Our initial piece of 2024, published at the start of the year, a relative value trade idea: shorting tech stocks represented by the Nasdaq index, while going long on small caps represented by the Russell 2000 ndex. At that time, the ratio between the two was just below 9, reminiscent of the Dot-Com bubble peak. To our surprise, within merely seven months, driven by the AI hype, Nvidia’s price surged over 180%, reaching a market capitalization exceeding three trillion U.S. dollars. Meanwhile, small caps remained overlooked and underowned, missing out on the tech stock rally. This pushed the ratio to an unprecedented high of 10, far surpassing the Dot-Com peak.
The landscape shifted dramatically on Thursday when a cooler-than-expected CPI print caused significant market ripples. The unexpected CPI data indicated that the disinflationary trend was back on track, leading the market to believe that the Federal Reserve might initiate the rate cut cycle in September, with one or two more possible by year-end, as CME FedWatch Tool suggested. Not only has the Short-Term Interest Rate (STIR) market started to price in rate cuts, but the 2-ear reasury note market also indicates that yields are about to decline meaningfully. Following this CPI release, we observed one of the largest intraday divergences between the Nasdaq and the Russell 2000 in history. Mega tech stocks mostly declined, while other sectors, especially small caps, significantly outperformed. This divergence continued Friday, suggesting that it was more than just a knee-jerk reaction.
Fundamentally, small caps are more sensitive to the interest rate environment because these companies often lack the strong cash positions of mega caps and rely more on debt financing for operations and growth. High interest rates increase their borrowing costs, impacting their profitability negatively. Conversely, lower rates provide them breathing room, reduce borrowing costs, and improve growth prospects.
We believe that the dramatic capital rotation into small caps is driven not only by fundamentals but also by very lopsided market positioning. Firstly, small caps have been extremely underowned in the past two years. Successful momentum strategies have favored long positions in the leaders and short positions in the laggers. The significant weight of the “Mag 7” stocks in the index, combined with prevalent passive investment strategies, has forced active fund managers to allocate heavily to tech stocks like Nvidia at the expense of small caps. This imbalance in allocation led to a pronounced reaction when the macro regime changed. Fund managers, realizing their underweight positions in small caps as these began to outperform tech stocks, had to quickly rotate their portfolios to avoid missing out.
Additionally, due to the enormous market caps of companies like Nvidia, even a small percentage outflow from these tech giants represents a massive inflow for smaller companies. For instance, a 1% outflow from Nvidia’s trillion-dollar market cap translates to tens of billions of dollars. In comparison, the median market cap for the Russell 2000 index is only 900 million dollars. When this substantial amount rotates into small caps, it has a much more significant impact on their share prices, thereby amplifying the overall performance divergence between tech stocks and small caps.
Fortunately, the rotation we have witnessed so far has been orderly, not yet a “de-grossing,” as evident from correlations between individual stocks remaining at historical lows. Such an orderly rotation refers to systematically reallocating capital between sectors without causing significant market disruption. In contrast, “de-grossing” involves rapidly reducing both long and short exposures, leading to heightened volatility and increased correlations among stocks.
However, we must remain vigilant. Past election cycles suggest that we might see the first pre-election volatility spike in July and August, with a second spike in October and November. In other words, the summer is over, and we should brace for a potentially bumpier second half of the year. If volatility continues to increase, the orderly rotation could turn into a full-blown risk-off/de-grossing event, where correlations rise significantly, and everything gets sold. Hence, we still favor the relative value trade, as even in that scenario, we believe small caps might still outperform the tech stocks by declining less. From a valuation perspective, tech stocks are much more expensive, giving them more room to fall. Conversely, small caps have been underweighted for the past two years and are less likely to face the same selling pressure during a broad market decline. This relative undervaluation and lighter positioning should cushion them better in a downturn.
