In the week that followed the catalysts from early November – U.S. election and FOMC meeting – equity markets advanced strongly. The Russell futures jumped over 8%, and the early days saw a spike in volume as well. The S&P 500 futures saw a move higher, but it was more muted, around 4%. Still a big move, but not the same in price or volume as the Russell. This had many people thinking, “Is this the start of a move into small caps and out of large caps?” as well as “Was that the Santa rally?”

In trying to answer the second question first, I look at the seasonality patterns for both the S&P 500 as well as the Russell 2000. For the former, I look at the last 10 years. For the latter, I look only at the last six years because there is not as much history. What I do see in this seasonality chart is that both futures contracts have strongly positive seasonality in November. As December gets closer, S&P 500 futures are basically flat on average, with the lowest positive (0.12%) month better only than the negative returns in September. It is a different story when I look at the Russell 2000 futures. Not only is December another strong positive month, but January is also a very positive month for Russell 2000. Moving into January, returns are positive but more muted on average for the S&P 500. Thus, the Santa rally seasonality for the end of the year and into next year looks much more favorable for the small-cap Russell 2000 than the large-cap S&P 500.

Getting to the other question – can small caps begin to outperform large caps –  I turn to different data. As you can see from the graph above, other than the period in late 2020 to early 2021, small caps have indeed struggled vis-a-vis large caps for the past 7 years. Coincident, if not leading, this decline was the NFIB Small Business Optimism Index, which has been in a sharp downtrend over most of this period. Given this decline has occurred across the terms of the last two presidents, one may surmise that the reason for this move lower has more to do with macro fundamentals than it does to the results of a particular election. That spike in outperformance as well as optimism coincided with a period of very strong monetary and fiscal stimulus. Once that went away, the optimism and performance has more than given back any gains. In the last few months, I have seen a move higher in the NFIB Small Business Optimism Index. Could this be presaging a relative move higher in Russell 2000 vs. the S&P 500? What may be driving this optimism?

The top chart may give us some indication of what is driving this optimism. It plots the NFIB number vs. the Federal Reserve Senior Loan Officer Net percent of respondents that are tightening credit to small businesses. I have inverted the line to show that when credit gets tighter (line moves down), small companies are less optimistic. The opposite is also true, as credit is easier to get, small businesses are more optimistic. Since banks are the lifeblood of capital for small businesses, this measure does a good job of encompassing a small company’s ability to borrow money to invest in their business or pay their bills. The overlap of the two lines is intuitive, and interestingly, in the last year, banks are becoming much more willing to lend money to small businesses as seen with the line moving higher. One might expect, then, to see small business optimism continue to head higher in the coming months.

What causes this survey measure to rise and fall? Why do banks become more or less willing to lend money? It all comes down to margins. How does one forecast a bank’s margins? The best way is the yield curve. Banks borrow short (via deposits) and lend long (commercial real estate, mortgages and the like). For the yield curve, I am using the 3-month vs. 10-years as it best approximates this business of banks. As the curve inverts, there is no financial incentive for banks to lend money, thus one sees the net percent of banks tightening credit rising (line falling as it is inverted). As the yield curve steepens, which it has been for the last two months, one typically sees banks more willing to lend money. This in turn gets small businesses to be more optimistic and for small-cap stocks to have a better chance of outperforming large-cap stocks.

Before determining if investors will want to allocate more of their hard-earned money into small caps instead of large caps, I need to look at the relative price they are paying too. For this, I look at the P/E multiple for the large-cap S&P 500 (white) and the small-cap S&P 600 (orange). You can see that there was rarely much disconnect until 2019. After that, and after Covid, not only has the spread widened, but it's at the most I have seen in not only the last 10 years, but the last 20 years. While large-cap valuations are near the max traders have seen ex-Covid, the small-cap stocks are trading at a P/E that is below the 10-year average. While valuation is not a great short-term market-timing tool (it is statistically insignificant), it is the only thing that matters to long-term investing. For those considering a change in portfolio allocations into the new year, this relative valuation disparity may be something that factors into the decision-making.

My next step is to see about the relative volatility pricing of the options on each future. For this, I look at the one-month at-the-money implied volatility in both S&P 500 and Russell 2000 options. You can see that Russell options tend to always trade at a premium relative to S&P 500 but that premium is larger than normal right now, as shown in the bottom panel above. The eight vol-point difference is one of the largest traders have seen, only eclipsed by the end of 2023 when there was a very sharp move in Russell futures. Other similar periods such as this were the late summer de-risking in 2024 and the regional bank crisis in spring 2023. A more typical spread is closer to four vol points. Thus, looking to express a view via long Russell options may be challenging as more volatility going forward is getting priced into these options.

One can also see the volatility premium show up if they move to QuikStrike to look at the term structure of implied volatility. The S&P 500 term structure is more muted for the end of the year, declining into the quiet year-end period and then slowly rising into the January expiration. Conversely, Russell 2000 options show a premium into the end of the year, a decline around the quiet holiday period and then another move higher into January expiration. To me, these term structures are representative of a higher degree of uncertainty and expectation on the movement of Russell 2000 options vs. S&P 500 options, where a more quiet end-of-year may be expected.

Sorting this information, I'm inclined to be long Russell 2000 futures either relative to the S&P 500 or on an outright basis. I looked at various relative-value option trades, but none were really attractive. I tried to find good expressions that'd let me be long Russell 2000 deltas vs. S&P 500, but short Russell 2000 vega vs. S&P 500. The best possible idea was to sell Russell 2000 puts vs. buying S&P 500 puts, but this was a trade that'd make more sense if there was a bearish market move into year end and beyond. I'm not convinced of that, so I didn't present that idea. If traders think markets could see a move lower in all equities, led by the S&P 500, with the Russell 2000 outperforming, that may be the trade for them.

Since I was more focused not only on the relative performance but also the absolute December and January performance of Russell 2000, I decided to put on a bullish Russell 2000 options trade. However, I showed you how implied volatility and term structure weren't really conducive to long options. I needed to find a short-option strategy that still allowed for some convexity on a bigger move higher to make me money. For this, I looked to a call butterfly, but where the strikes aren't set to be asymmetric, but instead skewed such that even if things move strongly through the highest strike, I'm still able to make multiples of my money. The cost of this spread is eight ticks, and a move up and through the upper 2500 strike by expiration means that I would make 25 ticks or more than 2x my money. The optimal ending area is at my short strike of 2475, which would yield a return of 125 ticks vs. the eight ticks I risked. While this is not the highest probability outcome, it is clearly the most attractive. My biggest risk is that futures stay below 2350 by expiration, in which case I would lose the premium I have spent of eight ticks.

The second two charts I have on here are designed to do two things: 1. Show the functionality of QuikStrike that allows me to plot not only the P&L of a trade but the option Greeks 2. Show how the option Greeks move with the underlying and decay over time. A trader can see that gamma is a small negative at the time of trade and it decays a little longer. However, the higher it goes, the more the gamma gets negative not only for the move in the underlying but also with the move in time. This makes sense moving closer to my strike, where I am short two options. The flipside of gamma is, of course, theta. If I am long gamma (and who doesn’t like positive convexity?) the tradeoff is paying theta. If I’m short gamma, I’m earning theta, something that benefits the option seller because if nothing happens, it's still a good day with options losing some time value every day. These two charts do a good job of showing how these two critical option Greeks change over time and over a range of underlying, giving the trader an idea of when may be a good time to look to close the trade, if they aren't inclined to let it run to expiration.

I went into this write-up thinking I'd be doing a relative value trade. However, the options market wasn't really pricing so that I could find an attractive way for me to implement my view. The thing is, while I have a strong positive view on the relative performance of the Russell 2000 futures vs. the S&P 500 futures, given the very positive seasonality, I also have a strong absolute view. Using a split strike call butterfly, the limits the premium at risk but allows me to make money even on a large move above my strikes, appears to me to be the best reward-to-risk way to implement the idea.

Good luck trading!

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