The most popular trade amongst institutional investors in recent weeks has been to short the Russell 2000 and buy the Dow Jones industrial average. This has worked very well because the Russell 2000 has declined aggressively but the Dow Jones industrial average has been stable and at times relatively strong. There are also additional reasons this trade worked, but thus far only institutional investors are paying attention to that behind the scenes rationale.
Interestingly, as this pre holiday week takes shape that popular trade is actually reversing itself and the Dow Jones industrial average has been weaker than the Russell 2000 as we head into the Memorial Day weekend. Traditionally, short Sellers do not like holding short positions through extended weekends, so this could be playing a role in the shift we are witnessing this week, but the technical patterns of the Russell 2000 also were preemptive to this transition.
The Institutional Rationale
The reason this trade has worked so well in recent weeks is directly tied to liquidity levels in the Financial System. During calendar 2013, the Russell 2000 was exceptional and that is because liquidity injections flowed like water. Excess liquidity supported every hit to the market last year, but this year is different. As the FOMC tapers its bond buying program the excess liquidity in the Financial System is drying up. In fact, according to our observations, the excess liquidity in the Financial System is already a net negative.
Institutional investors recognize this, and they got ahead of the curve. That is why they shorted the Russell 2000, but if you are asking yourself why they bought the Dow Jones industrial average in conjunction with that short, you will need to further understand the progression that happens when liquidity levels dry up.
Money managers only get paid when your money is invested, so they want to keep you invested in something at all times. When liquidity levels dry up and risks become apparent on an institutional level money clearly flows out of the higher beta asset classes, but the money needs to find a home. That home is usually in stocks like those in the Dow Jones industrial average. Therefore, when risks are perceived to have increased and liquidity levels are perceived to have dried up institutional investors know that money will flow from the higher risk assets like those in the Russell 2000 to more conservative stocks like those in the Dow Jones industrial average.
For the past couple of months, institutional investors have been taking advantage of this, but this week that trade, at least in some circles, is being unwound. This may be solely due to the extended weekend that lies ahead, but we have pointed out the outperformance that is likely in the Russell 2000 and its associated EPS in advance, and although this week is not over, the unwinding of that trade in some circles at least is likely to continue for at least a short while.
Ultimately, our macro economic analysis (The Investment Rate) continues to suggest that downside market risks are significant, so although we find a trading opportunity in identifying the unwinding of the above referenced institutional trade, we are not condoning buying and holding the Russell 2000 or the Dow Jones industrial average.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Business relationship disclosure: By Thomas Kee for Stock Traders Daily and neither receives consideration from the publicly traded companies listed herein.
Additional disclosure: UWM was called as the stock of the week this week for clients of Stock Traders Daily.