Early humans moved in herds – not just for protection, but to build social bonds and to share resources.
That instinct to stick together shaped our evolution.
And, while the world has changed, that herding mentality is still very much alive today.
Herding in Markets
As traders and investors, we need to recognize that these human instincts live in all of us.
The first step is making sure they don’t drive our decisions in the market.
But here, we take it further — we look to spot those same flaws in others, often before they even realize it themselves.
This behavior plays out in markets every single day.
And if you know where to look, there’s money to be made from it.
The Herd Hates Small-Caps
One area of extreme vulnerability, in my opinion, is in small-cap stocks.
Here’s a chart showing the small-cap iShares Russell 2000 ETF (IWM) at the exact same price levels that it was four and a half years ago:
For context, the large-cap SPDR S&P 500 ETF (SPY) and the Invesco QQQ Trust (QQQ), which tracks the Nasdaq-100, have each averaged more than 16% per year over this stretch.
Again, the small-cap Russell 2000 has had zero return this entire time.
Humans feel safer huddling in large-caps and steering clear of small-caps.
That sense of security – and the comfort of moving with the crowd – runs deep.
It’s an instinct rooted in our evolutionary past, passed down from our ancestors who knew survival meant sticking close to the herd.
Herding to Extreme
You can clearly see this flow of capital when you line up the small-cap IWM against the large-cap iShares Russell 1000 ETF (IWB):
But here’s the thing: The initiation dates for each of these index funds was May 2000.
The ratio between small-caps and large-caps is now all the way back down to those levels where they got started more than 25 years ago.
Last time this ratio was down here, small-caps went on to outperform over the next decade.
Will this time be like the last time?
Futures traders are flocking in unison, currently holding their largest net-short position in the Russell 2000 on record.
From extremes in positioning come massive unwinds in the market.
As it turns out, the same herding instinct that once kept our ancestors safe is one of the most dangerous things you can do with your money.
Most investors have no idea they’re doing it.
Some know – and they still can’t stop.
We know. But we act. And we profit by taking the other side.
I think everybody’s wrong here, and there could be a historic ripper in small-caps setting up.
We haven’t seen it kick off yet. But we’re monitoring the situation closer than probably anything else out there right now.
I encourage you to do the same.
Stay sharp,
JC Parets, CMT
Founder, TrendLabs