Latest / The Bear Market Podcast with Fexingo: Surviving Downturns, Buying the Dip, and Long-Term Resilience / Why the Small-Cap Rally in 2026 Has Room to Run
Transcript
- Lucas: So the Russell 2000 just put up a three-point-four percent gain over the last five trading days. The S&P 500, by comparison, managed barely one percent. That spread — more than two percentage points — is the widest we've seen since early 2024. Luna: And the VIX dropped to sixteen point seven, down more than six percent over the same period. So the 'fear gauge' is falling fast, and small caps are leading. That's a classic risk-on rotation. Lucas: Exactly. But the rhetoric from a lot of sell-side desks is calling this a 'catch-up trade' — basically saying small caps got left behind in the first leg of this rally and are now playing catch-up. I think that undersells what's actually happening. Luna: What do you see that they're missing? Lucas: Look at the macro backdrop. The ten-year yield is holding at four point five seven percent, basically flat over the last week. The two-year has crept up to four point zero eight, so the spread between them has narrowed to forty-three basis points. That's down from forty-nine a week ago. But here's the thing — the curve was inverted for two years. Now it's positively sloped again, even if only modestly. Luna: And positive yield curves have historically been good for small caps because they signal that the economy is in expansion, not contraction. Lucas: Right. Small caps are more levered to domestic growth. They don't have the global revenue diversification that large multinationals have. So when the US economy is growing — and real GDP just printed at two percent annualized in Q1 — that should benefit them disproportionately. Luna: But the Russell is still down relative to its 2021 peak. It's not like we're at all-time highs here. Lucas: No, and that's partly what's interesting. The index is at two thousand eight hundred sixty-nine. That's still about fifteen percent below its November 2021 record. So you have a situation where the economy is growing, the yield curve is normalizing, volatility is low, and small caps are still cheap relative to large caps. Luna: Cheap on what metric? Lucas: price to earnings ratio, forward earnings yield, price to book — take your pick. The Russell trades at roughly fifteen times forward earnings while the S&P 500 is at twenty-two. That's a spread that's historically been a buy signal for small caps. Luna: But there's a reason for that discount, right? Small caps have higher debt loads, more exposure to floating-rate debt, and they're more sensitive to credit conditions. The Fed hasn't cut rates yet. Lucas: That's the counterargument. And it's valid. But let's look at what's actually happening with earnings revisions for small caps. After two years of downgrades, we're starting to see a stabilization — and in some sectors, upgrades. Specifically in regional banks, select industrials, and biotech. Luna: Regional banks make sense. The yield curve normalizing helps their net interest margins. And the banking crisis of 2023 is in the rearview mirror. Lucas: Exactly. Regional banks are a big weight in the Russell. If those earnings start to recover, that's a powerful tailwind. Industrials are also benefiting from onshoring and infrastructure spending. And biotech — well, biotech is always a gamble, but the FDA has been approving drugs at a healthy clip, and the sector got hammered so badly that valuations are compelling. Luna: But there's also the 'unprofitable tech' problem. The Russell has a significant number of companies that don't make money. In a rising rate environment, those stocks get crushed. Even with rates stable, they're still vulnerable. Lucas: That's the biggest risk. About twenty-five percent of the Russell 2000 is unprofitable, depending on how you measure it. If we get a spike in yields or a credit event, those stocks will get hit hard. But the flip side is that many of those unprofitable companies have already been written off. The survivors have cut costs, extended their runway, and are closer to breakeven. Luna: So you're saying the bad news is priced in? Lucas: Partially. I think the market is starting to differentiate. The companies that have a credible path to profitability are being rewarded. The ones that are burning cash with no plan — those continue to get hammered. So it's not a blanket small-cap trade. You have to be selective. Luna: And that's where the 'rotation' narrative gets complicated. If you're a passive investor in a Russell 2000 ETF, you own all of it — the good, the bad, and the ugly. Lucas: Exactly. So I'd argue that the passive small-cap trade is more of a bet on the macro — on GDP growth, on the yield curve, on credit conditions. But the active opportunity is in the sectors where fundamentals are genuinely improving. Luna: Let's talk about one of those sectors. You mentioned industrials earlier. What's the concrete example? Lucas: Take a company like Applied Industrial Technologies — distributor of bearings, power transmission components. It's a boring business, but it's leveraged to manufacturing activity. The ISM manufacturing PMI has been ticking higher, and Applied Industrial just reported a beat on earnings and raised guidance. That's a real fundamental improvement, not just a multiple expansion. Luna: And the market rewarded it. The stock popped. But that's one data point. What gives you conviction that this is more than a one-off? Lucas: Earnings revision breadth is improving. The number of Russell 2000 companies getting upward revisions is now exceeding those getting downward revisions for the first time since late 2023. That's a leading indicator. Luna: But we also have to consider the geopolitical risk. The APEC headlines this weekend suggest the US and China are still far apart on trade. If tariffs escalate, small caps — which are domestically focused — could actually be less impacted than large caps. But if it leads to a broader economic slowdown, then small caps get hit disproportionately. Lucas: That's a fair point. And it's why you can't just buy the Russell blindly. You need to think about positioning. One approach is to focus on small-cap value — which has a higher weight in financials and industrials — versus small-cap growth, which has more tech and biotech. Luna: Value has been underperforming growth for years. A rotation into value would be a major regime shift. Lucas: It would. And we might be seeing the early stages of that. The Russell 2000 Value index has outperformed the Russell 2000 Growth index by about two percent over the last month. That's not decisive, but it's a pattern worth watching. Luna: Speaking of patterns worth watching — you know, a lot of our listeners have told us this show helps them think through these kinds of market shifts more clearly. We don't run ads, we don't push products — just honest analysis. If the episodes have helped you, and you want to keep them free for everyone, there's a simple way to support us. Lucas: Yeah, we've kept it ad-free from day one, and we'd like to keep it that way. If you feel like it, you can go to buy me a coffee dot com slash fexingo. No pressure, no perks — just a way to say this matters to you. Luna: It genuinely helps. And now back to the rally — what's your take on the duration of this small-cap move? Lucas: I think it has legs for the next few months, provided the macro backdrop holds. If the Fed does eventually cut rates — and the market is pricing in a cut later this year — that would be another catalyst. But the real test will be Q2 earnings season. If we see broad-based beats and guidance hikes from small caps, the narrative will shift from 'catch-up' to 'sustainable rotation.' Luna: And if earnings disappoint? Lucas: Then we're back to square one. The Russell gets sold off, and investors crowd back into large-cap tech. But I think the odds favor the rotation continuing. The data is improving, valuations are supportive, and the market is hungry for a new leadership group after two years of the Magnificent Seven dominating everything. Luna: That's a good point. Even a modest rotation away from mega-cap tech would provide a huge tailwind for small caps. The market cap of the Magnificent Seven alone is something like twelve trillion dollars. If just five percent of that flows into small caps, that's six hundred billion dollars — more than the entire market cap of the Russell 2000. Lucas: Exactly. It doesn't take much. So I'd say watch the Russell 2000 closely over the next few weeks. If it can hold above two thousand eight hundred and fifty and then break through two thousand nine hundred, that would be a technical confirmation. Below two thousand eight hundred, the rally falters. Luna: Clear levels. And a good note to end on. Lucas: For now, that's where we are. Small caps are having a moment — let's see if it lasts.