A Looming Headwind For Small-Cap Stocks

Via Dana Lyons' Tumblr,

Small-cap stocks are on a historic run; however, futures positioning could become a considerable headwind should the rally start to fade.

One of the biggest beneficiaries of the “Trump Rally” has been small-cap stocks. Since just prior to the election, the space ripped 20% in 25 days for just the 6th time in 25 years (using the Russell 2000 (RUT) as a gauge). And with the RUT now back into all-time high ground – and in the midst of its favorable “January Effect” season – sentiment is obviously sky-high for small-caps right now. So what are the red flags? Well, besides their obvious short-term “overbought” status, there may be a longer-term potential headwind for small-caps, should they begin to reverse.

Looking at trader positioning in ICE Russell 2000 Mini futures, we note that Commercial Hedgers have just adopted their largest net short position (-57K contracts) on record, going back to 2008.


Why is this significant? Commercial Hedgers are deemed the “smart money”. This isn’t because they are always right. They take positions opposite trend-following Speculators, e.g., hedge funds, etc. Thus, during long trends, they can be wrong for some time. However, at important junctures and turning points, they are almost always correctly positioned. That’s one of the benefits of tracking this data published in the CFTC’s Commitment Of Traders report.

Looking back at the prior times that Hedgers went net-short, we see that the RUT has typically struggled in the aftermath. A mid-September 2008 reading saw a subsequent 50% crash in the index. Net-short readings in March and September 2012 were followed by 10% pullbacks in the RUT. And readings in April-July 2015 occurred at the peak preceding last year’s 25% haircut in the index. So most net-short Hedger readings have not been conducive to positive returns in the Russell 2000.

Then there is 2013. Hedgers spent nearly the entire year in a net-short position, including their previous record of -47K contracts in March of that year. Of course, small-caps spent the year in an inexorable rally. So, it is an important reminder that A) the signal is not always right, and B) even if it is eventually, an extreme can always get more so before it marks a turning point.

Therefore, while Hedgers have a record net-short position and, by extension, Speculators have a record net-long position, the potential headwind represented by an unwind of those positions will only occur once prices reverse and begin to head lower. In other words, this data point is a major looming headwind for small-caps – but not its catalyst

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More from Dana Lyons, JLFMI and My401kPro.

Just for a little more color on how insane this move has been... here are speculative longs in Russell 2000 futures...

h/t Loic S.