Latest / The Bear Market Podcast with Fexingo: Surviving Downturns, Buying the Dip, and Long-Term Resilience / Why the Russell 2000s Stagnation Hides a Big Opportunity
Transcript
- Lucas: The Russell 2000 is sitting at 2,978 as of this morning. That's down a little over 1% in the last five days. And here's the thing — it's basically flat for the year while the S&P 500 is up. The divergence is getting hard to ignore. Luna: Yeah, we've talked about this before on the show — the Russell has been stuck in a range for months. But today I want to dig into why that might actually be an opportunity, not just a warning. Lucas: Exactly. The conventional read is that small caps are pricing in a recession. The Russell is full of domestic, cyclical companies — banks, industrials, retailers — that get crushed when the economy slows. And with the yield curve still inverted — the 10-year minus 2-year spread is 35 basis points — the bond market is sending a caution signal. Luna: But the VIX is at 15. That's low. Fear is not exactly spiking. So either the bond market is wrong, or the options market is complacent. Lucas: Right. And I think there's a third possibility: the Russell itself is mispriced. Look at valuations. The forward price to earnings ratio on the Russell 2000 is around 14 times. Historically, when small caps trade below 15 times forward earnings during a non-recessionary environment, they tend to deliver above-average returns over the next three years. Luna: So the bet is that we don't get a recession. What's the case for that? Lucas: Real GDP growth just came in at an annualized 2.1% for the first quarter. That's up from 0.5% before. The economy is actually accelerating. Consumer spending has held up. And the Fed — well, Kevin Warsh just named his task force members this week, including Marc Andreessen and Doug McMillon. That suggests the new administration is thinking structurally about regulation and productivity. Luna: Which could disproportionately help small caps. They're more sensitive to domestic policy and interest rates than the mega-caps. Lucas: Bingo. If the Fed even hints at cutting rates later this year — and the 2-year yield has already dropped from 4.21% to 4.16% in the last few days — small caps could rally hard. They're more leveraged to borrowing costs. A 25-basis-point cut matters more to a regional bank than to Apple. Luna: But what about the yield curve? It's still inverted. Historically, an inverted curve has been a reliable recession signal. Lucas: It has. But the lead time varies wildly — sometimes 6 months, sometimes 24. And this time, the inversion is mostly driven by the long end. The 30-year Treasury is at 5.05%. That's not a panic bid; that's term premium. Investors demanding more compensation for holding long-duration risk. That's different from a flight to safety. Luna: So the Russell is cheap, the economy is growing, and the yield curve might be sending a false signal. That's the bull case. What's the bear case? Lucas: The bear case is that earnings expectations are too optimistic. Small cap companies have thinner margins. If wage pressures stay sticky or input costs rise, they could miss estimates. Also, the Russell has a lot of unprofitable companies — about 40% of the index doesn't earn money. If credit conditions tighten further, those companies could face real stress. Luna: And the VIX at 15 could be a trap. We've done episodes on that before. Low vol doesn't mean no risk. Lucas: Absolutely. But I'd argue the VIX at 15 is actually consistent with a 'muddle through' economy — not a recession, not a boom. And that environment has historically been good for small caps. They don't need a booming economy; they just need stability. Luna: Let's talk about specific sectors within the Russell that look interesting. Lucas: Financials are the obvious one. Regional banks have been hammered. The KBW Nasdaq Regional Banking Index is down. But if the yield curve steepens — meaning long rates rise relative to short rates — banks' net interest margins expand. We've already seen the 10-year yield hold above 4.5% while the 2-year drifts lower. That's a steepening bias. Luna: And industrials? Small-cap industrials are tied to domestic capex. With the CHIPS Act and infrastructure spending still flowing, that could be a tailwind. Lucas: Yeah. But you have to be selective. The Russell includes a lot of commodity-sensitive names. If the dollar stays strong, that's a headwind for companies with export exposure. But domestically-focused industrials — think construction materials, electrical equipment — those could benefit from reshoring. Luna: One thing that comes to mind: the Russell's underperformance has been so persistent that a lot of active managers have given up. Underweight allocations to small caps are at multi-year lows. That sets up a potential mean reversion. Lucas: It's classic. When everyone is positioned for the same trade, the opposite often happens. Institutional investors have piled into large-cap growth — the mega-cap tech stocks. If that trade unwinds even a little, small caps could see inflows just from rebalancing. Luna: Speaking of which — if our conversations about market positioning and contrarian thinking have helped you think about your own portfolio differently, you know what we're going to say. If today was worth a coffee to you, you can find the link at buy me a coffee dot com slash fexingo. It's a small way to keep the show ad-free and independent. Lucas: Yeah, and we really mean it when we say no pressure. The show stays free either way. But those contributions genuinely help us keep digging into angles like this one. Luna: Exactly. Alright — back to the Russell. One more risk I want to flag: liquidity. Small caps can get hit harder in a sell-off because the bid-ask spreads widen. If you're a long-term investor, you can ride that out. But if you need to sell in a panic, you might get a bad fill. Lucas: That's a great point. And it ties back to the VIX. The VVIX — the volatility of the VIX — is at 87. That's elevated relative to the VIX itself. It suggests options dealers are pricing in a higher chance of a volatility spike. So the market isn't entirely complacent; it's just that the risk is skewed to the tail. Luna: So the Russell opportunity comes with a warning label: you need patience and a time horizon of at least 12 to 18 months. Lucas: Exactly. This isn't a trade for next week. It's a structural bet that the economy doesn't roll over and that small-cap valuations revert toward their mean. The data supports it, but it's not a sure thing. Luna: What's your favorite way to play it? Index ETF, or do you stock-pick? Lucas: For most listeners, the iShares Russell 2000 ETF — ticker i w m — is the simplest. But if you want to be more targeted, there are ETFs that focus on the profitable half of the Russell, like the iShares S&P Small-Cap 600 Value ETF. That screens out the unprofitable companies and tilts toward value. Luna: And if you're feeling adventurous, you could look at the regional bank ETFs. But that's more concentrated. Lucas: Right. The key is knowing what you own. The Russell 2000 is a broad index — it includes everything from biotech to restaurants. Do your homework on the sector exposures. Luna: So to sum up: the Russell is cheap, the economy is growing, the yield curve might be misleading, and positioning is extreme. That's a recipe for a contrarian opportunity, but it requires patience. Lucas: I'd add one more thing: keep an eye on the Fed's task force. If Kevin Warsh's group actually delivers on deregulation — especially in financial services — that could be a catalyst for small caps that the market isn't pricing in yet. Luna: Good note to end on. Thanks, Lucas. Lucas: Thanks, Luna. We'll be back tomorrow.