Latest / The Bear Market Podcast with Fexingo: Surviving Downturns, Buying the Dip, and Long-Term Resilience / Why the Russell 2000 Isnt Pricing a Recession
Transcript
- Lucas: The S&P 500 hit a new all-time high this week at 7,575, up half a percent over five days. The Nasdaq is basically partying alongside it. But the Russell 2000? Down 1.1 percent over the same stretch. That is a chasm. Luna: And it's not just this week. The Russell has been lagging for months. So the question is: is the small-cap index sensing something the big-cap indices are ignoring? Lucas: That's exactly the question. Historically, small caps are more sensitive to domestic economic conditions. They have less pricing power, more floating-rate debt, and their earnings are more tied to the US consumer. So when the Russell starts to stumble while the S&P 500 is making new highs, it's worth asking whether the market is pricing in a recession that hasn't hit the headline indices yet. Luna: Let's start with the data. The yield curve is still inverted at 35 basis points — the 10-year at 4.54, the 2-year at 4.16. That's been a reliable recession signal historically. But it's been inverted for over a year now, and we haven't had a recession. So maybe the curve is wrong, or maybe it's just early. Lucas: Right. And the VIX is at 15 — that's low. So the options market is not pricing in a lot of near-term fear. But the Russell's weakness is a real-time data point that contradicts that calm. Let me put a number on this: the Russell 2000 is down about 8 percent from its high earlier this year. The S&P 500 is up about 6 percent over the same period. That divergence is unusually wide. Luna: When was the last time we saw a divergence this big? Lucas: You have to go back to the second half of 2023, when the Magnificent Seven were carrying the S&P while the rest of the market struggled. But even then, the gap wasn't this pronounced. What's different now is that the Russell's weakness is happening alongside a yield curve that's still inverted, and GDP growth that's actually accelerating — real GDP grew at 2.1 percent annualized in the first quarter, up from 0.5 percent the quarter before. So the macro picture is mixed. Luna: Let's talk about why small caps might be struggling. One theory is that they're more exposed to higher interest rates. Their debt is often floating-rate, so when the Fed keeps rates high, their interest expense goes up. The 2-year yield is at 4.16 percent — that's still elevated, even if it's come down from the peak. Lucas: That's a big part of it. The Russell 2000 has a higher proportion of companies with negative earnings or high debt loads. According to data from Bloomberg, about 40 percent of companies in the Russell are not profitable. In the S&P 500, it's more like 10 percent. So when credit conditions tighten, the Russell feels it first. And we've seen bank lending standards remain tight — the Fed's Senior Loan Officer Survey still shows banks tightening standards on commercial and industrial loans. Luna: But if the Fed starts cutting rates later this year, that could flip the script. Wouldn't small caps be the biggest beneficiaries of lower rates? Lucas: Yes, and that's the bull case. If you believe the Fed will cut rates — and the market is currently pricing in about two cuts by year-end — then small caps could rally hard. But there's a timing issue. The Russell might not bottom until the recession actually starts, if it happens. Historically, small caps lead on the way down and lead on the way up. So buying now could be early, but it could also be the right time if you have a multi-year horizon. Luna: Let's look at the sector composition. The Russell 2000 has a big weight in financials, industrials, and healthcare. But it's underweight tech relative to the S&P. So part of the divergence is just that AI and mega-cap tech are driving the S&P, and those stocks are largely absent from the Russell. Lucas: Exactly. NVIDIA, Microsoft, Apple, Alphabet — those are the engines of the S&P 500 rally. The Russell doesn't have them. So when you see the S&P making new highs, it's really a story of a handful of mega-cap stocks. The equal-weight S&P 500 is actually flat over the past three months. So the Russell's weakness is consistent with the idea that the average stock is not participating in this rally. Luna: That's a crucial point. The equal-weight S&P 500 is a better benchmark for the typical company. If that index is flat, then the Russell being down is not that surprising. It's just a more extreme version of the same trend. Lucas: Right. And that brings us back to the recession question. If the economy is actually slowing, small caps will get hit harder because they have less margin for error. But if this is just a sector rotation — money flowing out of small caps and into AI mega-caps — then it's not necessarily a recession signal. It's a style factor. Luna: So how do you tell the difference? What data would confirm a recession vs. just rotation? Lucas: I'd watch the job market. The JOLTS data and nonfarm payrolls are still solid, but if we start seeing a trend of rising jobless claims and falling hires, that would be a red flag. Also, the ISM manufacturing PMI has been below 50 for months — that's contraction. If the services PMI also dips below 50, that's a classic recession signal. So far services are still expanding, but barely. Luna: And there's the consumer side. Small caps are more exposed to consumer discretionary spending. If consumer confidence drops and retail sales weaken, that would hit the Russell hard. Lucas: Exactly. So let's sum up where we are. The Russell 2000 is down 1.1 percent this week, the S&P is up. The yield curve is inverted, but GDP is growing. The VIX is low, but small caps are weak. It's a confusing picture. My take is that the Russell is pricing in a mild recession or a significant slowdown, while the S&P is pricing in a soft landing or no landing. One of them is likely wrong. Luna: Which side do you lean toward? Lucas: I think the Russell is closer to the truth. The lag effect of high interest rates takes time to work through the economy, and we're seeing signs of strain in commercial real estate, in consumer credit, in small business optimism. The NFIB small business optimism index has been below its historical average for over a year. That's a real-time read on how small business owners feel, and they're not optimistic. Luna: But if the Russell is right, then the S&P 500 is vulnerable. If a recession hits, those mega-cap earnings will eventually slow too. AI spending might get cut back if corporate profits fall. Lucas: That's the risk. I'm not saying a recession is guaranteed, but the probability is higher than what the S&P's price action suggests. The Russell is a canary in the coal mine. And when the canary stops singing, you pay attention. Luna: So what's the actionable takeaway for listeners? Is this a buying opportunity in small caps, or a reason to get defensive? Lucas: It depends on your time horizon. If you're a long-term investor, buying the Russell at these levels could pay off if the economy avoids a deep recession. The valuations are cheaper — the Russell's price to earnings ratio is around 15, compared to 22 for the S&P 500. But if you're a shorter-term trader, I'd wait for confirmation that the economy is stabilizing. Another few months of weak data could push the Russell down another 10 percent. Luna: That's a balanced view. I think it's important not to panic just because the Russell is down. But also not to dismiss it as irrelevant. The divergence is real and deserves monitoring. Lucas: Absolutely. And on that note — if our money conversations have helped you think about a decision differently, whether it's whether to buy small caps or rebalance your portfolio, a couple of dollars a month is genuinely what keeps these going. You can find us at buy me a coffee dot com slash fexingo. It's a small gesture that makes a big difference in keeping the show ad-free. Luna: Yeah, even just the price of a coffee helps cover hosting and research costs. We appreciate every bit of support. Lucas: So to circle back: the Russell 2000's weakness is a signal worth respecting, but not necessarily a reason to abandon your strategy. Watch the labor market and consumer data for confirmation. And if you're a long-term investor, lower prices in small caps might eventually be a gift. Luna: I'll drink to that — metaphorically. Thanks, Lucas. Lucas: Thanks, Luna. Until next time.