Investors should pay close attention to the behavior between small-cap and large-cap stocks
Source: shutterstock.com/Moor Studio
The stock market is dangerous right now and all investors are playing with fire.
What has happened over the last few trading days is nothing short of historic. Small-cap stocks have exploded while large-cap stocks fell. Nvidia (NASDAQ:NVDA) shares are down 4% — and were down more late last week. Although rotation from large to small is normal, and something I have even predicted would happen, rotation of this magnitude is unprecedented in modern markets.
Historically, hedge funds short sell small-cap stocks and take long positions in large-cap stocks to play the spread between them. The idea is that these funds can eliminate some risk by trading the momentum differential between large and small companies. Returns from such a trade can be smooth and steady, and in times like these, better than a general bet on the broader market.
This is all fine and good… at least until that pairs trade unwinds. When that happens, short positions in small-cap stocks are facing a squeeze while long positions in large-cap stocks are falling. It’s a double whammy for investors, and it’s exactly what we’ve seen in the last few trading days.
Then, compounding the problem is the fact that these short and long positions are often leveraged. This means when shocks of this magnitude happen, risk controls get tighter. Hedge funds have to deleverage their portfolios because the market stops behaving according to their models.
The result here is a cascading effect that causes forced liquidations take place. This is likely what explained weakness last week in stocks such as Nvidia.
The key point here though is that the effect is not immediate. That deleveraging of hedge fund portfolios could come days later after the losses are already underway. And if there’s a particular hedge fund that is late to that process and highly leveraged, then that hedge fund could very easily blow up and suffer even deeper losses as a result.
So, is this a blowup of hedge funds or just a normal rotation into small-cap stocks? Right now, it’s unclear. If it is the former, investors should brace themselves for more stock market volatility.
On the date of publication, Michael Gayed did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
On the date of publication, the responsible editor did not have (either directly or indirectly) any positions in the securities mentioned in this article.