Spreading Stock Index futures—Large Caps vs. Small Caps

Part II

In part I of this series we discussed how some traders might use spread trading to take advantage of shifts in the yield curve. Now we shall turn our attention to the equity markets. Investors keep a close watch on the key benchmarks—typically they will focus on the S&P 500 and the Dow. The S&P 500 is the main benchmark that is used to measure how a portfolio manager performs. As most people are aware it’s an index comprised of large capitalization stocks. The idea is to outperform the benchmark, making investors happy. The S&P 500 is also an important economic barometer. In growing economies, the companies within the index do well and their stock prices advance thus pulling the benchmark to higher levels. This has been amply demonstrated in 2019 as the S&P 500 has mounted record after record as the year draws to a close.

But beyond the large capitalization universe lies mid and small size stocks. For now, we will focus on large caps and small caps and omit midcaps for a later discussion. The key benchmark for small capitalization stocks is the Russell 2000 Index. And at times, this area of the market can sometimes march to the beat of a different drummer—i.e. outperform or underperform. Over the past 90 or so years, small cap stocks have outperformed large cap stocks by a few percentage points (13% annualized vs. 10% annualized). This is because small cap stocks tend to grow faster, although they are riskier. Large caps within the S&P 500 tend to be steadily growing stalwarts and are less nimble. But over the short term, large caps and small caps can leap frog each other in performance. Figure 1 below illustrates how these two index exchange periods of outperformance. Although the chart compares 20 years of small/large cap performance, we will focus on the period ending 12/31/2017.

Over the calendar year 2017, the S&P 500 outperformed the small cap benchmark Russell 2000 by 6.23 percentage points. But interestingly, by summer of 2018, small caps took the lead and by July were ahead by 5.7 percentage points. Why the abrupt swing?

In a word. China. Spring and summer of 2018 marked the beginning of the trade/tariff wars between the United States and China. Now, digging deeper why would this affect large caps more and cause them to underperform? The answer lies with the large multinational companies that make up the S&P 500.  Multinational companies like Caterpillar, United Technologies, Boeing and others have more to lose in a trade war as they derive a substantial percentage of revenue from overseas. Smaller companies that make up the Russell 2000 do not have as large a global footprint and thus they’re likely to be less vulnerable from trade wars.

Again, at the end of 2018, the relationship flipped again, and large caps took the lead despite the ongoing trade war. What happened? The fourth quarter brought a serious correction in the markets and when the market falls significantly, smaller, less well capitalized stocks fall further. Hence the Russell 2000 underperformed in the latter half of 2018. Astute traders can profit from these opportunities. Sometimes they can be short term opportunities, other times they can take days, weeks or months to develop.

With the liquid E-mini and Micro E-mini S&P 500 and Russell stock index products, a trader has a unique product suite that can allow the trader to set up a spread trade that’s geared toward the trader’s market viewpoint.