would NOT happen to small-caps. I have to imagine there are some serious losses taking place even though the broader S&P 500 is still looking very early in its correction. If I’m right about that, then I suspect in the coming months some negative headlines will be coming out for the alternatives industry.
On the date of publication, Michael Gayed did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
On the date of publication, the responsible editor did not have (either directly or indirectly) any positions in the securities mentioned in this article.
