When you boil the stock market down to its core, it’s really about supply and demand.
And if you can get an “advance notice” that there’s about to be a big shift in either of these …
It can present you with some killer profit opportunities.
For example, on Monday we’ll see new banking regulations go into effect that will send demand for gold skyrocketing, and, as a result, likely send the price of gold soaring in the weeks ahead. We could also see a resulting announcement from China announcing higher-than-anticipated gold reserves, which could have hugely detrimental consequences for the dollar.
Knowing this ahead of time, I’m able to anticipate potential shifts in demand, and anticipate changes in volatility and commodities.
But if I didn’t have a head start, it would be much harder to play events like this to my advantage.
Option Pit Commodity Expert Bill Griffo and I discussed the huge impact of these new regulations during the Digital Currency Arms Race: On The Brink live event this past week.
If you missed it, you can watch it here, so you’re not caught off guard when the new rules go into effect this Monday.
And that’s not the only market event I’ve been watching with anticipation.
Friday brought us one of – if not the – highest trading volume days of the year as the $47 trillion FSTP Russell group of indices underwent rebalancing. These indices serve as the benchmark for over $9 trillion in investor assets.
The FTSE Russell manages multiple indexes, including the Russell 1000 (top 1,000 largest market cap U.S. equities) and Russell 2000 (which tracks the 1,001 to 3,000 market caps). The indexes are rebalanced annually to reflect the current state of the market.
The initial rankings, which tell us which stocks made the cut, and which are being given the boot, are initially released in May, but because the indexes aren’t reconstituted until market close on the last Friday in June – which was yesterday – there’s usually some last-minute changes.
This year, a big focus was on meme stocks such as GameStop (Ticker: GME) which has seen huge growth in 2021, and is slated to be moved from the small- and mid-cap Russell 2000 to the large-cap Russell 1000. Fellow meme target AMC Entertainment (Ticker: AMC), however, was not slated to follow suit after May’s ranking, but it’s huge rally so far this month had plenty of investors wondering if it could be a last-minute inclusion.
Because of the sheer magnitude of the rebalancing, the shift can have huge impacts on the supply and demand for the equities affected, which can result in significant volatility and price-swings. And since the list of companies affected is released early, it is possible for traders to try and capitalize on the potential volatility and price movement.
But these trades still have a fair amount of risk to them. The FTSE releases an updated list each week in June as further guidance for what traders can expect, but nothing is ever set in stone until the rebalancing actually takes place.
Rather than trying to make a bullish play, I see the opportunity to fade some of the newly-listed companies, especially if they’ve run higher into the listing date.
It’s also not uncommon to see a sell-off going into the close, just before the rebalancing.
For example, First Western Financial Inc. (Ticker: MYFW) and Mimecast (Ticker: MIME) were both added to the Russell 3000 Index on June 26, 2020. Heavy selling action into the post-close reconstitution weighed heavily on the shares.
Charts courtesy StockCharts
And we’re not done yet!
In case that wasn’t enough, we’re also looking ahead to the quarterly rebalancing of the Invesco S&P 500 Equal Weight ETF (Ticker: RSP).
RSP is an equal-weighted ETF that holds the same equities as the S&P 500 (Ticker: SPX). But while the S&P 500 is market weighted – meaning larger companies account for a larger share of the index – the RSP instead allots an equal amount of its holdings to each of the S&P 500’s components. This gives smaller companies equal weight to the larger-cap stocks that tend to dominate the S&P 500.
For example, Apple (Ticker: AAPL), Amazon, (Ticker: AMZN), and Microsoft (Ticker: MSFT) – just three of the S&P 500’s components – account for over 15% of the S&P 500’s holdings. Meanwhile, companies such as Perrigo Co. (Ticker: PRGO) and Gap Inc. (Ticker: GSP) make up less than 0.02% of the market-weighted index. However, all of these companies account for an equal percentage of the RSP.
There’s no clear consensus on whether equal-weighting has concrete benefits when compared to market-weighting, and results are mixed.
Chart courtesy of Invesco
One argument for equal weighting is that smaller cap stocks tend to have higher growth potential than large caps. However, small caps also tend to be more volatile, making equal weighted ETFs more risky.
Equal-weighting does prevent the index from becoming “cap heavy,” and overly dependent on the performance of just a few top stocks, which is good for portfolio diversity.
Equal-weighting also helps prevent overexposure to particular sectors. For example, tech stocks make up a significantly larger proportion of the S&P 500 compared to the RSP, to a pullback in tech stocks (like we saw not so long ago) has less of an impact to RSP’s overall performance. Of course, that also means RSP benefits less from outperformance of those same sectors, so it’s a bit of give and take.
In order to keep its portfolio components equal, RSP undergoes quarterly rebalancing, where it sells outperforming stocks and buys its underperformers. In essence, it sells high, and buys low. This actually gives the index a slight contrarian tilt compared to its market-cap-weighted peers, as well as a smaller overall average market cap.
It also temporarily boosts demand for the underperformers, as RSP adds more to their holdings, while weighing on the outperformers, which are sold off to rebalance.
Knowing this is coming down the pipeline can give traders a good opportunity to make plays accordingly, focusing on the smaller S&P 500 members that will be more likely to show the impact of this rebalancing on the charts.
But as always, practice good money management, because there is always significant risk involved when playing into, or after, a catalyst event.
Your Only Option,