Latest / The Bear Market Podcast with Fexingo: Surviving Downturns, Buying the Dip, and Long-Term Resilience / Why Small-Cap Stocks Are Ignoring a Recession Signal
Transcript
- Lucas: The Russell 2000 closed Friday at 2,978. Down about 1.1 percent on the week. The S&P 500? Up half a percent. Nasdaq up six tenths. So we have this pretty striking divergence — large caps grinding higher, small caps stagnating. And here's the part I find genuinely interesting: the yield curve is still inverted. The 10-year minus 2-year spread is 35 basis points. Historically, that has been one of the most reliable recession signals we have. So why aren't small caps pricing in a downturn? That's what I want to dig into today. Luna: It does feel like the Russell is being stubborn. Or maybe large caps are being overly optimistic. But let's start with the yield curve because I think listeners have heard us talk about it a lot. The inversion has been around for a while now. How long has it been? Lucas: Over two years. This is the longest inversion since the late 1970s. And it has correctly predicted every recession since the 1960s. But here we are — real GDP grew 2.1 percent in the most recent quarter. Unemployment is still low. Consumers are still spending. So either the yield curve is about to be wrong for the first time in six decades, or the recession is coming and the market is ignoring it. Luna: And small caps are usually the canary. They're more sensitive to domestic economic conditions, higher borrowing costs, tighter credit. So if they're not panicking, maybe the canary is fine. Lucas: Or the canary has been sedated. Look at the composition of the Russell 2000. It's heavily weighted toward financials, health care, industrials — sectors that have actually benefited from higher rates in certain ways. Regional banks, for example, have seen net interest margins expand. Health care is fairly recession-resistant. So the index itself might be masking weakness beneath the surface. Luna: Let's talk about the VIX. It's at 15.03. That's low. The VVIX — the volatility of volatility — is at 87. So options market is not pricing in a lot of tail risk either. That seems consistent with the Russell's calm. Lucas: Right. And we've done episodes before about how the VIX can be misleading. But 15 is genuinely low. It suggests the market expects smooth sailing. But if you look at the dispersion under the hood — the difference between how individual stocks are moving — it's actually elevated. So the index-level calm is hiding a lot of stock-level churn. Luna: That's a good point. So maybe the Russell's stagnation is not complacency. It's a tug of war between sectors that are holding up and sectors that are getting crushed. Which sectors are dragging it down? Lucas: Consumer discretionary and real estate are the big ones. Small-cap retailers, homebuilders, landlords — they are feeling the pinch from higher rates. Consumer confidence has softened. But technology, which is a smaller weight in the Russell than in the S&P, has actually performed well. So the index is flat because the winners and losers are cancelling each other out. Luna: So is this a buying opportunity? If you believe the recession doesn't come, small caps look cheap relative to large caps. The price to earnings ratio on the Russell is around 15. The S&P is at 21. That's a big discount. Lucas: Historically, when small caps trade at that kind of discount, they tend to outperform over the next three to five years. But there's a catch. The discount is only meaningful if earnings hold up. And small-cap earnings have been under pressure. Higher interest expenses are eating into margins. If the economy slows, those earnings could drop, and the P/E would actually be higher than it looks. Luna: So you're saying the cheapness might be an illusion. Lucas: I'm saying you have to look at the quality of the earnings. Not all cheap stocks are bargains. Some are value traps. And in a higher for longer rate environment, the companies with weak balance sheets are going to struggle. The Russell has a lot of those. Luna: Let's get specific. Give me one example of a sector where the Russell's calm might be wrong. Lucas: Small-cap banks. The regional bank stress from 2023 hasn't fully resolved. Deposit costs are still high, and commercial real estate exposure is a ticking clock. The Russell has a lot of these banks. Their stocks have rebounded, but the underlying risk hasn't gone away. If a recession hits, that sector could drag the whole index down. Luna: On the other hand, if we avoid recession, those banks could be fine. So the market is essentially pricing in a soft landing. The Russell is saying 'no recession.' Do you agree? Lucas: I think the market is pricing in a soft landing, yes. But the yield curve is saying 'hard landing.' One of them is going to be wrong. And historically, you don't want to bet against the yield curve. But this time could be different — the inversion has been driven by central bank policy as much as by economic expectations. The Fed has kept short-term rates high to fight inflation, while long-term rates reflect a more neutral outlook. So the inversion might be more of a policy signal than a recession signal. Luna: That's a nuanced take. So maybe the Russell is right to be calm. Or maybe it's just early. How long does the lag typically last between inversion and recession? Lucas: Varies. Average is about 12 to 18 months. We're past that. But there have been cases where it took three years. So we could still be in the window. Or the curve could be wrong. Honestly, if today's conversation was worth a coffee to you, that's the link — buy me a coffee dot com slash fexingo. Luna: Yeah. If these money talks have helped you think about a decision differently, that's the place. No pressure, just a way to keep it ad-free. And Lucas, you were saying about the lag? Lucas: Right. So the lag is a real concern. But here's another angle: the VIX at 15 and the Russell at 2,978 might actually be a signal of something else — that the market has simply stopped believing the yield curve has predictive power. After two years of inversion with no recession, investors have become desensitized. That itself could be a contrarian signal. Luna: So the fact that nobody is panicking is what worries you. Lucas: Exactly. Complacency is often highest right before a shock. But I'm not predicting a crash. I'm saying the divergence between small caps and large caps, between the yield curve and the equity market, is worth watching. If the Russell breaks below 2,900, that would be a warning. If it breaks above 3,100, that would confirm the bulls are in control. Luna: So you're watching those levels. What about a dip buyer? Should they be adding small caps here? Lucas: I'd be selective. Don't just buy the index. Look for companies with strong balance sheets, low debt, and pricing power. Avoid the banks and the real estate plays unless you have a specific thesis. And keep some cash ready in case the Russell does dip another 10 percent. Then you can really buy. Luna: Good advice. So to wrap up: the Russell is telling us no recession. The yield curve is telling us yes. Who do you trust more? Lucas: I trust the yield curve more as a signal, but I trust the market more as a discounting mechanism. That's the tension. My gut says we get a mild slowdown, not a full recession. But I've been wrong before. That's why you diversify. Luna: And keep listening to podcasts like this one. Thanks, Lucas. Lucas: Thanks, Luna. Let's see what the Russell does next week.