It May Be Time to Show Some Love to The Russell 2000

At a Glance

  • Trade tension volatility affected the Nasdaq, S&P 500 and Dow more than the small cap Russell index
  • The latest small business optimism index reached its highest point in 7 months. That could be good news for the Russell

On May 6, CME Group launched a suite of products aimed at providing smaller, active investors and traders greater access to their heavily traded index futures products. The Micro E-mini index futures, which are 1/10 the tick size and margin requirements of the mini contracts, were an immediate hit trading well over 11 million contracts in the first month.

It was excellent timing given that the weekend of May 3 saw a complete breakdown of U.S./China trade negotiations and an 81 percent spike in the VIX. The subsequent volume spike in the cash indices bled into the four new micro e-mini index futures contracts, but one index lagged in terms of volume: the Russell 2000.

Trade War Misses Russell 2000

The reason for the less robust volume in the small cap Russell can be explained by looking at the performance of the indices over the prior four months. The price appreciation of the Russell for that period had lagged, and therefore when the bearish news of the trade deal falling apart hit the markets, there was a greater need to hedge and initiate short positions in the three larger cap indices than there would be in the Russell 2000.

In April, the NASDAQ and the S&P had both moved to new all-time highs with the Dow only falling around 250 points short of the same accomplishment. The Russell was still almost 8 percent away from its all-time high. The small cap Russell, whose companies receive a much larger share of their revenues domestically than the big three large cap indices, had not participated as much in an “international trade deal” driven rally. But that may change soon.

Historically, Small Caps Perform

It’s not unusual for small caps to outperform large caps. Robert Johnson, a finance professor at Creighton University in a recent U.S. News and World Report article  stated that between 1966 and 2016, small caps returned 28.4 percent and large caps returned 14.4 percent annually. In a more recent stretch, from the lows of February 2016 to the highs of December 2016 the Dow rallied 28.9 percent, the S&P ran up 25.8 percent, the NASDAQ was higher by 27.8 percent and the Russell 2000 outperformed them all by jumping 47.6 percent!

The macro picture may be telling us that this kind of small cap leadership is again imminent. Consider these factors.

The U.S. Federal Reserve has changed their interest rate policy position from one of raising interest rates to potentially lowering them. The markets are currently pricing in a 99.2 percent probability that rates are lower by December 2019 than they are now according to the CME Fed Watch Tool. Small caps outperform large caps during periods of falling interest rates. Small cap companies have a much easier time servicing debt and acquiring capital with interest rates lower, which is not as big a factor for large cap companies.

In addition, deteriorating international trade favors companies who get more of their revenue domestically as long as the domestic economy is strong. While the U.S. has seen some slowing in it’s economic data, the economy is still strong.  According to the National Federation of Independent Business, companies planning to increase capital expenditures rose to a seven-month high and their Small Business Optimism Index is at its highest level in eight months.

Even the yield curve has started to cooperate. The inversion between the three-month bill and the 10-year note yields in the U.S. had settled as wide as -28 basis points, but as of June 13 had flattened to only -9 basis points, due mainly to falling short-term rates (see above).

So while the resumption of the trade war may have been bad for the big three indexes, it may be a good idea to take a look at the Russell 2000 and specifically the smaller Micro e-mini futures contract. Putting in a little extra time to research the potential advantage that may lie ahead with small caps could be a way to mitigate risk from a prolonged trade war.

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