Latest / The Bear Market Podcast with Fexingo: Surviving Downturns, Buying the Dip, and Long-Term Resilience / Why the Small-Cap Squeeze Is Picking Up Speed
Transcript
- Lucas: So the Russell 2000 is down two point three percent over the past five days, while the Dow is down only one point three. That's a wider gap than people might expect, and it's not just noise. Luna: It feels like small caps are getting hit disproportionately. Why is that? Lucas: Part of it is the Fed minutes from Wednesday, which showed officials saw a need to hike if inflation doesn't cool. That's a direct headwind for smaller companies because they're more sensitive to interest rates. They carry more floating-rate debt, and their earnings are more tied to the domestic economy, which is cooling faster than the big multinationals. Lucas: Look at the real GDP growth number we just got for the April quarter: one point five percent annualised, down from two point one. That's a meaningful slowdown, and small caps feel that first because their customers are Main Street, not global supply chains. Luna: So it's kind of a double whammy. Higher rates and slower growth, and both hit small caps hardest. Lucas: Exactly. And there's a structural layer on top of that. The Russell 2000 has been lagging the S&P 500 for a while now, and when you see a divergence like that, it's often a sign that investors are rotating into safety. They're paying up for mega-cap quality, companies with strong balance sheets and pricing power, and they're dumping the riskier names. Lucas: The VIX is up almost ten percent this week, but it's still only at fifteen point six five. That's not panic. That's more like a slow bleed in the small-cap space while the big indexes hold up. Luna: But isn't some of that divergence just mechanical? I mean, the Dow is price-weighted, so it's dominated by a few big stocks, and the Russell is equal-weighted, so it's more representative of the average company. Lucas: That's a fair point, and it's part of it. But the gap we're seeing now is bigger than just the weighting methodology. Look at the Nasdaq, which is down two point three percent this week, basically matching the Russell. So it's not just small caps that are struggling. It's the high-multiple, rate-sensitive stuff across the board. The tech-heavy Nasdaq and the small-cap Russell are both down more than the blue-chip Dow. Lucas: And that makes sense when you think about the 30-year Treasury yield at five point two eight percent. That's a big number. It puts pressure on any asset that's valued on future cash flows, whether it's a growth stock or a small company that needs to refinance debt. Luna: So the market is pricing in a Fed that might not cut as much as we thought, and maybe even hikes again if inflation doesn't cooperate. Lucas: Right. And the yield curve steepening, with the 10-year at four point seven one and the 2-year at four point one nine, the spread is about forty-six basis points. That's a steeper curve than we saw earlier in the year, and it's usually a sign that the market expects growth to pick up eventually. But right now, it's more about the long end repricing higher because of term premium and fiscal concerns, not because the economy is booming. Lucas: And that's a tough environment for small caps. They need a steepening curve that comes from stronger growth, not from higher long-term rates. Luna: That's a good distinction. So what does this mean for someone who's been buying the dip in small caps? Is this the time to keep averaging in, or should they wait? Lucas: Look, I'm not going to tell anyone to catch a falling knife. But there's a difference between a company that's fundamentally sound and one that's just in the wrong index at the wrong time. If you're picking individual small caps, you need to focus on balance sheets and cash flow, not just the multiple. Lucas: And if you're using an index fund, you're getting the whole basket, including the companies that might not survive a higher for longer rate environment. That's a real risk. Luna: That's a really useful way to think about it. And it's actually a good reminder that when we talk about 'the market', we're not talking about one thing. The Russell is not the S&P, and the S&P is not the Dow. Lucas: And that's the kind of nuance we try to bring every week. If these conversations have helped you think about your own portfolio differently, you might consider supporting the show. We're independent and listener-funded, and that's what keeps us ad-free. You can buy me a coffee at buy me a coffee dot com slash fexingo. It's a small gesture that keeps the lights on. Luna: Yeah, and we appreciate every bit of it. It really does make a difference. Lucas: So back to the small-cap squeeze. One thing that's been interesting is the role of leveraged ETFs. When the Russell drops, funds that use leverage have to rebalance, selling even more of the underlying to maintain their target exposure. That can exacerbate the move. Luna: So it's like a feedback loop. The more it drops, the more they sell, which makes it drop more. Lucas: Exactly. It's a mechanical force that can turn a small dip into a larger one, especially in a less liquid index like the Russell. And with the VIX still at fifteen point six five, there's not enough fear to shake out the weak hands, but there's enough activity to keep the pressure on. Lucas: And it's not just the leveraged products. You also have trend-following strategies that are cutting risk across the board. When the five-day move is down across all the major indexes, systematic funds reduce exposure. That's another layer of selling that's not tied to fundamentals. Luna: So you've got real economic headwinds, plus these mechanical forces, and they're all compounding. That explains why the Russell is down more than the Dow, but also why the Nasdaq is down so much too. Lucas: Yeah, the Nasdaq and the Russell are both down about two point three percent, while the Dow is only down one point three. That's a common pattern when rates are rising. High-multiple growth and small caps both get hit, while value and dividends hold up better. Lucas: But here's the thing: this isn't a uniform sell-off. The NYSE Composite is only down point six percent, which is a lot less than the others. So there's still money moving into certain sectors, just not into the small caps. Luna: Where is that money going? Is it just the mega-cap tech, or are there other pockets that are still attracting inflows? Lucas: A lot of it is going into the quality defensive names we talked about a few episodes back. Utilities, healthcare, consumer staples. Those are the places where you can hide when the economic data is cooling and the Fed is still hawkish. Lucas: And you're also seeing a bit of a flight to international, particularly China, which is defying the global bond yield surge. That's interesting because it's offering a diversification benefit that people are starting to notice. Luna: So if someone is heavily weighted in US small caps right now, what's the play? Is it to cut losses, or to hold on and wait for the turn? Lucas: I'd say don't panic, but don't be complacent either. If you're in an index fund, you're taking on a lot of companies that might not have the balance sheet to weather a prolonged period of high rates. If you're picking individual stocks, look for companies with low debt, positive free cash flow, and a history of surviving tough cycles. Lucas: And remember, the small-cap discount is real. Historically, the Russell has traded at a discount to the S&P on a price to earnings basis, but right now that discount is wider than usual. That could be an opportunity, but only if you believe the earnings estimates are still realistic. Luna: Are those estimates realistic? Because we've seen a lot of guidance cuts this quarter. Lucas: That's the key risk. If the real economy is growing at one point five percent, and the Fed is potentially hiking again, then those estimates are probably too high. We might see a wave of downward revisions, which would hurt small caps even more. Lucas: But here's the counterpoint: the market is a discounting mechanism. If the Russell is already down two point three percent this week, and the VIX is creeping up, maybe a lot of that bad news is already in the price. The question is whether the Fed actually follows through on those minutes. Luna: So it all comes back to the Fed. If they hold, maybe small caps stabilize. If they hike, we could see another leg down. Lucas: Exactly. The data between now and the next meeting is going to be critical. We'll get the August jobs report and the next CPI print, and those will tell us whether the Fed has room to stay patient or whether they really are going to hike. Luna: And in the meantime, the small-cap squeeze is a good reminder that not all sell-offs are created equal. Understanding what's dragging the index down, whether it's fundamentals or mechanics, can help you decide what to do. Lucas: Absolutely. And that's the takeaway for today. The Russell 2000 is down two point three percent this week, and it's not just because of the Fed. It's the combination of higher rates, slower growth, and those mechanical flows that amplify the move. Keep an eye on the data, and don't let the big index moves fool you about what's happening underneath. Luna: Well said. And we'll be back tomorrow with another look at what's moving the markets.