This Divergence Signals A Monster Rotation In 2022

By TradeSmith Editorial Staff

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Monday’s newsletter began our discussion on divergences.

I demonstrated how relative strength can uncover equities with enough momentum to keep outperforming the market.

Today, I want to give you a different perspective on divergences, a total one-eighty.

Instead of looking for stocks to buy high and sell higher, I’m going to show you how to use market divergences to find mean-reversion trades between indexes.

Because the divergence between the Russell 2000 Small Cap Index (IWM) and the S&P 500 (SPY) is setting up one of the largest rotations of 2022.

Plus, I will lay out a few strategies to wet your whistle.

Market Rotation

In the last few months, I noticed a pattern.

On days when the tech-heavy Nasdaq 100 led the indexes, the small-cap Russell 2000 heavily lagged.

When the Russell led the way, the Nasdaq lagged.

This back-and-forth is a microcosm of market rotation.

Market rotations occur when money flows out of one sector, index, or subset of stocks and into another.

You see this when money flows out of financials and into technology, or out of industrials and into consumer discretionary stocks.

The relationship between stocks and Treasuries is a classic example.

Generally, money flows out of stocks and into Treasuries when investors want to reduce their risk.

Conversely, money rotates out of Treasuries and into stocks when investors seek higher returns.

Rotations occur based on investors’ perceived value of one group of stocks compared to another.

The change in perception can be driven by either cyclical influences, which follow predictable patterns, or non-cyclical influences, which create new trends that extend for years.

  • Cyclical Influences — Business and economic cycles create cyclical trends among stocks. For example, industrial stocks often lead markets out of a recession as businesses invest in expansion. Prior to the recent shortage, semiconductors went through cycles of high and low supply and demand.
  • Non-Cyclical Influences — Structural changes to our lives create non-cyclical influences. The rise of fracking and green energy created a new dynamic for energy stocks. More recently, the work-from-home trend put pressure on office real estate while boosting online productivity tools.
As investors, we find opportunity when markets push the relative value to extremes.

That’s why we want to focus on cyclical influences for this particular setup.

Now, let’s dig into my small-cap thesis a bit more.

The Difference Between Small- and Large-Cap Indexes

Investors view large-cap companies as more stable and less volatile than small caps.

That is usually true, but not always.

We’ve seen massive companies with multibillion-dollar market caps, like Tesla (TSLA) and Rivian (RIVN), swing around like someone lit their pants on fire.

Yet small caps haven’t received much love in the last year, let alone the last decade.

We can measure this by charting the ratio of the price of the S&P 500 SPY ETF to that of the Russell 2000 IWM ETF.

Between 2008 and 2020, the price ratio between the SPY and the IWM sat in a range of around 1.6x to 1.8x.

When markets collapsed in 2020, large-cap tech helped the SPY outperform the IWM, leading the ratio to peak around 2.35x.

The IWM then began to outperform relative to the SPY all the way through March 2021.

Since then, the SPY has significantly outperformed small caps, leading to the current reading of 2.2x.

To me, this signals a potential rotation.

And there are two cyclical trends that back this up.

First, financials make up 21.63% of the total weighted holdings of the IWM, compared to 13.62% of the SPY.

Since higher interest rates drive higher profitability for banks and financials, I want exposure to this upcoming cycle.

Second, although supply chain congestion will compress margins in the first part of 2022, this should clear by the second half of the year. At the same time, demand for goods and services will remain heavy through all of next year, leading to an economic expansion.

This enormous economic growth potential favors small-cap stocks, which tend to do better when economies expand.

Potential Strategies

Now that we understand what we’re looking at and why, I want to give you a few ideas of how you can create an investment or trading strategy out of this.

First is to simply use the ratio chart as you would any other stock chart.

I took the ratio chart and added two orange support/resistance lines where most of the bottoms and tops occurred, at 2.13x and 1.95x, as well as one at the recent high of 2.35x.

Using these parameters, I can look to initiate a position between 2.13x and 2.35x while targeting 1.95x or lower as my exit.

If the ratio exceeds 2.35x, I can consider this my “stop loss” and exit the trade. Otherwise, I want to hold the position until the ratio drops down to 1.95x or lower.

Next, I want to choose how I wish to execute this trade.

The simplest way is to buy the IWM and short the SPY.

However, I know many of you use retirement accounts that don’t allow for shorting.

Instead, if you own the SPY or S&P 500 fund, simply rotate money into the IWM or small-cap fund.

This is akin to changing the weight of your portfolio selections to favor small caps over large caps.

Lastly, if you want to get very specific in the small-cap sector and look for financial stocks likely to benefit from higher interest rates, I suggest using a screener tool like the one available at TradeSmith Finance to look for healthy regional banks that earn a significant portion of their income from net interest.

Whichever strategy you choose, make sure you measure and understand the change in your portfolio weighting.

2021 was an exciting year. And I know 2022 is going to be even better.

As we head into the new year, what new strategies do you plan to put into action? Email me and let me know.