Those new to the equity space might think of the “stock market” as a singular entity that summarizes the state of all public companies, whereas more experienced traders will clarify that the current state of stocks depends on the index you subscribe to. This idea is especially relevant now, as the Nasdaq rests near all-time highs and other indices such as the Small Stocks 75 (SM75), S&P 500, and Dow Jones fight to reach unchanged on the year.
How could this be? Well, for one thing, the Nasdaq and Small Stocks 75 do not hold all the same stocks – the Nasdaq favors technology stocks while this sector is only one of five diversified sectors in /SM75 – the futures on the Small Stocks 75 index. More significant, given current stock trends, might be the weighting of the two indices. While both indices are exposed to the four largest companies in the US – Apple, Microsoft, Amazon, and Google – they make up more than 40% of the Nasdaq and less than 10% of the Small Stocks 75.
Creators of SM75 opted for a different view of the same “stock market” by attributing relatively equal weightings to all its constituents. The Small Stocks 75 tracks those outperformers listed above, but it also has a healthy dose of stocks that are currently unchanged, like the financial Visa, and underperforming, like the airline American. While these stocks are present in many indices such as the S&P 500, their presence is not fully felt with their much smaller weightings relative to the big names.
Investing in the Future
The Small Stocks 75 has greatly underperformed the Nasdaq, but this comes while the stocks that make up the greater part of the Nasdaq are exhibiting outlier moves to the upside. The value play of /SM75 could prove a better long-term investment moving forward, and its more diversified approach could make for smaller losses if the outperforming technology sector ever falls out of bed.
Speculating on Short-Term Divergences
There is also potential opportunity for more active traders eyeing the 30% difference between the Nasdaq and Small Stocks 75 in the first six months of 2020. The one standard deviation measure, which dictates how much variation there is between markets about 68% of the time, is 8.5% over six-month rolling periods since 2016. While these indices have their distinctions, they still boast a high positive correlation. Finally, the six-month difference between the two was at its highest in the last four years just last week.
Pairs trading the two markets takes advantage of convergences and divergences by applying opposing positions. The current ratio of /SM75 to Micro E-mini Nasdaq (/MNQ) futures is 4 units to 1 unit.