Why Big-Caps Are Outperforming Small-Cap Stocks

Caution persists outside of hedge funds, which has bullish implications from a contrarian view

Senior Vice President of Research
Apr 15, 2019 at 7:07 AM
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"It’s hedge funds, who have stubbornly refused to embrace stocks even as global equities added $10 trillion in value over the last three months. At the end of March, their net exposure as measured by the ratio of bullish bets to bearish ones stood near the lowest level in more than a year, client data compiled by JPMorgan’s prime brokerage unit showed …

"Hedge funds that focus on equities climbed 6 percent in the first quarter, according to Hedge Fund Research, compared with a 13 percent gain in the S&P 500. While comparing that two returns is arguably unfair, it remains the industry’s worst relative start of a year since 2012.  Any number of concerns could be keeping hedge funds on the fence. The easiest to explain is the state of the economy and corporate earnings, both of which are forecast to see slowing growth in 2019

-- Bloomberg, April 5, 2019

Last week, I discussed certain groups of market participants who have effectively sat out or bet against the rally in equities this year. Those sitting out -- or more appropriately said, crawling back in at a much slower pace than at which they sold last year -- are fund investors. And there are those playing the short side of the market, particularly on S&P 500 Index (SPX - 2,907.41) component stocks and the e-mini futures. In the Bloomberg article that I excerpted above, entitled, “Hedge Funds Keep Sitting Out $10 Trillion Global Stock Rally,” we got a hint as to who, exactly, might be on the short side of the equity market. 

Whether it was JPMorgan’s observation of the low ratio of bullish bets to bearish ones when measuring hedge fund exposure, or the fact that, through March, hedge funds trailed the SPX’s year-to-date returns by 700 basis points, it is clear that the hedge fund world is either under-invested and/or making miserable directional bets. To the degree that the underperformance in the hedge fund world is driven by being under-allocated to equities, if they feel the need to close the performance gap, an unwinding of caution among these market participants could be the additional fuel needed to push the SPX above its 2018 all-time high.

Whether or not the hedge fund community takes actions to "chase" the SPX is another question, as investors typically use hedge funds as a protection tool in the event of a bear market or nasty correction. In fact, despite the massive underperformance of hedge funds in 2019, a JPMorgan survey said roughly double the respondents planned to boost allocations to hedge funds relative to survey results in 2018. This reinforces the idea that caution persists even outside the hedge fund industry, a takeaway that has bullish implications from a contrarian perspective.

Above said, even if hedge funds are not actively buying, there are certain areas of the market in which they may be covering short positions, while adding to short exposure in others. For example, note in the first chart immediately below that there was evidence of short covering on large-cap SPX components, per data that came out at the end of March. Coincidentally, as seen in the second chart below, short positions on small-cap Russell 2000 Index (RUT - 1,584.80) components remained flat and near the highest level since 2017.  

Such maneuvering (or lack thereof) may explain in part why large-cap issues have outperformed small-cap names in recent weeks. That said, if the RUT manages to take out the 1,600 level in coming weeks -- a source of resistance since October -- short covering could pave the way to its all-time highs in the 1,700 area.

SPX short interest MMO

RUT short interest chart MMO

History suggests that a run through 2,900 and back to the September intraday high of 2,940 is imminent. Since 1950, in the 11 instances in which the SPX experienced at least a 20% decline from intraday high to intraday low, as it did in the fourth quarter, and then rallied back to within 2% of its intraday high, which occurred on Friday when the SPX closed above 2,882.09, the previous intraday high was touched on nine of those occasions within 33 calendar days.
-- Monday Morning Outlook, April 8, 2019

On Friday, the SPX experienced its first touch of the round 2,900 mark since early October, when the SPX was in the beginning of heading south to its eventual December low at 2,351. Per the excerpt below, history is on the side of the bulls as far as the SPX taking out 2,900 and testing its intraday high at 2,940.91 by early May. 

But with standard April options expiration coming on Thursday, due to an exchange holiday on Good Friday, sellers of April 290-strike calls may try to keep the SPDR S&P 500 ETF Trust (SPY - 290.16) from pushing above the 290 strike through Thursday’s close. The 290 strike is home to peak call open interest in the immediate vicinity of the SPY.

That said, open interest of about 85,000 contracts here is small relative to the accumulations of 200,000 and 300,000 contracts that regularly build up at round put strikes. This implies that any actions related to the open interest at this strike will not have a huge impact -- unless overall trading volume is exceptionally thin, which is a possibility as we move into the latter part of the trading week and ahead of a three-day weekend.

The good news for bulls is that if selling would hit the market, it is not going to be exacerbated by heavy put open interest strikes that bring the possibility of delta-hedge selling into play, like we last saw during December 2018 expiration week.


Two immediate macro uncertainties that could have impacted the broader market were removed last week, with no major surprises in the Federal Open Market Committee (FOMC) meeting minutes, and Brexit being kicked down the road from April 12 to Oct. 31. With that said, the Cboe Volatility Index (VIX - 12.01) closed at its lowest level since October, and is on a trajectory that could push it to its 52-week closing low at 10.85.  

VIX chart MMO

The biggest risk that we continue to see for bulls is the massive net short position that large speculators have on VIX futures, which is now more extreme than that of October 2018 and the biggest net short since 2017. The extreme net short position -- per Commitments of Traders (CoT) data -- is in the context of the VIX trading just above 2018's floor. The one difference between the two extremes, per the second chart below, is that there are not nearly as many VIX futures contracts open relative to late September 2018, implying that there are not as many participants betting on volatility to move lower. However, it is a situation that we continue to monitor.

I think euphoria needs to be more widespread before this risk comes into play, but history has taught me to be nearly certain that these speculators will be caught wrong-footed when volatility eventually pops. Therefore, I would emphasize options to manage this risk -- specifically, buying calls on directional bets, but also using straddles and pair option trades in cases where implied volatility on equities and/or index and exchange-traded fund (ETF) options are near 52-week lows.

large specs VIX for MMO

total VIX futures for MMO

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