We run several different models that help us to determine what the market is favoring in regards to style-growth/value and size-market cap and right now they are pointing to a potential mean reversion trade going long Large Cap Value against Small Cap Growth.
Looking at the chart below you can see that over essentially the last decade the Russell 1000 Value and Russell 2000 Growth ratio has reached extremes around 1.00 and .82. We are obviously nearing the lower end of the range where the Russell 1000 Value index typically takes over. (Click on chart to enlarge)
Russell 1000 Value/Russell 1000 Growth ETF Ratio
Since these types of mean reversion trades can last for a few years at a time it is important to look at as much data as possible. Looking at monthly Russell data from 1979 to now you can see in the lower panel below that when normalized using a 36 month moving average that the ratio is more than one standard deviation away from the norm. While it has been, and could definitely become more extended we are looking at this as a potential pairs trade using the ETF’s IWD for the Russell 1000 Value and IWO for the Russell 2000 Growth indexes. (Click on chart to enlarge)
R1KV/R2KG Ratio and Mean Reversion Charts
We also like the fundamentals of this trade. If as we believe we are going to see what we are calling a slowth (slow growth) period for at least the next year or so and possibly for the next five plus years (what PIMCO calls the “new normal”) it would follow that the market would start to back out of small cap growth stocks and go to areas where there is more safety of principal as well as decent and reliable dividends. This area typically is large cap value where most of the companies are diversified across the globe, across product lines, and have large cash positions. In addition to the macro landscape, on a valuation/expected returns standpoint this area is also favored by some well known asset class return forecasts such as the GMO 7-Yr forecast seen in the chart below. (Click on chart to enlarge)
GMO 7-Yr Forecasts for US Stocks
Disclaimer-The Macro Trader currently does not hold any of these securities.