Last summer, I often covered the difference in short-term performance between the Russell 2000 and S&P 500.  I suggested that the VIX, as a measure of implied volatility, was a good predictor for this capitalization premium, and that claim often held up.  I even went so far as to analyze the high-amplitude periods of this relationship.  However, as the actual volatility of volatility has increased dramatically since last fall, my suggestions have been more and more difficult to implement. 

I wanted to explore why this relationship had changed, and so I've taken a look at the Dow 30 (DIA), S&P 500 (SPY), and Russell 2000 (IWM) since 2002.  The figure below shows the cumulative return of each index ETF in the top pane.  The bottom pane shows  the trailing 100-session percentage-correlation between each pair of indexes.

One of the most striking features of these plots is that all three indexes are trading at or above their highest historical correlations on this range.  The only timespan of comparable length was during late 2002 and early 2003 as a short bear market held sway. 

The other relationship that caught my eye was that the trend in correlation between the indexes was inversely related to the overall market performance.  In other words, as the correlation between indexes fell, the markets rose on average.  Furthermore, during these falling correlation periods, the Russell often outperformed its counterparts, and vice versa in rising correlation periods.  This relationship likely reflects the fact that the capitalization premium and discount on small caps and large caps is very much a function of the strength of the economy and credit market. 

In the future, I'll be watching closely for a decline in the correlation between these indexes as a confirmation of overall market uptrend.

    I've taken some of the most commonly referenced indexes and calculated a general comparison of their respective tracking ETFs' behavior over the past 1600 sessions.  All numbers are calculated on daily adjusted log-returns.  Once these first four moments and the Omega measure are calculated, I rank them as optimally desired - increasing mean, decreasing standard deviation, increasing skewness, decreasing kurtosis, and increasing Omega ratio.  Finally, the indexes are sorted by their average rank as shown in the last column.

• DIA: DIAMONDS Dow 30
• IJH: iShares S&P MidCap 400 Index Fund
• IJR: iShares S&P SmallCap 600 Index Fund
• IWB: iShares Russell 1000
• IWM: iShares Russell 2000
• IWV: iShares Russell 3000
• SPY: SPDR S&P 500

Index Ranking

    The results are somewhat surprising and likely due to the equal-weighting of rankings.  Other than the Dow 30 Diamonds, the iShares ETFs seem to take the cake as a whole, with the S&P 600, S&P 400, and Russell 3000 taking the top three spots. 

The log-return of the S&P 500 today outpaced the Russell 2000 dramatically in a fashion only matched 6 times over the last year.  Assuming similar conditions, it is likely to be the case that shorting the S&P 500 tracker SPY and going long on the Russell 2000 tracker IWM would be a profitable strategy.

In my opinion, the most indicative relationships to watch in these graphs are:

1. Russell and S&P (IWM and SPY): Note how they have diverged in the month and week graphs.
2. Consumer Discretionary and Consumer Staples (XLY and XLP): Note how Discretionary and Staples fall on opposite sides of the Russell/S&P nodes in the 6-month and 1-year graphs, with discretionary tied more to the small cap Russell index and staples tied more to the large cap S&P index, as would be expected.  However, in the past week, the opposite is true, implying that consumer staples is more tied to small caps than large caps, and likewise inversely for consumer discretionary.
3. Energy, Industrials, and Utilties (XLE, XLI, and XLU):  Note how these three have slowly diverged over each progressive duration graph.  Normally factory production is directly tied to utility and energy utilization, but it appears that this correlation is not present in the short term.

1 Week MST

1 Month MST

6 Month MST

1 Year MST

    Though the VIX touched below 20 during Wednesday morning, afternoon jitters and an investor-focused statement from President Bush led volatility higher into close.  Between close and Thursday's open, data and sentiment swung in favor of the bears, with this trend continuing well into today's trading.

    Treasuries continue to strengthen, as even gold's 2% burst rally today has not matched the persistent strength seen in the 5- and 10-year bills.  The S&P likewise remains weak relative to fixed income today.

    Again though, the Russell continues to make up losses against the S&P.  This is somewhat perplexing, as a tightening credit market should affect smaller firms with less collateral and cash much more than large firms that can sustain growth out of pocket.  Some of the correction is likely due to the S&P's heavy financial weighting, as well as the already-overextended difference between the two over the last month.

    The VIX has broken below 20 just before 10:30 in morning trading on what appears to be convincing volume.  Though China and yesterday's FOMC statement have been taking their toll on treasuries, the volatility correction seems to be most apparent in the correction going on between the Russell 2000 and the S&P 500.  Note how the Russell's differential strength versus the S&P skyrocketed, forecasting the VIX drop.  The market seems to accept now that the FOMC statement did not change its stance on the relative securities of large and small caps over the last month, and is thus correcting accordingly.  As of 11 o'clock, the Russell ETF is trading at over twice the return of the S&P 500 ETF, with IWM up over 3% and SPY up near 1.25%.