Trading the trade war : A trade idea for the US-China trade war, Long small caps, Short large caps
By: Keeno Ruark Koopman
Tags: Stock Market, Tarrifs, Economics, Trade War, Trading

This is a trade idea report i wrote for my university’s traders club. I compiled this on August 9th 2018 — before any of the actual tariffs were enacted

Trade idea: Long Small Cap US Equities, using an ETF that tracks the Russell 2000 Index. The Russell 200 serves as the benchmark for small cap stocks in the US. Our ETF of choice being IWM, an ETF which is essentially a mirror of the Russell 200, tracking its performance at a 1x level. We are essentially long the Russell 2000.

The second part of this trade idea is to short US large Cap Equities, using an ETF that tracks the S&P 500 index. The S&P 500 is a market cap weighted index of the largest 500 publicly traded US companies. Our ETF choice being SPY. An ETF which is a mirror of the S&P 500, tracking its performance at a 1x level. We are essentially also short the S&P 500.

Presuppositions Of The Trade

Preface: I believe the presuppositions behind a trade are just as — if not more — important than the actual trade itself. The reason behind why you enter a trade is what determines your entry and exit and it also allows you to control your emotions when price action goes against you. This is why such a big focus is placed on the why behind the trade. Without the why, a trade is just an order to buy or sell a security.

This trade along with the other 6 trade ideas we will be presenting, all center around the effects of a trade war between the US and China, which has the potential to expand to the rest of the world. A good example of this contagion being the recent tariffs on US imports by the EU. The effect that this trade focuses on is the tariffs imposed on US exports by China, and most recently, the EU. The core relationship here being that increased tariffs on US exports will result in higher prices for imported US products, resulting in lower revenue and lower earnings. This will negatively affect the profit of companies heavily reliant on exports. The theme of export dependence is central to this idea.

A question that breaks down the main presupposition of this trade is: “What if the trade war doesn’t happen?” Now this is a valid and very important question. We believe that trade war developments have reached a critical stage. An inflection point from being a possibility to now being an inevitability. The inflection point I’m referring to was Trump’s recent announcement that there would be $200 Billion worth of Chinese imports subject to a 10% tariff. This is in addition to all the prior tit-for-tat tariffs between the US and China. This announcement was important for 3 reasons:

Market Sentiment — After this announcement was made, not only the US but global markets where badly offended. The US expanded its losses after the announcement for the rest of the week while China saw some of its worst losses for the year. Up until this point, the market has had a fairly subdued reaction to trade war news. It is a well-known fact that in the short term, price movement is highly tied to market sentiment. And a clear change in sentiment has been observed. Reaction by the Chinese government — After Trump’s announcement, the Chinese minister of commerce made the following harrowing statement: “The US has initiated a trade war,” adding that it will respond with “comprehensive quantitative and qualitative measures and retaliate forcefully”. This all but confirms the inevitability of a trade war and paves the way for further tariffs. EU involvement — Nearing the end of last week, the European Union announced tariffs on $3.4 Billion worth of US imports. While this amount is dwarfed by the hundreds of billions being thrown back and forth between the US and China, it has opened up a second front of conflict and a second headache for the US economy along with US equities.

Why Small Cap stocks ?

Firstly, what exactly is a small cap stock? Small Cap is short for small capitalization. It is used to classify companies with a relatively small market capitalization — the market value of its outstanding shares.The definition of a small cap stock differs between brokers but it is generally considered as a stock with a market cap between $300 million and $2 Billion. To put this into perspective, the market cap of a large cap tech giant like Amazon (AMZN) is $820.56 Billion.

Small cap stocks are companies who operate on a small scale and as a result have a much lower global presence than large cap companies and focus on domestic markets. This means that less revenue is derived from global markets. Essentially, small cap companies are less export dependent than large cap companies. We mentioned how export dependence is central to this trade idea. This is because companies who are heavily export dependent could potentially take a large hit to bottom lines because of the tariffs imposed by China and most recently the EU. Very simply, our small cap companies who aren’t export dependent will not be affected by this.

Essentially, trade tariffs attack multinational companies and stocks that derive most of the revenue from the domestic US market have the advantage. To put this in numbers: the S&P 500 (Large cap) generates 38% of their income from foreign markets while those in the S&P Small Cap 600 only derive 20% of their income from foreign markets.

Very simply, the same reasons why we want to be long small cap stocks with a smaller exposure to global markets and hence lower export dependence are the same reasons why we want to be short their large cap counterparts with greater global market exposure and higher export dependence. Being short large caps is simply another way of expressing this trade and another potential source of alpha. The same factors driving investors away from large cap stocks: import tariffs hurting export dependent companies — are the same factors which will push investors into short cap stocks.

Now For a Quick Look At The Proposed Securities For The Trade: IWM & SPY

Below: 1 year graph of IWM and SPY with 1 day intervals.

Green line: 50 Day SMA; Pink line : 200 Day SMA

IWM:

IWM has had great market beating performance for the year. Returning just under 20%, beating out the 13% of the S&P 500 in the same period. The small cap trade has been a popular one in 2018, as market participants fear for the health of large caps because of the possibility of the trade war and other geopolitical issues which small cap’s have lower exposure to. It’s safe to say that momentum is on our side in this respect. It must be noted that we have also selected iShares due to its high daily trading volume.

Now for a quick look at SPY:

There is not much more to say about SPY other than it has performed worse than IWM. It is also important to not that SPY has recently tested its 50 day SMA.We put these graphs here for our more technically inclined members as we do realise that our trade ideas are heavy in fundamental analysis.

Time Horizon Of The Trade And Entry & Exit

This trade is one reliant on macroeconomic development. Because of this, we are not reliant on a technical indicator for entry and exit but can use them to better aid us.

When it comes to entry I see now as the perfect time for entry because of the reasons explained above. In short: it seems as if we have reached an inflection point in the trade war narrative and at this point, a trade war seems inevitable.

Because this is macroeconomic trade, exit depends solely on if the narrative surrounding trade wars change. What would change this narrative would be policy coming from either China or the US aimed at cooling down the prospect of a trade war. For this reason, our exit is not at a specific price level but is rather situational.

The entry and exit of this trade also explains the time horizon when dealing of a trade of this nature. From the offset, this seems to be a medium-long term trade. While sentiment can and has driven price action in the short term, it will take some time for the effects of tariffs to be seen in earnings.

Now let’s get to the possible shortcomings of this trade.

Devil’s Advocate

I want to quickly go over what can wrong with this trade idea. There are two main factors I want to address:

A possible bear market in equities — There are many potential headwinds when it comes to US equities, including geopolitical issues, macroeconomic issues such as trade wars and regulations as well as rising rates pushing investors out of risk assets. All of these factors could spark a possible bear market in equities. If this were to happen, our short position in large cap equities could soften the blow that our long position in short caps would take. In this sense, we have some kind of protection from the prospect of a bull market. Nevertheless, this is a valid fear to keep in mind. Policy aimed towards defusing the trade war — While at this point it seems unlikely, there is always the possibility that either the US or China takes steps to ease trade war tensions. Again, if this were to happen, we would see a rally in both small and large cap equities. In this case, the long position in small cap equities will help soften the blow that our short position in large cap equities will take.

Playing devil’s advocate with this trade reveals one strength of the trade. Because we have both a long and a short position (essentially a pair trade) we have reduced risk. As pointed out in the above scenarios, having both positions offers some kind of protection in the event that our thesis is wrong. This is the beauty of pair trades.

To conclude: This trade idea is a simple one that plays off of the possibility of a trade war. We are essentially entering a pair trade being long small cap stocks and being short large cap stocks. The reason behind this being that larger firms who have a higher export dependence will be hurt by import tariffs, causing investors to turn to small cap equities.

Return isn’t everything; it’s the only thing.

Keeno Ruark Koopman