Big Institutions Bet "All In" On Small Caps

Tyler Durden's picture

Last week, over a year after we first forecast a major short squeeze-driven outperformance of the most shorted small- and micro-cap stocks, none other than Goldman jumped on the "buy the most shorted names" bandwagon, which promptly led us to wonder if the rally in both the most shorted names, and also in the small cap Russell 2000 index, is finally coming to an end.

The reality, as the chart below shows, is that despite 2013's rate-driven headfake, where Russell 2000 stocks have outperformed the S&P in close approximation with the 10 Year yield, whose surge was incorrectly translated as an indication of economic strengthening when it was merely reacting to fears about the Fed's gradual tapering, that the Russell is still solidly outperforming the S&P year to date.

In fact, to many buying the Russell 2000 is merely the highly levered bet with which the bulk of institutions (recall that almost all hedge funds, and a majority of mutual funds, are underperforming the S&P for a 5th consecutive year) seek to make up for losses in their portfolios. Which is why as the next chart below shows, in a furious scramble to catch up by year end, the institutional Russell net futures (i.e. levered) positioning just hit a record high: the biggest investors are now all-in the smallest names.

And once again, as so often happens, flows are confused for fundamentals. Because even Goldman edmits that the entire outperformance of the small cap sector is purely due to multiple expansion, not from actual fundamental improvement.

So is the massively overbought small cap sector due for a correction?

With these manipulated, centrally-planned markets, nobody has any idea. However, for those who have once again bet all in, which just happens to be most plain vanilla dumb money, it may be time to reevaluate. Below is Goldman's David Kostin with his take on what has emerged as the most overbought small cap sector in history:

From Goldman

Investors have cast their ballots, and so far in 2013 the vote goes to small cap US equities. 2013 has been an excellent year for US equities in
general, and an even better one for small caps in particular. The Russell 2000 has returned 28% YTD, outperforming the S&P 500 by 370 bp. Its 36% return over the last 12 months ranks a standard deviation above historical averages both in absolute terms and relative to large caps.

Small caps have outperformed large caps in almost every sector. Most notably, Russell 2000 Consumer Staples have returned nearly 40% YTD and outperformed their large cap counterparts by 15 pp. Info Tech is another notable difference, with investors citing the lack of growth among S&P 500 Tech as the reason for the small cap sector’s 33% return and 14 pp outperformance relative to the lagging large cap sector.

The two major drivers of Russell 2000 returns are US economic growth and valuation. We highlighted in April that the prospect for accelerating US GDP combined with undemanding valuation set the stage for strong returns. From May through September, the Russell 2000 returned 14%, outperforming the S&P 500 by 800 bp. After lagging by 300 bp in the last month, however, investors wonder whether the small cap rally is over.

The opposing forces of improving US GDP growth and above-average valuation suggest that the Russell 2000 will post a decent but less impressive return of 6% in the next 12 months. This compares to a historical average of 11% and implies that small caps will trade in line with large caps. We forecast the S&P 500 will reach 1850 in 12 months (also +6%).

One core pillar of small cap performance, growth, remains supportive. We expect US GDP will accelerate above-trend to a 3% pace in 2014 from under 2% this year, and remain at that rate at least through 2016. Strong expectations for earnings growth reflect the economic picture. We forecast 2014 EPS growth of 23% for the Russell 2000 compared with 8% for the S&P 500. Consensus expects earnings growth of 33% and 11%, respectively.

The other major driver, valuation, is the strongest obstacle to small caps, and the most common concern raised by investors. The Russell 2000 P/E multiple has risen 25% YTD, explaining more than 80% of the index return. It now stands above 10-year averages both in absolute terms and relative to the S&P 500. Price/book, our preferred metric for small caps, has similarly risen from a standard deviation below to nearly a  standard dev. above average levels during the last two years.

Rising interest rates should be a tailwind for Russell 2000 returns. From a fundamental perspective, small cap borrow costs, and therefore  margins and earnings, have a low sensitivity to changes in Treasury yields. Russell 2000 performance relative to the S&P 500 tracked the general path  of yields this year, with small caps garnering most of their excess returns as 10-year yields rose from 1.7% in May to nearly 3% in September. Our rate strategists forecast the 10-year will rise to 2.75% by YE 2013 and 3.25% by YE 2014.

Several other macro factors that supported small cap outperformance of large caps this year may become headwinds in 2014. The Russell 2000 has historically outperformed the S&P 500 during periods of accelerating EPS growth, expanding P/E multiples, and a strengthening dollar. We expect S&P 500 EPS growth to decelerate to 8% in 2014 from 11% this year, and that P/E multiple expansion has largely run its course. The current S&P 500 forward multiple of 15x is in line with our year-end 2014 forecast level. Our FX strategists expect USD to weaken against EUR and GBP but strengthen relative to JPY during the next 12 months.

The Russell 2000’s leverage to domestic growth boosted the index this year but may be a detriment as growth in foreign markets improves. Roughly 80% of Russell 2000 sales are derived domestically compared with 66% for the S&P 500. This benefitted the small cap index earlier this year as investors worried about growth in Europe and Asia. Both data and sentiment have improved, however; Eurozone and China PMIs are back above 50, and regional equity markets have responded.

Positioning also poses a risk to small cap performance. Small cap mutual fund and ETF flows have totaled $22bn (5% of AUM) YTD, putting 2013 on pace to be the strongest year on record. Institutions are currently $6bn net long Russell 2000 futures, the largest position since the data start in 2006. Leveraged funds have a modest $2bn net short, a decline from their $2bn net long earlier this year but enough to rank in the 85th percentile historically.

Micro data are also mixed. 81% of Russell 2000 companies have reported 3Q results. 41% of firms beat on earnings by at least a standard deviation of consensus estimates, 25% missed, and the average surprise was 3%. These metrics are all in line with the 10-year historical average. In 3Q the NFIB Small Business Optimism Index averaged its highest level since 2007, but remains well-below average levels prior to the crisis. According to the survey, revenue growth concerns are fading, and respondents continue to point to government requirements as their most important problem.

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VD's picture

R2K is a farce: it will crash and now that GS is as per above 'all in' you know correction is all but assured...

Dr Benway's picture

The reason institutional investors love small caps is simple. A fund can in the short term create its own strong "performance" when it buys into a small cap, as it moves the prices while doing so.

These unrealized profits can then be used to attract new suckers to invest in the fund, and new small caps to ramp can be found. 

In Australia this mechanic has reached farcical proportions, my newly updated blog covering financial markets fraud has many examples, check it out:

VD's picture

thx doc; the ticket will explode...

ebworthen's picture

With QE, lowered earnings expectations becoming "beats", and the off-shoring of profits is probably bullish for small-caps.

It's all bullshit, but bullish bullshit.

Bearish for real people.

akak's picture

OT, but has anyone else here noticed ZH being INCREDIBLY slow and glitchy this morning?

I can barely open any article, or link to any comment, right now, and half of all attempts to do so just lock up my computer.   And the problem is definitely NOT my computer or internet connection, as every other webpage opens just fine.

EDIT: I have to wonder why any asswipe would downvote this post.

LetThemEatRand's picture

I just downvoted you because I am an asswipe.    Ask anyone.

As an aside, no problems with ZH here.

akak's picture

I might argue that you USED to be, but I have sensed a real awakening in you LTER.

At least, before this particular comment.

But that's OK, I can be a dick at times myself here.

LetThemEatRand's picture

I once spent an hour insulting a tomato.   I explained to it that it is inferior as a fruit.  So inferior, in fact, that most people consider it a vegetable, including the Supreme Court.  Then I explained to said tomato that the term "vegetable" is insulting when applied to humans, and rightly so, and how does it feel that humans see it also as a vegetable?  Then I compared it to other tomatoes.  While it was actually a pretty nice tomato in both size and taste, I told it otherwise.  Then I logged into ZH and downvoted random posts.  It's how I roll.  

And I just changed my downvote to an upvote just to confound whatever vegetable downvoted you.

akak's picture

I understand your sentiments here, as I have for long harbored deep-seated sociopathic feelings towards beets, whose very existence both taunts and outrages me.

LetThemEatRand's picture

What is really infuriating to me is how they just look at you, dispassionately, as if they don't care even when you know you really landed a zinger.   And I'm with you on beets.  They stink when they're driven around in the country, and they laugh at passing motorists even though they are destined to be eaten.  It makes a guy want to log in to ZH, find a post with 100+ upvotes, and then be "that guy" who is the random unexplainable downvote.  

ebworthen's picture

Not having problems but am using Ad Blocker Plus which made a great improvement (shhh!  Don't tell the advertisers!)

pitz's picture

"Rising interest rates should be a tailwind for Russell 2000 returns."


So let me guess, the past 35 years have indicated under-performance, a head-wind, for the Russell 2000 because of falling interest rates? 

Do the authors of these reports even bother to test them for sanity?

asteroids's picture

The correction, when it happens must be brutally fast. A few days or so to fall 20%. It might start with a Friday ramp, and then a Sunday night implosion somewhere, A Monday morning flush.... Ooops I'm saying too much eh?

Law97's picture

"It might start with a Friday ramp." 


Oh, you mean like yesterday?

g'kar's picture

Good thought but I wouldn't hold my breath waiting for that to happen. When they reach critical mass of muppets investing in the markets and the FED stops buying, and the FEDS buddies are given notice ahead of time, then maybe.

ThisIsBob's picture

RUT is down on the month, SPX is up.  Go figure.

polo007's picture

According to BMO Capital Markets:

November 8, 2013

In Search of the Mythical Market Correction

Strong Market Performance Has Amplified Correction Chatter

Many clients we speak with are convinced that the market is on the verge of correction. Sure, the stocks have been on an impressive and almost uninterrupted run these past few months, but we believe performance patterns alone are not enough to justify directional market calls. Instead, investors should consider the macro and fundamental backdrop along with risk-taking levels to determine whether or not the performance is justified. From our perspective, the data simply do not support the correction talk and we remain committed to our optimistic market outlook through year-end and into 2014. As such, we believe those investors waiting to “buy on the dip” are likely to be disappointed.

Performance Patterns Have Followed the Script

Despite the fact that it has been over a year since the last major market pullback, recent performance patterns are not totally unprecedented. In fact, the current bull market has already produced as many 5%-10% and 10%+ pullbacks as the prior six bull markets dating back to 1970, on average. The main difference has been the duration between corrections, which has been roughly half the average since 1970 even with the latest correction free period. Therefore, the past year or so can be at least partially viewed as a reversion to the mean since more investors are beginning to accept this market for what we believe it is – the early to middle stages of a secular cycle that has at least five more years of life in it.

Macro Trends Contradict the Correction Talk…

The one thing that almost all market corrections during bull markets have in common is that they are usually triggered by a Fed rate hike or a spike in oil prices. In addition, high levels of confidence, expensive market valuation, and underperformance from Financials are also typically associated with bull market corrections. Fortunately, most of these conditions are nonexistent in the current environment making the probability of any sort of major market correction very low over the near term, in our view.

…As Does the Absence of Excessive Risk Taking

Excessive risk taking has been another common precursor to meaningful market pullbacks based on our experience. However, the risk measures we track suggest no indication of excessive risk-taking by investors.

disabledvet's picture

We now have day trading in exchange traded funds. With leverage due to the "perception of low to zero risk." The policy folks are worried about money market funds but my understanding is they still have a net asset value to report and "it should be at or around one" at the close of business. Is this true of an actively managed "ETF"? I mean there is an ETF for IPO's right now. That's something new. Let me guess..."levered a thousand to one." Take a look at the gold etf if you want to see what a drain in liquidity looks like. At one time that thing held as much gold as 4th or 5th largest country in the world. Obviously the amount of liquidity in that thing was once truly massive. "No mas." I look at that Russel and sure...the gains are flows are now soaring into it (Facebook, Tesla, who knows what else). That says "beware" to me...."real money dead ahead."

moneybots's picture

"And once again, as so often happens, flows are confused for fundamentals."


As so often happens in a bubble, flow is substituted for fundamentals.

jonjon831983's picture

Didn't you see the ads?  People make 100% gains on small caps!

The more people that are aware of this and start buying into it, the higher the small caps will go.  We all win!