IWM - Russell 2000

[thepupil]

With all this talk of the merit (or lack thereof) of Mr. Watsa's "hedging", I am curious if anyone else is short the Russell 2000. I looked for a dedicated thread but could not find one, though did see mentions of being long IWM puts etc.

 

I have taken about a 10% position around $112 and change over the past few weeks.

 

While there are ancillary hedging benefits, I am shorting with the intent to make money, rather than reduce volatility. This is the first time i've ever bought or sold an index and the conventional wisdom is that index shorting is stupid and won't add to long term absolute returns (it will just reduce vol) because in the long run, indices rise in value because of inflation and corporate earnings growth. It definitely is not worth paying someone to do, but i don't charge myself. It is also my first "macro" ish trade which everyone says you should not do and is stupid.

 

I believe that it is high time to question convention given the broad statistical valuation of the index along with anecdotal examples of hyped up small caps (cloud, biotech, 3d printing, growth stories etc.)

 

I think i lose on a permanent basis if

1) a true bubble develops like 40/50 PE and i relent and cover

2) earnings in aggregate grow like crazy and the companies collectively grow into their multiple

3) tail risk of hyperinflation where stocks go parabolic and venezuela on us as you are short a non cash asset and recieve cash.

 

Index shorting does have its appeal in that you can't get squeezed, borrow is always available, there is low cost of carry, margin requirements are low, etc. zero "alpha" which is guaranteed by shorting index is better than negative alpha which i've experienced in small bits by sitting on lit rockets like TSLA (which i am still short in small size and will fight to the bitter end, ya i'm stubborn).

 

Sitting on a lit rocket is the opposite of catching a falling knife and I'm quite proud to have thought of it as i think it captures the experience of shorting open ended growth stories. Any success i've had shorting which is slightly positive in dollars but low in returns per unit of stress and returns per unit of time, has been from shorting things that actually earn money since you can't just value those on the future. But i digress.

 

 

It is tough to pinpoint exact valuation Russell 2000 figures but there is:

 

the index's own measure of 21X not including negative earnings (so it would be materially higher if we included the ~1/3 of companies in the index that are not profitable)

http://www.russell.com/indexes/americas/indexes/fact-sheet.page?ic=US2000

 

WSJ has 81X trailing (probably wrong) and forward PE of 18 with a 1.33% dividend yield

http://online.wsj.com/mdc/public/page/2_3021-peyield.html

 

                                                  P/E RATIO

                                                                        DIV YIELD

          2/14/2014† Year ago† Estimate^ 2/14/2014† Year ago†

Russell 2000 81.27 32.33 18.53 1.33 1.90

 

 

 

Gurus and commentators:

Prem Watsa, been short for 3 years if i'm not mistaken (fairfax experts correct me)

 

Marc Faber Barron's Roundtable "I am negative about U.S. stocks, and the Russell 2000 in particular"

 

Joel Greenblatt:so we do have a bottoms up standpoint. russell 1,000, stock number 1 to 1,000. right now we’re in about the 38th percentile over our valuations. in the past when we’ve been at these valuation levels it’s been up 10% over the next year. it’s a different story for small caps. russell 2,000 is stocks number 1001 to 3,000. it’s in the fitth percentile. it’s been cheaper 95% of the time over the last several decades. and when it’s been here in the past, the year forward return has been a negative 3%. so large caps have a little bit better prospects than small caps. these are the indexes. there are opportunities.

 

http://www.valuewalk.com/2014/01/joel-greenblatt-rare-interview-magic-formula-video/

 

http://www.valuewalk.com/2013/11/us-small-caps-overvalued/

 

Some may recognize where I'm plagiarizing my sources from (VIC writeup). I did make the effort to find the sources public links. But yes, that's where I got the ideas for the valuation links.

 

Please proceed to tell me that cash is the only hedge, that i shouldn't do this, that i'm making a macro bet and that I should have just make more money on the long side rather than shorting to generate additional capital, that i'm young and stupid and will learn my lesson, that the market can remain irrational longer than i can stay solvent, etc. etc. etc.

 

[sys]

you are expecting that the index will perform as it has in the past - which has resulted in a mean 3% decline?

 

to my mind, you could do many things with less risk if you're targeting a 3% return.

[thepupil]

I don't have a hard expectation of a certain % return. The 3% is from a Greenblatt quote about an average 1 yr return in these types of conditions, not me talking about what i expect.

 

I expect earnings to not grow enough to offset what i think should happen in terms of a reversion of rating (multiple contraction).

 

Let's say Russell trades for 25X (22X ex negative earnings so i'm adding a bit for the zero to negative earnings guys). The drivers of return over some time frame  are earnings growth and exit multiple. I expect the combination of the change in those two things to lead to a positive return shorting the index.

 

I also expect this to happen in conjunction with some general worsening of market conditions, de risking, price decline or what have you. That is the hedging part and the traditional reason people short index.

 

If you can withstand volatility, there's no real reason to hedge or enter a trade that should have negative expected value over the long term (short the market). I have no clients and only report to me so there's no real reason to dampen volatility. I am not long a ton of small cap U.S. based stocks so I have "basis risk" between my longs and this particular short, which is fine for me in the size I have on at the moment but would become more problematic if I Watsa'd it all the way up to 100% short. 

 

My point is that the Russell may be at a valuation where one can short and actually expect to make positive returns, while also hedging.

 

Let's take a 5 year time horizon. If I think the Russell should be at a more reasonable 15X in 5 years, then I break even if earnings grow by 10.6% for 5 straight years and make money if they grow by less (before dividends, which actually aren't that bad since this provides cash which offsets borrowings that cost me 1.6% so the 1.3% Russell divvy is not a net detractor).

 

You can obviously play around with assumptions. Earnings grow 15% per annum and Russell trades at 40X five years from now and this trade will lose a solid 220% and will be in rough shape. Of course, that situation is not very likely, but the possibility of that is enough for some people to just say "i'll never short, the loss is unlimited"

 

I don't really understand why Prem shorted Russell 50% ago. He is 1000X smarter and more experienced than I, but I can definitely understand beginning to short it now and have done so. I can't be the only one...

[sys]

i shouldn't have used the word targeting.  just that, based on past performance, it doesn't look like there is a high probability of garnering appreciable returns.  based on the mean returns you listed, wouldn't you have a higher probability of a greater return if you were long on the russell 1000?

 

 

if you mean this as a hedge, rather than an investment, that's another matter.

[mcliu]

I have a similar position. On the iShares website, you can see the portfolio fundamentals. http://us.ishares.com/product_info/fund/overview/IWM.htm

 

Currently it's trading at 30x earnings, 4.5x BV, and 1.25% dividend yield. If you look at GMO's 7 year forecast, U.S. small caps are expected to return -4.9% annually. I think IWM is a decent proxy for that.

 

My thinking is that my small cap long positions will outperform this index over the long run.

[thepupil]

sys, upon re-reading your post and mine and thinking it over some, I'll rephrase in an attempt to be more intellectually honest. It is a hedge, an imperfect and indirect hedge that i believe is likely to  make money in many different circumstances other than the type of situation I am hedging. I don't think i need a broad based market crash or crisis or anything like that to make 20% or 30% in a year or 2 shorting IWM. And because I am not long a bunch of small caps, it is also a bet.

 

It is a hedge/bet whose cost is unknown and because of the very high starting valuation, I believe its cost will be negative over a number of time periods (obviously as your time horizon increases your short at today's price becomes less and less likely to make money because hopefully earnings are growing over time).

 

mcliu, thanks for that, didn't even think to look on IWM's website lol. I've seen many different P/E's and stats between bloomberg, Russell, MSCI, WSJ, this and that. I take comfort in that they are all very high!

 

And I also take comfort that i did not think to do this 20 or 30% ago a i probably could've seen the data then and done the same thing. That is the risk of shorting. I get to enter Prem's (and many others' I presume) bet at much better prices.

[sys]

i would be very leery of shorting a basket of growing, viable companies based on valuation (and especially so when similar valuations in the past tended towards pretty small corrections over the course of a year).  however, i was moved to temporarily shift the funds in my 401k invested in a small cap index fund to other index funds based on the information you presented here.  so, thanks for presenting your thesis.

[Aberhound]

I looked at the Russell 2000 as well. There are a bunch of news articles if you google it. It is trading at high value but still well below past peaks so perhaps being a value investor as usual you are too early? Much of last years' increase is driven by ETFs and institutional investing. So I thought for now the better approach for a value investor is to find the better companies and if you short, short only the lousy companies which benefited from the lazy index investing. Some enterprising value investor should set up such an ETF! Ray Dalio says we are half way through the short term debt cycle so it is like 2004 or 2005 and the Russell 2000 is not so sensitive to rising interest rates. There is also massive technological innovations and this index is the most likely place where this action will occur. Finally a lot of capital will flow to the US for this reason.