Latest / The Bear Market Podcast with Fexingo: Surviving Downturns, Buying the Dip, and Long-Term Resilience / Small Caps Are Finally Outperforming Large Caps Here Is Why
Transcript
- Lucas: So the Russell 2000 is up more than three percent in the last five trading days. The Nasdaq is basically flat. The S&P 500 is up maybe a third of a percent. That's a pretty stark divergence. Luna: It is. And it's not just one day of noise. We've seen this for about two weeks now. Small caps are finally getting some love. Lucas: Right. For most of 2025 and the first half of 2026, the story was mega-cap tech or nothing. The Russell 2000 was trailing the Nasdaq by double digits. Now the tables have turned. Luna: What's driving it? Is this a genuine rotation or just a dead cat bounce for small caps? Lucas: I think it's a mix of macro and sentiment. Let's start with the yield curve. The two-year Treasury yield has come down from 4.13 percent to 4.05 percent in the last week. The ten-year is also down, but the spread has widened a bit. A steeper curve is historically good for small caps because they tend to be more sensitive to domestic economic activity and borrowing costs. Luna: And the VIX dropped to 17.68, down more than six and a half percent in a week. That suggests the fear trade is unwinding. Lucas: Exactly. The VVIX, which tracks volatility of volatility, is also falling. It's at 93.82, up slightly from last week but still well below the 100 level that tends to coincide with panic. So the rotation looks orderly, not chaotic. Luna: Orderly rotation is what you want to see if you believe in broadening market leadership. But we've been burned before. Remember the small-cap surges in 2023 and 2024? They fizzled. Lucas: They did. And that's the key question: is this time different? Let's look at the fundamentals. Small-cap earnings have actually been improving relative to large caps. The earnings recession that hit the Russell 2000 in 2023 and 2024 is largely over. Profit margins are stabilizing. Luna: And valuations. Small caps are still cheap relative to history. The Russell 2000 trades at around 15 times forward earnings, while the S&P 500 is at 21 times. That's a gap that can close if earnings hold up. Lucas: Right. But there's a risk. If the economy slows more than expected, small caps get hit harder because they have less pricing power and more debt. The yield curve uninverted, but that doesn't guarantee a soft landing. Luna: So what's the play for listeners? Is it time to rotate out of the Nasdaq and into the Russell? Lucas: I wouldn't say dump your tech holdings. But if your portfolio is 40 percent Apple, Microsoft, NVIDIA, and a few others, you are taking a concentrated bet. The data from the past week suggests that bet is underperforming. Luna: What's one concrete takeaway? Lucas: Historically, when the Russell 2000 outperforms the Nasdaq by more than three percentage points in a week, it often signals a broadening of leadership. But it can also be a warning if earnings don't follow. Watch the small-cap earnings reports over the next few weeks. If they beat expectations, the rotation has legs. Luna: And if they miss? Lucas: Then this rally could reverse quickly. Small caps are more volatile. The VIX is down, but it's still above 17. That's not complacent territory. Luna: Let's zoom out a bit. The S&P 500 is at 7,431. That's near all-time highs. The Dow is above 51,000. The Nasdaq is at 25,889. Those are high levels. Are we in a new bull market for small caps or a catch-up trade within an aging cycle? Lucas: I lean toward catch-up trade. The macro backdrop is still uncertain. GDP growth is only 1.6 percent annualized. That's not booming. Real GDP is up but modestly. The ten-year yield at 4.45 percent is still restrictive. Small caps need lower rates to really thrive. Luna: But the two-year is down to 4.05 percent. That's a meaningful drop from where we were. Lucas: It is. And the market is pricing in rate cuts later this year. If the Fed delivers, small caps could rally further. But if inflation stays sticky and cuts get delayed, the Russell gets squeezed. Luna: Speaking of that, I want to mention something. We keep this show ad-free because we think it's the right way to have honest money conversations. If you find value in that, you can support the show at buy me a coffee dot com slash fexingo. Lucas: Yeah, that's important. No ads means we can say what we actually think. And listener support is what makes that possible. So if you've gotten something out of these episodes, that's the link. Luna: Okay, back to the rotation. One thing I'm watching is the sector composition of the Russell 2000. It's heavy on financials, industrials, and healthcare. Those sectors benefit from a steepening yield curve. Lucas: Right. Regional banks, for example, have been crushed by the inverted yield curve. Now that it's uninverted, their net interest margins should improve. That's a tailwind. Luna: And industrials like construction and manufacturing. If the economy holds up, those names could see earnings upgrades. Lucas: But there's a catch. Small caps are also more exposed to domestic consumer spending. And consumer sentiment has been shaky. The savings rate is down, credit card debt is up. If the consumer weakens, small caps feel it first. Luna: That's the tug of war. Better valuation, better earnings momentum, but more macro risk. Lucas: Exactly. So for listeners, I'd say don't go all-in on small caps. But if you've been ignoring them, it's worth allocating five to ten percent to a Russell 2000 ETF as a diversifier. Just be prepared for more volatility than you get from the S&P 500. Luna: And if you're a dip buyer in the Nasdaq, what's your advice now? Lucas: The Nasdaq has been resilient. It's only down 0.2 percent in the past week. That's not a dip. It's more of a pause. The mega-cap tech stocks are still generating massive cash flows. But the upside may be limited if money keeps rotating out. Luna: So you're not buying the dip in tech right now? Lucas: Not aggressively. I'd wait for a bigger pullback or for earnings to reset expectations. The risk-reward is better in small caps at current levels. Luna: Thanks, Lucas. Let's see if the Russell can hold these gains. Lucas: Yeah. Next week's earnings will tell us a lot.