Latest / The Bear Market Podcast with Fexingo: Surviving Downturns, Buying the Dip, and Long-Term Resilience / How the Russell 2000s Stagnation Hides a Big Opportunity
Transcript
- Lucas: The Russell 2000 closed at 2,978 today — down about 1.1 percent on the week. Meanwhile the S&P 500 is at 7,575, up half a percent. That divergence is getting hard to ignore. Luna: It's not just a one-week thing either. Small caps have been lagging large caps for most of the past 18 months. Lucas: Right. And the question is whether this is a structural problem — higher rates hit smaller companies harder because they carry more floating-rate debt — or whether it's creating a buying opportunity. The Russell's price to earnings ratio relative to the S&P 500 is near a 15-year low. Luna: That's the classic value argument. But value has been a painful trade for a while. What's different now? Lucas: Maybe the yield curve. The 10-year minus 2-year spread is 35 basis points today, down from 38 earlier in the week. That's still positive, but the direction matters. When the curve flattens or inverts, small caps tend to get punished because the market prices in slower growth. But when the curve steepens from here, small caps historically rally hard. Luna: So you're watching the spread direction, not just the level. Lucas: Exactly. And credit spreads are starting to widen a bit. That's usually an early sign that investors are getting nervous about lower-quality debt. But it's also the kind of environment where, if you have a longer time horizon, you can start picking up small-cap names at distressed prices. Luna: Let's talk about the Fed angle. Kevin Warsh just announced his task force members — Marc Andreessen, Doug McMillon from Walmart. That suggests the Fed is thinking about structural changes to how they approach monetary policy. Does that matter for small caps? Lucas: It could. Warsh has been more hawkish historically. If his task force recommends a higher neutral rate, that's another headwind for small caps because they're more sensitive to borrowing costs. But the market reaction so far has been muted. The two-year Treasury yield actually fell a few basis points today, to 4.16 percent. Luna: So the bond market isn't buying the hawkish narrative right now. Lucas: Not yet. And the VIX is at 15.03, down 3.5 percent on the week. That's complacent. If small caps are truly pricing in a recession, the VIX should be higher. So either the options market is wrong, or the Russell is overreacting. Luna: Which do you lean toward? Lucas: I think it's a mix. Some sectors in the Russell — like regional banks and small-cap biotech — have genuine headwinds. But broad-based selling seems exaggerated. The nominal GDP growth rate was just revised up to 2.1 percent annualized for the first quarter. That's not recession territory. Luna: So you're saying the macro backdrop supports small caps, but the market isn't pricing it that way. Lucas: That's the disconnect. And historically, when the Russell 2000 underperforms the S&P 500 by more than 20 percentage points over a 12-month period, the subsequent three-year annualized return for small caps averages about 14 percent. Luna: Fourteen percent annualized is strong. But you have to survive the near-term volatility. Lucas: That's the challenge. If you bought the dip in small caps in early 2020, you did great. If you bought in early 2022, you got crushed. The difference was the Fed cycle. In 2020, rates were going to zero. In 2022, they were going up. Luna: And now? Rates are arguably at or near the peak. The 30-year Treasury is at 5.05 percent, the 3-month at 3.83 percent. The curve is still inverted at the front end, but the long end is elevated. Lucas: Right. So the cost of capital is high, but it's not rising anymore. For small companies that can refinance at current rates, the uncertainty is lower. That's actually a positive for planning. Luna: One thing I keep noticing is that the Russell's composition is heavily weighted toward financials and industrials — about 30 percent combined. Those sectors benefit from a steepening curve and solid GDP growth. Lucas: That's a good point. If the curve steepens from here, regional banks — which are a big chunk of the Russell — could see their net interest margins expand. The market might be ignoring that because it's focused on the deposit flight fears from last year. Luna: So the opportunity might be in specific sub-sectors rather than the index as a whole. Lucas: I think that's the right approach. The Russell includes a lot of low-quality companies that probably shouldn't exist in a higher-rate world. But there are also well-run small caps with strong balance sheets that are being sold off indiscriminately. Luna: How do you distinguish between the two? What metrics do you look at? Lucas: First, debt to ebitda. If it's above 4 times, be careful. Second, free cash flow yield. If a small cap has a free cash flow yield above 6 or 7 percent and is trading at a reasonable multiple, that's a signal the market is mispricing it. Third, insider buying. When executives are putting their own money in, that's worth paying attention to. Luna: Are you seeing any insider buying patterns in the Russell right now? Lucas: There are pockets. In the last two weeks, I've noticed insider purchases at a few small-cap regional banks and some industrial distributors. Nothing massive, but it's more than I saw in Q2. Luna: That's interesting. It suggests the people closest to these companies think the sell-off has gone too far. Lucas: Exactly. And look, I'm not saying go all-in on small caps tomorrow. But if you have a 3- to 5-year horizon, the risk-reward is starting to look attractive. The key is patience and selectivity. Luna: And having a plan for the volatility. Because the VIX at 15 can spike to 30 overnight if something breaks. Lucas: That's the risk. But the flip side is that if you wait for the VIX to be at 25 and the Russell to be down another 10 percent, you'll be buying with the crowd. The best entries are usually when nobody wants to buy. Luna: Speaking of which — if conversations like this help you think through your own portfolio decisions, and you value that we keep the show ad-free, listeners can support us at buy me a coffee dot com slash fexingo. No pressure, just a way to keep the lights on. Lucas: Yeah, we appreciate everyone who tunes in. It's what keeps us going. Luna: So back to the Russell — one more data point. The nominal GDP growth rate came in at 2.1 percent annualized for Q1. That's up from 0.5 percent in the prior quarter. That's a pretty sharp acceleration. Lucas: It is. And it's not just a one-quarter blip. The year-over-year nominal GDP is now around 6.5 percent. That's nominal, so it includes inflation, but even real GDP growth is running at 2.1 percent. That's above trend. Luna: So if the economy is growing above trend, why are small caps struggling? Lucas: Part of it is the lag effect of higher rates. Small companies have shorter-duration debt, so they've already felt the pain. But another part is simply market narrative — everyone is obsessed with AI and mega-cap tech. The Russell doesn't have much AI exposure, so it's out of favor. Luna: That can persist for a long time. Narratives don't shift overnight. Lucas: No, they don't. But valuations do. And when the Russell's forward price to earnings ratio is around 14, compared to the S&P 500's 20-plus, you're getting a significant discount. The question is whether that discount is warranted. Luna: What would change your mind? What would make you say 'okay, this time it's different'? Lucas: If we see a sustained spike in small-cap defaults. Right now, default rates are low, but they're ticking up. If the high-yield market seizes up and small companies can't refinance, then the Russell could go lower. But I'm not there yet. Luna: So you're cautiously optimistic. Lucas: Cautiously curious, I'd say. I'm not buying blindly, but I'm building a watchlist. And I think the next few weeks — with earnings season ramping up — will tell us a lot about whether small-cap fundamentals are actually deteriorating or just being mispriced. Luna: Earnings will be the real test. If small-cap companies can show they're managing margins despite higher rates, that could be the catalyst. Lucas: Exactly. And we'll be watching it closely. For now, the divergence between the Russell and the S&P 500 is the most interesting signal in the market — it's either a trap or an opportunity, and we're going to find out.