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Risky Stock Trades Back in Fashion as Investors Play Catch-Up

Small-cap stocks are back in vogue for hedge funds.

Risky Stock Trades Back in Fashion as Investors Play Catch-Up
A trader talks on the phone while working on the floor of the New York Stock Exchange. (Photographer: Michael Nagle/Bloomberg)

(Bloomberg) -- The megacap safety trade that has ruled stocks for months is slowly giving way to a broader embrace of risk among investors captivated by tentative signs of a turn in the economy.

Small-cap stocks are back in vogue for hedge funds. ETFs tracking economically sensitive sectors are seeing large cash infusions. And investors are bailing from groups that had led the rally previously, among them health care.

The positioning is a lens into broader market psychology, with everyone from tiny retail investors to institutions scrambling to get in front of economic reports they’re increasingly convinced show the economy has bottomed. A data dashboard tracked by Bloomberg is showing stabilization or slight improvements in mortgage applications, airline trips and filings for jobless benefits.

“That’s where the opportunity is because those are the parts of the market that haven’t participated as much,” said David Spika, president of GuideStone Capital Management, which has about $12.5 billion under management. “The fear of missing out is definitely a big factor in this.”

Risky Stock Trades Back in Fashion as Investors Play Catch-Up

While economic data is still awful by any historical comparison, among investors, a consensus is clearly building that the worst is over. The positioning explains days like Tuesday, when the S&P 500 jumped 1.6% and an index of small caps rose 3.5%. With big groups like tech and health care holding steady, gains in more speculative categories are fueling a second leg of the recovery rally that has restored $6 trillion to share values since the March bottom.

Companies, industries, and equity styles that were pummeled in the sell-off roared back after the holiday weekend. United Airlines Holdings Inc., Royal Caribbean Cruises Ltd and MGM Resorts International all surged at least 12% Tuesday. The KBW Bank Index jumped nearly 10%, the most since March 24, the day after stocks bottomed. A Dow Jones market neutral index of value stocks that reflects a portfolio that goes long the cheapest stocks and shorts growth shares rose almost 4.5% in its best day since at least 2002.

The most famous benchmarks also felt the shift, with the Dow Jones Industrial Average, whose venerable Old Economy names have been a major drag on its returns, handily beating the S&P 500 and Nasdaq 100 on Tuesday. The Russell 2000 index of small-fry stocks is beating the S&P 500 by more than 3 percentage points this month, the most since May 2018.

“People get more confident and look for things that haven’t made a move,” said Sandy Villere, portfolio manager at Villere Balanced Fund.

Read more: Tracking the Recession -- High Frequency Dashboard

To Jefferies’s Steven DeSanctis and Eric Lockenvitz, there’s historical precedent for these areas of the market to outperform once a recovery begins. With GDP set to sharply rebound next year, smaller companies could get a bigger boost both in earnings growth as well as returns, the strategists wrote in a note. Over the last 10 recessions, small caps have beaten large nine times, with average returns of 37% one year after the economic downturn ends versus 21% for large, they said.

Risky Stock Trades Back in Fashion as Investors Play Catch-Up

At Morgan Stanley Wealth Management, Lisa Shalett also favors cyclicals over defensives and value over growth plays. Shalett, the firm’s chief investment officer, says consumers could prove more resilient than expected, and recommends taking profits in high-flying names and rotating toward laggards. What matters for investors is the direction and rate of change of data, not the absolute levels, she wrote in a note.

“Inflections and positive surprises in the macroeconomic data are quickly factored into earnings estimates, separating leaders from laggards,” she said. “In that vein, we expect the biggest positive surprises and rates of change to occur in classic early-cycle, consumer-related sectors.”

Hedge funds are starting to position for a comeback, too. After scaling back their short exposure in the Russell 2000 Index since late April, they turned long small-caps last week, data compiled by the Commodity Futures Trading Association released on Friday show. Speculators were short the group for nine consecutive weeks.

Risky Stock Trades Back in Fashion as Investors Play Catch-Up

Though exchange-traded funds tracking small-cap stocks have seen outflows this year due to their heightened credit risks, they could draw inflows from investors anticipating a recovery, according to Bloomberg Intelligence’s strategists including Morgan Barna. Already, Vanguard’s small-cap growth ETF, which goes by the ticker VBK, has seen nine straight weeks of inflows. Investors have also thrown money at funds tracking economically-sensitive sectors, with materials on track for the best month of inflows since November.

Meantime, pockets that stood to benefit in recent weeks, including health care, are getting shunned. State Street’s health care fund XLV lost about $595 million last week in what was its largest weekly outflow since March 2019, Bloomberg data show.

“The gains have been made so people are looking for somewhere else to rotate to, to the next area of recovery,” said Bob Phillips, managing principal at Spectrum Management Group.

To Phillips, the fact that more areas of the market are participating in the recovery is a positive signal. “That’s broadening out the recovery across more and more stocks,” he said. “It adds to the overall breadth of the economy.”

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