Source: Lane Pearman
Investors are growing complacent. After the rally in small cap stocks sent the Russell 2000 up +3% in the past month, we think the stock market bears have capitulated and this should be cause for concern for investors long small caps.
There are some general rules guiding our process that lead us to this conclusion. As Hedgeye CEO Keith McCullough writes in today's Early Look, "Here are some ABCs you can consider within your research and risk management process:
A) Are we at the top or bottom of the risk range?
B) Is there an implied volatility premium or discount developing?
C) Is there an extended net long or short position in futures & options contracts?"
Let’s use at the Russell 2000 as an example, with Keith's bolded commentary and additional context italicized.
A) "Russell 2000 went from immediate-term TRADE oversold, multiple times in April-May, to overbought today."
With more downside than upside in Keith's quantitative risk ranges (see Daily Trading Ranges below), today is not the day to buy the Russell 2000. We've been saying buy the Russell 2000 on pullbacks to the low end of the range for the better part of six months, since the small cap index is in a bullish trend (i.e. bullish on a duration of 3 months or more). In other words, as Keith says, "Buy the dip, sell the rip!"
B) Russell 2000 went from having a double-digit implied volatility premium in April-May to a discount today.
Russell 2000 investors are growing increasingly complacent. Implied volatility is a measure of investors' expectations for future volatility that's implied in options markets. We use the measure of implied volatility as a ratio to historical (i.e. realized) volatility to get a read on fear and complacency in markets. This is expressed in either an implied volatility premium (i.e. consensus is fearful and buying downside protection) and discounts (i.e. consensus is complacent). We look at this as a contrarian indicator. Investors can be overly fearful or overly complacent, that's when you take the other side of the trade.
With an implied volatility discount in the Russell 2000, we think formerly bearish investors have capitulated and investors are now getting complacent. Note: This is typically what happens after the move. In the past month alone, the Russell 2000 is up +3%.
C) Russell 2000 went from having its highest net SHORT position of the year to a net LONG position in less than a month.
Two weeks ago, the CFTC's data on institutional investors' futures and options positioning showed a net short position in the Russell 2000 of 72,910 contracts. That was the highest short position of the year. As of the most recent data, institutional investor consensus has flipped to net long 7,700 contracts. Yet more confirmation of the complacency embedded in small caps.
Bottom Line
All told we'd reiterate our call that today was not the day to own small cap stocks. On pullbacks to the low end of the range though (currently 1,400 for the Russell 2000), we say buy, buy, buy...
