Latest / The Bear Market Podcast with Fexingo: Surviving Downturns, Buying the Dip, and Long-Term Resilience / How the Russell 2000 Is Outperforming the S&P 500 in 2026
Transcript
- Lucas: The Russell 2000 is up 3.4 percent over the past five trading days. The S&P 500, by comparison, has gained just 1 percent. That is not a rounding error—that is a serious divergence, and it raises a question we haven't really asked on this show yet: are we seeing the start of a genuine rotation into small caps? Luna: I've been watching that gap widen. The Russell is sitting at 2,869, which is not far from its post-pandemic highs. Meanwhile the S&P is at 7,473, which feels like it's grinding higher, not charging. So what's actually driving this? Lucas: There are a couple of clear catalysts. First, the market is pricing in a higher probability of rate cuts later this year. The two-year Treasury yield has crept up to 4.08 percent, but the market is still expecting the Fed to ease by year-end. Small caps are more sensitive to borrowing costs—they have more variable-rate debt than large caps. So if rates come down, their earnings get a bigger relative boost. Luna: Right, and they also have less exposure to the strong dollar, which has been a headwind for multinationals. The Russell is mostly domestic revenue. Lucas: Exactly. The S&P 500 gets about 40 percent of its revenue from outside the U.S. The Russell gets maybe 20 percent. So when the dollar is strong—and it has been—small caps feel less pain. That is a structural advantage right now. Luna: There is also the valuation angle. Large-cap growth stocks, especially in tech, are still trading at elevated multiples. The S&P's price to earnings ratio is around 22. The Russell is closer to 15. That is a discount that investors may be starting to exploit. Lucas: And the VIX falling to 16.70—down 6.3 percent in five days—supports the idea that risk appetite is returning. When fear subsides, investors tend to move down the market-cap ladder. They sell their defensive mega-caps and buy smaller, more cyclical names. Luna: But is this a sustainable rotation, or just a temporary catch-up trade? I mean, the Russell has underperformed for years. Could this be a mean reversion that fizzles out? Lucas: That is the million-dollar question. The last time small caps really led for an extended period was in the early 2000s, and then again in the 2016-2018 period after Trump's tax cuts. Both times, it was driven by an improving domestic economy and a friendly rate environment. And we have some of that now: real GDP growth just came in at an annualised 2 percent, up from 0.5 percent in the prior quarter. The economy is accelerating. Luna: But the yield curve is still inverted. The 10-year minus 2-year spread is just 43 basis points. Historically, an inverted curve has been a recession signal. So you have this tension: the economy is growing, but the bond market is still flashing yellow. Lucas: Right. And that is why I think this small-cap rally has room to run, but not without volatility. The market is essentially betting that the Fed will cut rates before the economy rolls over. If that bet is right, small caps benefit. If the recession actually materialises, small caps get crushed because they have thinner margins and less pricing power. Luna: So what's a specific sector within small caps that looks interesting here? Lucas: Regional banks. They are heavily represented in the Russell, and they have been under pressure since the banking turmoil in 2023. But if rates come down, their net interest margins should stabilise. Also, the yield curve steepening—even modestly—helps their traditional lending model. Borrow short, lend long, capture the spread. Luna: On the other hand, regional banks still face headwinds from commercial real estate exposure. Office loans are not going to be resolved quickly. So there is a real risk there. Lucas: Absolutely. You cannot ignore that. But the market seems to be looking past it for now. The KBW Regional Banking Index is up about 5 percent over the past month. Investors are betting that the worst is over. Whether that is a good bet depends on how the economy evolves over the next six months. Luna: And speaking of bets that pay off—if our money conversations have helped you think about a decision differently, like whether to rebalance into small caps or just stick with an index, a couple of dollars a month makes a real difference to keeping this show ad-free. Lucas: Yeah, genuinely. It's buy me a coffee dot com slash fexingo. If you've gotten something out of our discussions, it directly keeps us going. No pressure at all. Luna: So back to the rotation question. One thing I've been tracking is the relative strength of the Russell versus the S&P on a weekly basis. The gap has been widening for about three weeks now. That is a meaningful trend. Lucas: And it's not just price action. Look at the inflows. Small-cap ETFs have seen net positive flows for five straight weeks, while large-cap growth ETFs have seen some outflows. That is real money moving. Luna: Who is doing the buying? Is it retail or institutional? Lucas: Hard to pin down exactly, but the options market is showing increased call activity on Russell futures. That suggests institutions are hedging or positioning for further upside. Retail tends to trade single-name small caps, not futures. Luna: So if this is institutional, it could have more staying power. They don't flip positions as quickly. Lucas: Right. And there is also a seasonality factor. May through October is historically a weaker period for the S&P, but small caps often perform better in the summer months. So the calendar is supportive. Luna: But let's not ignore the macro risk from trade. The headlines out of APEC suggest the U.S. and China remain far apart. If tariffs escalate, small caps with domestic supply chains could actually be less affected than multinationals. So that might be another tailwind. Lucas: That is a good point. If you're a small company that manufactures in Ohio, you don't care about Chinese tariffs. In fact, you might benefit from import substitution. So the trade uncertainty actually reinforces the small-cap thesis. Luna: So what's the one thing listeners should watch to gauge whether this rotation is real? Lucas: Watch the yield spread. If the 10-year minus 2-year spread widens—that is, if the curve steepens—it usually signals that growth expectations are improving. That would be a green light for small caps. But if the curve inverts further, below 40 basis points, that would be a warning that recession fears are building again. Luna: And the VIX. If it stays below 17, risk-on is intact. If it spikes above 20, small caps will likely get hit first. Lucas: Exactly. So the barometers are clear. For now, the data says small caps have momentum. But in this market, momentum can change fast. Luna: It's a good reminder that no rotation lasts forever. But for the moment, the Russell 2000 is where the action is. Lucas: And that is exactly why we're talking about it today. If you are paying attention to market structure rather than just headlines, this is the kind of shift that can define your returns for the next year. Luna: We'll keep watching it. And next time, maybe we can dig into specific sectors within small caps beyond regional banks. Lucas: Good idea. There is a lot to unpack.