Large caps to outperform small on uncertainty

It’s interesting to see the sharp underperformance of the Russell 2000 (the US small cap index) relative to the of the Dow Jones index of late.

Dow Jones
Source: Bloomberg

With the Federal Reserve closing off on its asset buying program next month and short-dated bond yields moving aggressively higher recently, we are seeing traders leveraging themselves to high-quality earnings streams – hence why the Dow Jones is outperforming.

We have seen high-yield debt and corporate credit spreads under pressure, while emerging market funds have started to see outflows for the first time in 15 weeks. As the chart highlights, we have seen a rotation from small caps into larger cap names since September.

It feels as though the trade is still in its infancy, and I personally believe it has some way to play out. There is increasing uncertainty about how both developed and emerging markets will fare when the Federal Reserve raise short-term rates. The rotation in asset classes we are currently seeing is the faster-acting money looking to get ahead of the curve.

With this uncertainty only likely to build, I would look to take advantage of this through a long/short index strategy. With the Wall Street Cash (Dow Jones) currently trading at 17,155 and the Russell 2000 cash at 1125.71, I would look to be long 3 contracts of the Wall Street cash and short one contract of the Russell 2000.

I have looked at mini contracts in this example and to understand this I need to net off my USD exposure. The trade effectively takes external market forces out of the equation and just focuses on the outperformance of one index over another.

My calculations:

$100 (the value of one pip) * 1125.71 (the current price of the Russell) = $112,571

$2 (the value of one pip in the Wall Street mini contract) * 17,155 (the current price of the Wall Street Cash) = $34,310

 

So now I have the nominal USD values on both indices, I simply divide the larger total by the smaller total to net off my exposure as best I can.

So 112,571 / 34,310 = 3.2 contracts

Dow
Click to enlarge

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