I have often talked about how Emerging Markets correlate very highly with small cap stocks in the U.S. for a couple reasons:

Emerging-markets1) Smaller companies tend to have higher cost of capital or more difficulty accessing capital markets when liquidity dries up or there are global shocks

2) Because the market caps of the companies in the Russell 2000 are smaller they tend to act like Emerging Market companies when markets liquidity changes and there is less ability to trade through difficult environments.

We have been very clear about our iShares Russell 2000 Index (IWM, quote) shorts on Fast Money and I have actively traded proxies over the last month to cover against market volatility or to switch to offense when I thought they were oversold and covered short before throwing them out again.

After what has been a large run of underperformance of the Russell 2000 to the SPX or S&P 500 (SPY, quote) we think small caps are a potential place for defensive positioning vs the SPX but also could be resilient against Emerging Market (EEM, quote) equities.

We would be cautious about the IWM hedge against EEM positions in the short term here and would seek to get our short Emerging Market exposure thorough some multinationals who are pegged specifically to Emerging Market (see: SIE, SAP – also have EU exposure as German companies, or autos like DAI, Fiat, VW).    

While EEM has underperformed the IWM by about 350bps YTD it was underperforming by significantly more in early March when the world was grappling with Fed fears but feeling pretty good about the U.S. economy.   And despite recent poor data points out of the U.S. economy, I would maintain we are in a place where the same dynamics are at work and other elements are at work which make long EEM short Russell a dangerous trade.

The U.S. Dollar (UUP, quote) is now more in play than it was in March despite the fundamental backdrop being similar to March. Fed exit, more positioning, other central banks globally still easing or needing to ease such as the BOJ and ECB.   Emerging Market growth arguably has slowed from mid-year and remains caught in the crossfire of lower commodity prices and global deflation.

 Trading:

Small caps have outperformed over last couple days to SPX and EEM and this may be more than short covering for many cross over players who see small cap also as a great hedge to U.S. slowdown fears. What many are coming to believe is that we are in a place where there are dynamics in place which are small cap relative positive to Emerging Market relative negative. We explain:

If you believe that the U.S. economy will continue to be an oasis in the weak global economy – BUY U.S. SMALL CAPs

  • Strong USD = more defensive small caps who get only 17% of earnings and 43% of exposure from foreign vs 35% earnings and 78% exposure for SPX (source: BAML)  - I believe the USD stays strong and thus in addition to the small cap relative benefit to SPX, there is also the negative correlation with EM equities form the strong USD that is hard to fight.
  • If you think global vol continues: small caps have lower correlation to MSCI world vs SPX (.8 v .92)
  • Small cap earnings growth more pegged to US economy – if you think US economy grows 3% or better (this is def. consensus on the street right now for 3Q and 4Q ) then small caps will do better (23% earnings growth v 3.8% earnings growth if below) (source: BAML)

 Conclusion:

Emerging Market equities are caught in between liquidity tightening concerns, and slower global growth despite having underperformed the U.S. large cap and small cap markets since October of 2010.

A strong run in late summer for Emerging Markets was built off improving macro and valuation arguments that make sense against the U.S. and developed Europe.

We think Emerging Markets are setting up for another run of outperformance to the U.S. but in the short run would be very cautious about using U.S. small caps as our hedge and might in fact be outright long the IWM for the first time in a long time…or at a minimum long small cap vs large cap in the U.S.

 EEM

 

 

 

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