Michael Burry's Russell 2000 Short

Why Michael Burry may be wrong about his Russell 2000 verdict.

Summary
  • Michael Burry shorts the Russell 2000
  • Based on inflation and past returns, you could say the Russell 2000 is a good short candidate.
  • However, other key data suggests it isn't the best of moves at the moment.
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For those not familiar with the Russell 2000 (^RUT, Financial), it is an index of small-cap stocks which includes the likes of AMC Entertainment Holidngs (AMC, Financial), Intellia Therapeutics (NTLA, Financial) and Crocs Inc. (CROX, Financial).

Michael Burry of Scion Asset Management recently made a bearish bet on the Russell 2000; in fact, this positon makes up 1.61% of his portfolio. It's a bold move considering certain metrics, in my opinion; even if inflation and past returns may seem to suggest that shorting the index could be profitable, other factors lead me to believe that's not necessarily the case.

Small-cap stocks are volatile in nature, but they can be very lucrative. The main driver for small-cap stocks is GDP growth. Although it's anticipated that GDP will be lower in the fourth quarter and in 2022 than initially forecasted, you need to ask yourself the question of whether 5.9% growth versus 7% growth (2021 forecast) and another 4.9% in 2022 is a real slowdown in growth or just a numerical adjustment, because historically speaking, 2-3% growth in GDP is considered to be excellent (and yes, I'm aware you need to account for recovery growth). GDP growth may need to be higher in order to account for hot inflation numbers, but it's still unknown how much extra GDP growth will be needed to account for higher inflation.

Furthermore, if we look at the forward price-earnings ratio of the Russell 2000, it's not exceptionally high. As a matter of fact, it suggests a 10-year annualized return of 8%.

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Source: Bank of America (BAC, Financial)

If we look at this statistic out of isolation, we'd have to conclude that it stacks up fairly against the rest of the market, which is significantly overvalued. The Buffet indicator suggests that the broader stock market is 204.7% above GDP and likely to return -3% per year for the next year, even if you include dividends.

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Source: GuruFocus

Final word

Yes, the Russell 2000 does include some stocks that have faced irrational upside recently, which you could probably short individually. However, it doesn't make sense to me to be short the entire index based on how undervalued it is relative to other indices. It's true that inflation does hurt small-cap stocks, but you've got to ask yourself whether that should be the only independent variable to look at.

Disclosures

I/we have no positions in any stocks mentioned, and have no plans to buy any new positions in the stocks mentioned within the next 72 hours. Click for the complete disclosure