Small-cap stocks are falling behind the broader market as rising bond yields hit the Russell 2000 harder than large-cap indexes. Options traders are loading up on puts on the iShares Russell 2000 ETF (IWM), with several large trades betting on further declines if rates keep climbing.
Small caps have turned into September's weak link. At the start of the month the Russell 2000 was up 20% year to date, ahead of the S&P 500's 13% gain and the Nasdaq-100's 17% advance. Since then the index has slipped to a 14% year-to-date gain, versus respective returns of 20% and 12% for the S&P 500 and Nasdaq-100.
Bond selloff drives the divergence
Rising rates and falling bond prices explain the gap. The correlation between the iShares Russell 2000 ETF and the 20+ Year Treasury Bond ETF currently sits at 0.51, compared with 0.29 for the SPDR S&P 500 ETF Trust and 0.1 for the Invesco QQQ Trust. Last week, small-cap correlation with the 10-year note touched a one-year high above 0.97.
Kevin Gordon, head of macro research and strategy at the Schwab Center for Financial Research, said small caps have had a harder time adjusting to the Fed's hawkish turn than large caps, since their negative correlation to the 10-year Treasury yield runs twice as high.
Options market leans toward puts
Options positioning points to more pain ahead. More puts traded than calls in IWM on Thursday, while the volume ratio in SPY stayed close to even and calls outnumbered puts in QQQ. Options volume in SPY and QQQ ran 40% above the 30-day average by midday Thursday, while IWM volume nearly doubled.
Traders likely bought 480,000 puts against 371,000 calls, pushing total open put interest to just shy of 7 million contracts, according to Cboe LiveVol data. Of the $322 million in premium traded in IWM Thursday, $100 million likely went toward buying puts versus $50 million for calls, per SpotGamma data, though some large put sales also appeared in the market.
The 280 and 281-strike puts expiring Thursday accounted for over 120,000 trades between them, part of the top-four most popular trades by volume. The next most popular trade, the 269-strike put expiring Oct. 16, needs a 4% selloff to turn a profit.
Still, Gordon noted the fundamentals underneath small caps remain intact, pointing to improving PMIs and solid forward earnings estimates as reasons not to discount the group entirely, even as further weakness looks likely if rates keep rising.
Source: CNBC
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