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Taking a Look at Small-caps October 1, 2006
The other day my two boys were having a fight, which unfortunately is more common than not.
The source of acrimony this time was the big candy dispenser that Best Buy has in the lobby of its local outlet, much to the chagrin of every parent with small children. I rarely carry change, but have learned that it's best to have a few quarters in my pocket if we're going to Best Buy.
So my youngest son wanted Chiclets, because they're small and he could fit a bunch in his pockets. My older one wanted the Super Monster Jawbreaker because, well, it was big. They both ended up getting what they wanted (I'm a sucker that way), but that didn't stop them from fighting over which was better - small candy because you get more, or big candy because it's big.
I know this is a stretch, but investors face similar decisions, too - buying more of a cheaper stock or less of a bigger one. One of the more consistently heated debates out there is small-caps versus large-caps and which style is more likely to out-perform going forward. Over the next month or two, the talk about small-caps will heat up, as every year we go through the same theories about the little guys doing better or worse as we approach the end of the year.
Let's go through a set of guides to see if we can derive a solid conclusion about the current state of sentiment towards small-caps.
FUTURES POSITIONS
Reading the Commitments of Traders report anymore can be an exercise in frustration.
This weekly report tells us how many contracts, long and short, several classes of traders are holding in a variety of futures contracts. They are classified as commercial hedgers (aka the "smart money" that use the futures markets to hedge their day-to-day business risk), other large traders (big speculators that could be hedging, but also purely speculating on market direction), and non-reportables (aka the "dumb money" that includes small traders taking bets on market direction).
By watching how the various groups of traders are positioning themselves in various markets, we can sometimes get a good clue about what might most likely happen next. Unfortunately, the introduction of e-mini contracts screwed up a straightforward analysis of the data, and recently the CFTC, which compiles the report, changed the classification of some traders making it impossible for us to compare apples-to-apples.
In early August of this year, the CFTC re-classified a group of traders in the Russell 2000 futures contracts that drastically changed the net positions of commercial traders. Supposedly this re-classification made the report more accurate, but we'll see if it helps or hurts going forward.
The chart below shows the total nominal dollar value of the outstanding net position of commercials in the Russell full and e-mini contracts.
As of the latest report, which includes positions as of the close of business this past Tuesday, commercials were net long just under $10 billion worth of contracts in the small-cap index. This is by far a new all-time record, with the previous record being about $6 billion in October 2005.
Again, due to the recent re-classification of some traders, I'm uncertain how much we can rely on this data as far as comparisons to past extremes. On the surface, at least, it looks pretty darn bullish.
PUT/CALL RATIO
A put/call ratio simply shows the number of put contracts being traded on a given security or index divided by the number of call contracts traded. The higher the ratio, the more pessimistic are the traders (theoretically).
The advisory service Hamzei Analytics puts a twist on the ratios for a bunch of stocks and exchange-traded funds, and calculates a dollar-weighed put/call ratio. This is the same concept, but it multiplies each trade by the dollar value of the option being traded.
This can be significant if there is high volume in a low-priced option. For example, if a trader bought a huge amount of far out-of-the-money put options, then a traditional put/call ratio would spike higher and we would conclude that traders in general were pessimistic.
However, since the options were so far out, they were likely very cheap and perhaps didn't cost the trader much at all. If that's the case, then the dollar-weighted p/c ratio would give a more normal reading and wouldn't mislead us into thinking something bearish was going on.
So let's take a look at a 10-day average of the dollar-weighted ratio for IWM, the popular exchange-traded fund that tracks the Russell 2000 small-cap index.
We can see that the ratio did quite well at highlighting intermediate-term lows in IWM when it spiked to very high levels, say above 5 or so. It last did so in July of this year, coinciding with the summer low, but has backed off over the past couple of months and is now at the lower end of its range.
This is not necessarily bearish - very low readings did a poor job at highlighting tops in IWM. While I would much prefer to see a large amount of money being bet on a decline as opposed to what we're seeing now, this isn't an outright sell signal.
SHORT INTEREST
Keeping with the IWM fund, next let's take a look at short interest.
Short interest includes all those shares that were sold short (betting on a market decline) that have not yet been covered. The chart below is a little different than most others, since it calculates the short interest as a function of how many shares of the ETF are outstanding (due to how some ETFs are structured, it's possible to see short interest greater than the actual number of shares outstanding).
If we look at the two spikes in the indicator, it's quite clear that it was a good tip-off that sentiment had perhaps gotten too pessimistic and shares were due to rebound.
Over the past few months, short interest as a percent of the float has come down from close to 150% this summer to 85% as of mid-September. That's still higher than average over the past couple of years, but not necessarily indicative of imminent higher prices.
RYDEX MUTUAL FUND ASSETS
I have some bones to pick with the Rydex asset data, but most of my concerns are with the popular index funds at that fund company.
The sector funds that Rydex offers still seem to enjoy relatively normal flows into and out of the funds. Meaning, when the NAV of the fund rises, then we see more and more assets gravitate to them as traders try to jump on the bandwagon. This allows us to compare current flows to those past and determine if we're seeing an extreme.
First let's look at the Rydex Mekros fund, which is chartered to track the Russell 2000 index. Rydex recently changed the name to Russell 2000 Advantage, but it'll always be Mekros to me.
Assets in the fund are currently at $90 million, one of the lowest levels in years. It hit a similarly low level in 2004 and twice in 2005, both of which were opportune times to invest in small-cap shares.
In 2004, the Russell 2000 jumped about 26% after assets in the fund dipped this low. By the time that leg of the move was over, traders had poured an additional $320 million into the fund, a rise of nearly 510%.
In the spring of 2005, the Russell rallied 20% over the next few months off the next "buy" signal, and assets in the Mekros fund jumped over 300% to $250 million. Later that year, the next signal resulted in an 18% rise in the Russell and another 300%+ jump in Mekros assets, once again pushing it over $250 million.
The most recent signal, however, has been met with a collective yawn from these traders. Despite a 9% rally in the Russell, assets in the Mekros fund have only risen by $40 million.
This display of apathy towards the little guys can also be seen in a few of the charts we post to the site that tally total "size and style" assets. By that, I mean that Rydex offers six funds based on market cap and style - Small Cap Growth and Value, Mid Cap Growth and Value, and Large Cap Growth and Value.
We look at the total assets invested in all six funds, then calculate how much is concentrated in small-caps, mid-caps or large-caps. You can see this updated each evening by pulling up a chart of each of those funds.
The chart below shows the percentage of these assets invested in the two small-cap funds. I've included a chart of the Russell 200 index at the top, and also a relative strength line between the Russell and Dow Jones Industrial Average to give us a flavor of how small-caps performed relative to their big brothers.
Last month, assets in the small-cap funds had dwindled to about 10% of total size and style assets. That was a pathetic amount that hadn't been matched at any time since the funds were introduced in 2004.
The Russell has out-performed the Dow since that time (not by much, but still...) yet assets in the small-cap stocks remain under the lows seen over the past couple of years. Typically when assets in the small-cap funds had dropped near 20% of the total, they rallied heartily, but so far this time their percentage of the total has barely climbed to 20%.
SEASONALITY
Given the recent poor record of formerly consistent seasonal biases, we may want to take any current ones with a grain of salt.
So just briefly, I'll mention that the Russell 2000 has had a consistent tendency to take a dive in early October. Looking at the past 19 years of data, the index was lower than its September close two weeks into the month 13 times (69% of the time) by an average of -1.4%. It's average maximum gain during the two weeks was +1.9%, compared to an average maximum loss of -4.7% - more than twice as great.
After that, though, the rest of the year was often gravy, as it showed a positive return nearly 70% of the time by an average of about 5.5%.
Taken all together, the case for concentrating on small-caps looks intriguing. If we do see some trouble to begin the month, but the Russell doesn't completely break down below the summer lows, watching IWM for a run into the end of the year doesn't sound like such a bad idea. Home | Commentary | Indicators | Models | Sectors | COT | Subscribe | About Us
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