Stop Freaking Out Part II: long Nasdaq 100 & short Russell 2000 details

August 13, 2014 10:28 AM

Late last week we suggested that investors seeking new equity exposures consider a simple trade of long Nasdaq 100 and short Russell 2000.  We continue to believe in this trade in light of the current fickleness of global risk markets.  Geopolitical pressures and monetary policy risks seemingly linger around every corner largely validating our theme of a “high conviction only” market.  That is, take appropriate risks that are of a high conviction and hedge those risks where cost effective to do so. 

In essence, we believe that the Russell 2000 is subject to greater negative outcomes should volatility increase or level off at a higher rate.  Likewise, we believe that the Nasdaq 100 with its strong representation of US large cap technology companies should benefit from smoother US economic growth and provide some downside protection to higher volatility.  Since the beginning of July, the daily percentage changes of these two indexes have shown the Russell 2000 to be slightly more effected by negative headlines and associate market fear.

The foundation of this idea is that the long side of a new US equity trade is likely to benefit from cyclical growth, high profitability, good balance sheets and perceived value of the top companies that make up the Nasdaq 100.  The Nasdaq 100 is a modified capitalization weighted index with large cap US technology companies that benefit from both growth and the perception of relative value representing 58% of the index.  The Nasdaq 100 has 51 stocks that currently pay a dividend giving the index a yield of 1.12%.  The Nasdaq 100 trades at a trailing Price-to-Earnings of ratio of 22.

On the short side, the Russell 2000 looks expensive by several measures including a trailing price-to-earnings ratio of 65.  The Russell 2000 has a greater representation of small cap financial stocks, healthcare and industrials to go along with technology stocks which make up 16% of the index. The crux of the idea is to short companies that are more vulnerable to the global macro environment because they are perceived as already fully valued with future multiple growth highly dependent upon steady US economic health (i.e., “Goldilocks” data) and low volatility.  Although a genuinely better trend in US economic data is anticipated, US small cap companies have already traded into optimistic valuations.  In addition, and perhaps most importantly, small cap stocks are likely to be subject to negative returns should volatility tick up in any meaningful way.  One reason for a possible volatility increase may be a mismatch between Federal Reserve policy and market expectations driven by gains in employment or wages.  

The higher level of risk in the Russell 2000 compared to the Nasdaq 100 is reflected in the fact that the standard deviation of the indices are 1.05 and 0.76 respectively.  Another way to measure potential risk-to-return and the effect of overall market volatility is through beta which is the systemic risk of a specific asset as compared to the broader market.  The beta for the Russell 2000 is 1.2 with the Nasdaq 100 at 1.1.  Much academic literature points to the fact that over the longer term small cap stocks tend to outperform large cap stocks as they benefit from the “small stock effect” whereby hidden value is eventually and meaningfully unlocked in less liquid and less well-known small stocks.  Since 2010, both indices have largely performed well.  This performance synchronicity may eventually end, at least in the near to medium term, as the uncertainty over central bank policy becomes more obvious to markets and above-consensus economic news is perceived as bad for stocks vis a vis tighter monetary policy. 

Over the past 100 days, the Russell 2000 is down 4.75% while the Nasdaq 100 is up 6.0%. In the near term, as the CBOE Volatility Index (the “VIX”) has risen, the Russell 2000 has suffered greater losses than the Nasdaq 100.

Investors who believe in the US growth story and the relative value of US stocks compared to their European and Asian counterparts are likely to gravitate to large cap US technology companies which continue to drive the US economy.  The Nasdaq 100 represents that type of conservative optimism and can be layered in with a small short position in the Russell 2000 for a higher conviction exposure to US equities. 

DISCLAIMER: NOTHING HEREIN SHALL BE CONSTRUED AS INVESTMENT ADVICE, A RECOMMENDATION OR SOLICITATION TO BUY OR SELL ANY SECURITY. PAST PERFORMANCE DOES NOT NECESSARILY PREDICT FUTURE RESULTS.  SEEK THE ADVICE OF AN INVESTMENT MANAGER, LAWYER AND ACCOUNTANT BEFORE YOU INVEST. DON’T RELY ON ANYTHING HEREIN.  DO YOUR OWN HOMEWORK.  THIS IS NOT A RESEARCH REPORT. THIS IS FOR ENTERTAINMENT PURPOSES ONLY AND DOES NOT CONSIDER THE SUITABILITY OR INVESTMENT NEEDS OF ANY INDIVIDUAL.

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