Latest / The Bear Market Podcast with Fexingo: Surviving Downturns, Buying the Dip, and Long-Term Resilience / Why Small Caps Are Flashing a Bearish Signal While Large Caps Soar
Transcript
- Lucas: Stocks as a whole feel calm right now. The S&P 500 is practically at 7,430, the Dow is above 52,700. But if you scroll down the market cap list, you'll see something else entirely. Luna: You mean the Russell 2000? It's down about 0.4% in the past five days. That's not a huge move, but while large caps are flat to up, that gap stands out. Lucas: Exactly. And that kind of divergence is exactly what we try to unpack on this show. Quick honest thing — a handful of listeners chip in monthly through buy me a coffee dot com slash fexingo, and that's literally what funds making this many of these episodes. No ads, just listener support. So if our money conversations have helped you think about a decision differently, that's where the link lives. Luna: Yeah, it's a small group that keeps it going. Appreciate those who do. So back to the Russell — what do you think is driving that weakness? Lucas: A couple of factors. First, small caps are more sensitive to domestic economic conditions and interest rates. The 30-year Treasury is still yielding 5.12 percent. That's down slightly from last week's 5.16, but it's still high enough to choke off borrowing for smaller companies. Luna: Right, because they rely more on bank loans and variable-rate debt than large caps with investment-grade bonds. Lucas: Exactly. And the yield curve has un-inverted — the 10-year now yields 4.65 percent, the 2-year is at 4.31, so the spread is 34 basis points positive. Historically, that has been a lagging recession signal. Small caps seem to be pricing that in faster. Luna: So the Russell is effectively acting as a canary. Meanwhile, the VIX is up 9.4 percent this week to 18.21. That's not panic territory, but it's above its long-term average. Fear is creeping in. Lucas: And the VVIX, which tracks options on VIX, is at 98.5, up 5.6 percent. That tells me traders are hedging tail risk — they're not complacent even as large cap indexes hover near records. So the divergence between large and small is consistent with a market that's relying on a few mega-cap names to stay elevated. Luna: Is this a buy the dip opportunity in small caps, or should investors treat it as a warning to stay large? Lucas: That's the million-dollar question. If you believe the economy is genuinely resilient — and real GDP growth just printed at 2.1 percent annualized, up from 0.5 percent last quarter — then small caps could be undervalued. They trade at a discount to large caps on price to earnings basis. But the catch is earnings momentum is weaker. Luna: Right, the Russell's earnings per share growth has been negative year-over-year for the last two quarters. That's a fundamental headwind that the VIX spike is reflecting. Lucas: So a long-term investor who buys this dip in small caps is making a bet that the economy avoids a recession and that interest rates come down. The Fed is on hold, but the market is pricing in two cuts by year-end. If that happens, small caps should rally hard. Luna: But if we get a recession — even a mild one — small caps could fall another 20 to 30 percent from here. The 2022 bear market saw the Russell drop 26 percent. We're still above that low, but not by much. Lucas: Exactly. The Russell is at 2,954. Its low in 2022 was around 2,600. So there's only about 12 percent downside to that prior bear market low. If you think we're in a new downturn, you wait. But if you think the large-cap strength will eventually pull small caps higher, then the risk-reward is compelling. Luna: And of course, there's the factor of passive investing. So much money flows into S&P 500 ETFs that it props up large caps automatically. Small caps don't get that tailwind. Lucas: That's a structural point. A record share of equity assets is in passive large-cap funds. So the Russell underperformance could persist even if fundamentals improve. That doesn't mean small caps are a bad investment — it means you need a longer time horizon and more patience. Luna: So for the listener who's trying to survive downturns and buy the dip, what's the concrete takeaway? Lucas: I'd say don't ignore the divergence. If you're already heavily weighted in large caps, consider taking some profits and rotating into small caps — but only if you can stomach near-term volatility. The VIX at 18 and the VVIX at 98 tell me the easy money has been made. The next leg will require disciplined allocation. Luna: And if you're not ready to act, at least watch this indicator. A further drop in the Russell below 2,900 would confirm a new downtrend for small caps. That would be a louder warning. Lucas: Right. Meanwhile, the 30-year yield at 5.12 percent is offering a decent real yield. That's competitive with equities. So bonds are once again a genuine alternative. That's something long-term investors haven't had to worry about for a decade. Add that to the mix, and the case for a diversified portfolio becomes even stronger. Luna: So we're back to the basics: have a plan, check the internals, and don't chase the headline index. Lucas: Exactly. The bear market podcast isn't just about when things fall apart — it's about recognizing the cracks before they spread. Right now, small caps are a crack worth watching. Luna: Well said. Let's leave it there for today. Lucas: Thanks for listening. If today's conversation was useful, you know where to find us.