Traders Bet Against Small-cap Stocks at Precisely the Wrong Time

Hedge funds and other savvy investors seem to have bet against small-cap stocks at a particularly inopportune moment. On Thursday, they faced the consequences as traders shifted away from dominant Big Tech stocks and into small caps, midcaps, and sectors sensitive to interest rates, such as real estate.

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This dramatic rotation led to the Russell 2000 small-cap index outperforming the Nasdaq Composite by over 5 percentage points, the largest margin ever recorded. The shift was spurred by the June consumer price index report, which revealed a decline in prices for the first time since the pandemic, catching many hedge funds off guard. According to strategists and portfolio managers consulted by MarketWatch, numerous funds had to hastily reverse their positions, closing out their short bets on small caps and their long bets on high-flying Big Tech stocks.

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Public data supports this scenario. Analysts at Bespoke Investment Group indicated in a recent report that traders had significantly increased their short positions against the struggling Russell 2000 in the futures market over recent weeks. Using data from the Commodity Futures Trading Commission, Bespoke noted that net short positions against Russell 2000 futures grew by 9.5 percentage points to 16.8% over five weeks, marking the largest such increase since March 2020.

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However, hedge funds' positions are only part of the story. The unexpected market shift surprised many, according to Callie Cox, chief market strategist at Ritholtz Wealth Management. She stated that this unexpected direction change contributed to the market's frenzied reaction.

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Bob Elliott, CEO and CIO at Unlimited Funds, suggested in a social media post that the hedge funds' positioning squeeze might continue for some time. Beyond this, there are other reasons for optimism about small caps in the near term. Historical data suggests that small caps, after a period of significant underperformance, might be poised for gains.

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In the first half of 2024, the Russell 2000 underperformed the S&P 500 by 13.5 percentage points, the largest margin on record according to Dow Jones Market Data. Although small caps have had false starts before, such as their outperformance in November and December, which then faded as the new year began, future gains might be more sustainable once interest rate cuts commence. Research from Jefferies shows that small caps tend to outperform large caps in the first year after the Federal Reserve lowers borrowing costs. The reasoning is simple: rate cuts can boost small-cap earnings and help these companies better manage their debt.

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With increasing expectations for rate cuts, Jordan Irving, a portfolio manager at Glenmede Investment Management, believes Thursday's rally for small caps could signal a larger movement. He noted that from current valuation levels, small caps have more potential to spring back compared to large caps. Following the CPI data release, San Francisco Fed President Mary Daly indicated that the central bank now has enough evidence of slowing inflation to proceed with rate cuts, further boosting small-cap stocks.

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Additionally, the relatively low valuations of small caps compared to their large-cap counterparts should attract bargain-hunting investors. FactSet data reveals that companies in the Russell 2000 are valued at 1.2 times the past year's sales, whereas S&P 500 firms are valued at 3 times sales. This valuation gap is one of the widest in history, according to Matt Kaufman, head of ETFs at Calamos Investments.

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While rate cuts alone won't resolve all issues for small caps, they should significantly help, according to Irving. Investors will still need to see small caps boost earnings and invest in growth. Lower rates will reduce financing costs for small-cap companies, which should improve their earnings. This month, Calamos launched the Calamos Russell 2000 Structured Alt Protection ETF, offering exposure to small caps with downside protection.

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On Thursday, the Russell 2000 rose by 3.6% to close at 2,125.04, its best day since November, according to data. Meanwhile, the Nasdaq Composite fell by 364.04 points, or 2%, to 18,283.41. The S&P 500 declined by 49.37 points, or 0.9%, to 5,584.54, while the Dow Jones Industrial Average gained 32.39 points, or 0.1%, to 39,753.75.

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