It appears hedge funds and other sophisticated investors piled into bets against small-cap stocks at exactly the wrong time.
On Thursday, they paid the price as traders dumped market-leading Big Tech stocks and rotated into small caps, midcaps and interest-rate-sensitive sectors like real estate.
The intensity of the shift — which saw the Russell 2000 RUT small-cap index outperform the tech-heavy Nasdaq Composite COMP by more than 5 percentage points, the widest margin on record — stoked talk of hedge funds being caught offsides by Thursday’s June CPI reading, which showed prices declined last month for the first time since the pandemic.
According to market strategists and portfolio managers who spoke with MarketWatch, many funds were forced to quickly change course by closing out their bets against small caps as well as their long positions on highflying Big Tech names.
See: Is a stock-market rotation under way? Small-caps surge as Magnificent Seven gets punished after cool CPI reading.
At least some publicly available data appears to bear this out. A team of analysts at Bespoke Investment Group showed in a report published earlier this week that traders had dialed up their bets against the struggling Russell 2000 in the futures market at an increasingly rapid pace over the past few weeks.
Citing data published weekly by the CFTC, Bespoke showed that the net short position against Russell 2000 futures had widened by 9.5 percentage points to 16.8% over the past five weeks, the largest such move over a five-week period since March 2020.
To be sure, hedge funds’ positioning is likely only part of the story. The reality is that the rotation away from 2024’s stock-market winners has taken the broader market by surprise, said Callie Cox, chief market strategist at Ritholtz Wealth Management, in an emailed response to a question from MarketWatch.
“All I can say is that this was clearly an unexpected switch in direction for all types of investors. That’s why this particular down day feels a little more frantic,” she said.
At least as far as the hedge-fund cohort are concerned, there is scope for this positioning squeeze to “run for a while,” according to post on X from Bob Elliott, CEO of Unlimited Funds.
But there are other reasons for investors to be more optimistic about the near-term prospects for small caps aside from the prospect that Thursday’s short squeeze might not be over yet.
An analysis of historical data suggests that this unloved corner of the market could be poised for more upside in the not-too-distant future following a historic stretch of underperformance.
The small-cap Russell 2000 RUT underperformed the S&P 500 SPX during the first half by 13.5 percentage points, the widest margin on record, according to Dow Jones Market Data.
Of course, false starts have happened before. Back in November and December, when the Russell 2000 outperformed both the S&P 500 and Nasdaq Composite only to see its gains fade once the new year arrived and investors started paring back their rate-cut bets.
Any gains could prove more durable once rate cuts finally begin. An analysis by a team of analysts at Jefferies shows that small caps have tended to outperform large caps during the first year after the Federal Reserve lowers borrowing costs.
The rationale behind this is pretty straightforward: rate cuts could help boost small-cap earnings while helping these companies to better manage their debt.
As rate-cut expectations grow, there is reason to believe that Thursday’s rally for small caps could be the start of a bigger move, said Jordan Irving, a portfolio manager at Glenmede Investment Management.
“Certainly there is potential for a rotation,” Irving said during an interview with MarketWatch. “From current valuation levels, the spring is a lot tighter for small caps than it is for large caps.”
After the Thursday CPI data hit, San Francisco Fed President Mary Daly told reporters that the central bank now has enough evidence of slowing inflation to move ahead with rate cuts, helping deliver an additional boost to small caps.
Small caps’ low valuations relative to their large-cap peers should help to entice investors looking for bargains in an expensive market, Irving said.
FactSet data show companies in the Russell 2000 are, in aggregate, valued at 1.2 times past year’s sales. S&P 500 firms, by comparison, are valued at three times sales.
This leaves the gap between small-cap and large-cap valuations among the widest in history, said Matt Kaufman, head of ETFs at Calamos Investments.
Irving noted that rate cuts alone likely won’t solve small caps’ problems. Investors will still need to see them boost earnings and invest in growth via large capital projects. But they should go a long way toward helping.
“Broadly, as rates go down, the cost of financing for those small-cap companies improves, and that tends to work its way through to the stocks’ earnings,” Kaufman said. Earlier this month, Calamos launched the Calamos Russell 2000 Structured Alt Protection ETF, which offers investors exposure to small caps with downside protection.
The Russell 2000 rose 3.6% on Thursday to finish at 2,125.04, according to FactSet data. Meanwhile, the Nasdaq Composite COMP fell by 364.04 points, or 2%, at 18,283.41.
The S&P 500 SPX fell by 49.37 points, or 0.9%, to 5,584.54. The Dow Jones Industrial Average gained 32.39 points, or 0.1%, at 39,753.75.