The 'Style-Box' Trade

 | May 08, 2014 | 12:00 PM EDT  | Comments
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Stock quotes in this article:

iwo

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iwo

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ive

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ive

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feye

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spy

There are times in markets when people get inappropriately wound up on whether the market is going up or down, what it is doing directionally, when meanwhile, all kinds of interesting stuff is happening below the surface. 

Like now.

Over the last few weeks, small-cap growth has gotten absolutely annihilated (see the iShares Russell 2000 Growth Index ETF (IWO)), while large-cap value and emerging markets have done great. This is what I like to call a "style-box" trade. The overall market hasn't really moved at all. But you'd never know it, because there is a lot of pain out there, not only among retail investors but in the professional community as well.

Here's why. Style-box trades work for years and years. I distinctly remember large-cap growth working throughout the late 1990s. It worked and worked and worked. Then, during the bear market, value stocks not only outperformed but rallied hard, with small-cap value rallying the most. That trade worked for about three years. Three years is a long time.

The point is, do not mess around with style-box trades. There are usually important fundamental reasons why they persist. It may be tempting to stand in front of a trade like this, to look at a stock like FireEye (FEYE), which is down almost 75%, and take a shot, but it's probably unwise. 

Before exchange-traded funds, these trades could be difficult to take advantage of, outside of open-end mutual funds. But there are multiple products available for each quadrant of the style box: large-cap, small-cap, growth and value. If you want to be short small-cap growth (IWO) it is just as easy to be long large-cap value (iShares S&P 500 Value ETF (IVE)), and if you're right, and this is a long-term trade, this can work for thousands of basis points.

These are not sexy trades at all. But a style-box trade done right by even the most unsophisticated of investors can be a big home run. Back when I didn't really know what I was doing, I owned a small-cap value mutual fund in the early part of the 2000s that gave me a triple-digit return over the course of a couple of years. It's not something to be taken lightly. And if you know that small-cap is broken, you don't go hunting for long candidates among small-caps, because you'll be pushing a rock uphill.

Of course, people continue to try and play the index, because it's fun. A friend of mine was lamenting his decaying SPDR S&P 500 (SPY) puts today, having had the right idea, but since it was a style-box trade, the overall index was unchanged. Some people are calling this a sector rotation, and for sure, some sectors are outperforming, but this is really about small vs. large and growth vs. value.

Remember, as traders, we do what works. If tech and growth don't work anymore, don't do it. Find out what is working and do that instead. My wall has enough dents in it from me beating my head against it over the years.

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