Investor expectations that the U.S. economy was set to re-take global leadership were strengthening well before the American electorate's collective brain cramp in November. Now, however, the optimism has not only faded, but turned to outright pessimism.
"Short America" has become one of the most popular hedge fund trades.
The first chart below shows the relative performance of U.S. small cap and emerging markets stocks by simply dividing the value of the iShares Russell 2000 exchange-traded fund by the iShares MSCI Emerging Markets ETF. The trend, rather than the values on the Y-axis, is the important takeaway. A rising line indicates U.S. small cap outperformance of emerging markets equities.
The chart design was chosen by Bespoke Investment strategist George Pearkes as a way to measure the extent to which U.S. equities were assuming global leadership. Small cap stocks were chosen because, unlike the megacaps that dominate S&P 500 returns, the bulk of revenues are generated domestically and better reflect U.S. economic activity.
The performance trend has generally been positive for U.S. small caps during the past five years despite the notable hiccup between March and August, 2014. The sharp upward surge in relative small cap performance in November, 2016, was part of the Trump trade, as managers positioned for infrastructure spending, corporate tax cuts and an acceleration in U.S. economic growth.
On Dec. 16, 2016, investor faith in U.S. small cap stocks relative to developing world equities came to an abrupt halt. The trend line on the chart fell sharply.
The second chart illustrates that the rise and fall of small cap-based U.S. optimism was even more exaggerated in futures markets, where hedge funds dominate the action.
The net futures position has been negative – more short positions than long positions – for much of the past three years despite the performance of the index itself. This likely reflects hedging activity, with hedge funds buying actual small cap stocks (or the Russell 2000 ETF) and using short futures positions to hedge the risk of loss.
From April, 2016, to January, 2017, futures markets reflected a huge surge in optimism on U.S. small caps. Net positioning went from net short by over 66,000 contracts to net long by about 92,600 contracts in a few short months.
These bullish futures positions have now all been unwound. After hitting a low of minus 73,000 contracts earlier this month, the net short position is now hovering in the minus 35,000 contract range.
It's impossible to know how much of the short positioning is a straight bet against small cap stocks, and by extension the U.S. economy, and how much are being used as insurance against long positions in equity markets. It is clear, however, that a sizable about-face (often known as a "stop and reverse" in professional trading circles) in sentiment has occurred, from bearish to bullish and back again.
Taken together, these charts underscore an ongoing skepticism regarding U.S. markets and economic growth that domestic investors should track closely.
Scott Barlow