Russell 2000 is CHEAP relative to S&P500

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IWM long vs SPY short
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This is a "spread trade" between two indexes which is sometimes called a "pairs trade". Typically a "pairs trade" is between two similar stocks in a similar industry whose fortunes are tied together to a similar end user or buyer. Imagine KO and PEP (Coca-Cola vs Pepsi) as a decent example.

The typical "pairs trade" swings back and forth on expectations from different economic environments. The Russell 2000 (IWM and RTYM2023) can be influenced by perceptions of interest rates and projections of economic activity. The rationale is that smaller companies like those in the Russell have higher dependency on borrowed money and will be hurt more in an economic contraction. They don't have the international reach and have more risk to the domestic economy and have lower borrowing capacity, which makes them overall more risky.

This isn't necessarily true, but it is the way the market views this trade and what gives it the potential to generate returns.

What this ratio tells me here is that expectations are very low for Russell 2000 companies and very high for S&P500 companies and that there may be risk to that assumption. Therefore, we should research into the actual facts and see if that is true.

The fact is that here at current levels the Russell2000 has lagged the S&P500 Index by 30% from the high in 2021 but in order for this ratio to move back to the levels of 2017-2018-2021, it would need to advance by over 45%.

How much do we risk in this trade here? The average "monthly" range in this ratio is about 4%, so we can risk about 4%-5% and admit we are wrong if the ratio slides under 0.41 (the bottom of the green box). The upside? Let's see how it moves, but the goal initially would be a gain of 3x the average monthly range or 12%-15%.

Tim 11:11AM EST 5/1/2023

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ملاحظة

The ratio has stabilized here and still looks good to me. Look for strength from here to add to this position. Look for an day when IWM is outperforming SPY by 1% and 2% to add.

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ملاحظة

IWM setting up really nicely here against SPY. It has 'held its ground' and 'formed an uptrend' and building a mode here. No new lows for the ratio and it is set up nicely for a move up. Buy any strength in IWM vs SPY. May 18, 2023 1:45PM EST

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ملاحظة

Sharp breakout of the base here in IWM/SPY ratio = bullish for more relative outperformance of the Russell 2000 after its extreme underperformance against the S&P500 over the past year.

Money is moving into value stocks with the lower valuation multiples of the Russell2000 vs the higher valuation of the S&P500.

5/23/2023 10:20AM EST

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ملاحظة

IWM has lagged badly in the last week and has brought the ratio back down to the original levels where this trade looked the most opportunistic. Any fears of inflation coming from higher oil prices seems to be driving this ratio down the most lately.

Spread trading can make risk significantly lower, up to 75% lower, but not every trade works, that's for sure.

Rising interest rates have also hurt the Russell 2000 companies as people continue to fear that they have more debt than average and less growth and in a world where inflation is "perceived" to be higher than it is, people want to own growth stocks so they can win over the long haul. Low growth, highly-indebted is the wrong place to be according to the crowd. With bankruptcies, delinquencies, bad-debts and interest payments soaring, you can bet the economy is headed down over time, not up. I will position for lower interest rates and a weaker economy ahead.

September 7, 2023
5:15PM EST
Tim West