Few areas of the US market performed better than small-cap stocks following the presidential election. But hedge funds are betting the group’s best days are finished.
The Russell 2000 has surged 17% since Donald Trump’s victory — handily outpacing the S&P 500 by more than three percentage points — amid expectations that the more domestically-focused group would be best positioned to benefit from a lower corporate tax rate.
Now that investors are growing increasing sceptical that any of Trump’s policies will be passed in timely fashion, those big relative gains in small-cap shares look awfully precarious.
Large speculative investors agree. They hold the biggest net short position in six years on the Russell 2000, according to data compiled by the Commodity Futures Trading Commission.
That hedge funds were the most bullish in history on the small-cap gauge as recently as January highlights the degree to which investors have thrown in the towel on the so-called Trump trade.
While major indices still sit at or near record highs, the general consensus is that the strength is due more to earnings growth and improving fundamentals than any lingering expectations of major legislation from Trump.
However, not all profit expansion is created equal, and looking at simple year-over-year statistics doesn’t tell the whole story. Morgan Stanley recommends looking at a measure called earnings revision breadth, which looks not only at upward adjustments to profit forecasts, but also how widespread they are.
Using this metric, the S&P 500 looks to be in much better shape. The number of companies in the main US equity benchmark that are revising future profits higher is outpacing those making downward adjustments by the most since 2012. Looking at this same measure for the Russell 2000, the small-cap gauge is underperforming the S&P 500 by the most in two years, Morgan Stanley data show.
And with hedge funds still net long the S&P 500 while betting against the Russell 2000, it’s clear this development is not lost on them.