Options traders are showing signs they agree with the Federal Reserve about small-cap stocks.
The Chicago Board Options Exchange’s Russell 2000 Volatility Index is up almost 11 percent this year, compared with a 6.6 percent drop in the VIX, which tracks the cost of protecting against losses in the Standard & Poor’s 500 Index. The small-cap measure last week reached the highest level since 2006 relative to the gauge known as the VIX, data compiled by Bloomberg show.
Investors are showing skepticism toward the group at the same time the Federal Reserve said valuations for smaller biotechnology and social media stocks are stretched. In February, Fed Governor Daniel Tarullo said the surge in small caps was one reason policy makers should ensure they weren’t creating systemic risk in financial markets.
“There’s a still of bit of concern,” Russell Rhoads, the author of “Trading VIX Derivatives” and a senior instructor for CBOE’s Options Institute, said in a July 16 interview at Bloomberg headquarters in New York. “If we do get some sort of market pullback, to me, the premium indicates that we’re going to see a bigger pullback in small-caps than large-caps, so investors are hedging against that.”
The Russell 2000 Index sank 0.4 percent yesterday, extending a two-week retreat amid speculation that earnings don’t justify share prices. The index is up 234 percent since March 2009. Excluding unprofitable companies, it trades at 20.5 times earnings, close to the highest level since 2007, data compiled by Bloomberg show.
Small-cap stock returns will probably be limited after analysts cut earnings forecast for this year by 13 percent, according to a July 18 report from Goldman Sachs Group Inc. Chief U.S. Equity Strategist David Kostin. The New York-based bank predicts the Russell 2000 will rise 4 percent in the next 12 months, versus a 6 percent gain forecast for the S&P 500.
The VIX fell 4.5 percent to 12.24 at 4:15 p.m. in New York, while the Russell VIX slid 5.4 percent to 18.39. The ratio of the small-cap volatility gauge versus the large-cap measure is about 20 percent above last year’s average.
Institutional investors are buying options linked to the small-cap index to protect their holdings from future losses, Patrick Fay, director of listed derivatives at Russell Investments in Chicago, said in a July 16 interview at Bloomberg headquarters.
On July 17, options volume on the Russell 2000 reached 260,000, the highest level in almost two years, as equities tumbled and tension intensified in Ukraine and the Middle East. For an exchange-traded fund tracking the index, almost 900,000 bearish contracts changed hands, the most since May, data compiled by Bloomberg show.
Faster U.S. growth and the busiest quarter for deals since 2007 make the stocks a good bet, said John Canally, an economic strategist at LPL Financial Corp. The economy has rebounded from a harsh winter and gross domestic product may expand 1.7 percent this year and 3 percent in 2015 and 2016, according to the median estimate from a Bloomberg survey of economists.
“Small-cap stocks are very focused on the U.S. and the U.S. is probably one of the best stories out there,” Canally said in a July 17 phone interview from Boston. His firm oversees about $447.1 billion. “We’re still overweight small-caps.”
Smaller companies are usually more dependent on the domestic economy. Russell 2000 companies get an average of 83 percent of their sales from North America, according to data from the firms in the index that provide the information in their financial statements. That compares with 70 percent for S&P 500 companies.
The retreat has led bearish investors to ramp up bets that the Russell 2000 will continue its 1.5 percent retreat this year. Large speculators such as hedge funds were net short about 42,000 contracts as of July 15, the most since December 2011, data from the U.S. Commodity Futures Trading Commission show.
“Valuations are no longer as compelling as they were a couple years ago,” Max Breier, a senior equity-derivatives trader at BMO Capital Markets Corp. in New York, said by phone on July 21. “Short-sellers are focusing their attention on stocks of the highest valuation once again, and these stocks naturally occur in the Russell 2000 versus the S&P 500.”