This week’s outperformance of IWM over SPY has been notable considering that small cap relative weakness had been a theme of this market for the past 6 months. In fact, IWM is up about 3% this week, vs. the SPY down 0.8%, and that includes today’s underperformance by IWM.
However, I am anticipating a return of small cap underperformance in the coming weeks, as the IWM / SPY ratio returned to its downtrend line. More importantly, the 0.58 level is likely to be resistance as many fund managers that rotated into small caps near there are probably happy to be near flat on the trade:
One other important point on small caps. Because of the steady, uninterrupted nature of small cap underperformance since the spring, many hedge fund managers had been using a short Russell 2000 position as a portfolio hedge against their long positions (short Russell 2000 futures among hedge funds was near 10 year highs). Over the past week, as hedge funds have been forced to reduce their gross risk (both cutting long positions and covering short positions), they were likely forced to reduce their portfolio hedge by covering the Russell 2000 index short.
With that in mind, my hunch is that today’s price action indicates that that short covering in IWM is close to done. If that’s the case, then on the next bout of market weakness, I anticipate that IWM will actually be a leader to the downside, since the small caps are more difficult to sell. And aggressive forced sellers will have to find bids, likely at much lower prices.