Perfect Pair Trade: Long Dollar, Short Small-Caps

ETF Trends

It was a decent week for U.S. stocks with the S&P 500 rising 0.2%, but small-cap exchange traded funds did not get the memo.

For the week ending November 1, the iShares Russell 2000 ETF (IWM) lost 2.1% and more than $1 billion was pulled from the fund. The Vanguard Small-Cap ETF (VB) was off 1.2%. International small-caps were a not place to hide either. For example, the Market Vectors Brazil Small-Cap ETF (BRF) dipped 5%. [October's 10 Worst ETFs]

Coincidence or otherwise, the rough week for small-cap ETFs coincided with a strong week for the U.S. dollar as the PowerShares DB US Dollar Index Bullish (UUP) gained nearly 2%. [Trouble Looming for Commodities ETFs]

Actually, it is not much of coincidence. Over the past three years, IWM and UUP are epitome of “inversely correlated.” As the Federal Reserve’s quantitative easing regimen has punished the dollar, UUP is down 3.3% for the three years ending October 31 while IWM has jumped 63%.

Perhaps those that pulled money out of IWM were too hasty.

“The US dollar index hit the relief valve around its 50% retracement level – launching the index some 2% higher for the week. Although it’s rattled the already fragile resolve of the commodity markets and asset sectors closely tied to it, we view the move as representative of a classic bear market rally. We also see it as another opportunity to rebalance positions that should outperform – as we expect the fast move in the dollar to reverse lower over the next few weeks,” according to Market Anthropology.

And while investors may have pulled cash from IWM last week, that does not mean they turned around and made bearish bets on small-caps because the Direxion Daily Small Cap Bear 3X Shares (TZA) saw outflows on the week despite popping 6.2%.

For UUP to pose a deeper near-term threat to small-caps, it would need to break resistance at $21.80 and reclaim its 200-day moving average, which is about 2% away.

Dollar Index SPX: RUT

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Chart Courtesy: Market Anthropology. Tom Lydon’s clients own shares of IWM.

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