Latest / The Macro Memo with Fexingo: Daily Conversations on Inflation, GDP, and Federal Reserve Policy / Why the Russell 2000 Is Getting Left Behind
Transcript
- Lucas: So you look at the headline numbers this week and you see the S&P 500 at 7,537, up 1.3 percent in the last five days, the Dow up 1.7 percent. But then you glance at the Russell 2000 and it's basically flat. Down about zero point zero percent on the week. That gap is the real story. Luna: It's been that way for months though, hasn't it? The small caps just can't catch a bid. Lucas: They can't. And the data we got in the last week helps explain why. The June jobs report on Thursday showed payrolls growth of just 57,000. That's a big miss. Unemployment ticked down to 4.2 percent, but only because the labor force participation rate dropped to its lowest in fifty years outside of the pandemic. Luna: Right, fewer people looking for work means the unemployment rate can fall even if hiring is weak. But what does that have to do with small caps specifically? Lucas: Smaller companies are more sensitive to labor costs. The average hourly earnings number ticked up again, to 37.6 dollars. That's a 2.4 percent year-over-year raise for workers. For a small business with thin margins, that's a real squeeze. Meanwhile, a company like Walmart or Amazon can absorb higher wages through scale and automation. Luna: So the labor market dynamic is actually working against small caps. And then there's the rate picture. Lucas: Exactly. The 10-year Treasury yield hit 4.48 percent this morning, up 2.5 percent on the week. The 30-year is pushing five percent — 4.99. That's a brutal headwind for any company that needs to refinance debt. Small caps carry more variable-rate debt than large caps. Luna: I saw a stat from Goldman recently that something like 40 percent of Russell 2000 debt is floating rate. Compare that to maybe 15 percent for the S&P 500. Lucas: That's the killer. The Fed funds rate is still at 3.63 percent. The central bank hasn't cut all year. So small companies are paying more to service debt, and that eats into earnings. Meanwhile, large cap tech companies are sitting on piles of cash — they benefit from higher rates because they earn more on their own cash reserves. Luna: It's a tale of two balance sheets. And the market is rewarding the ones with cash. Lucas: Absolutely. Look at the S&P 500 concentration. The top ten stocks now make up over 35 percent of the index. That's a level we haven't seen since the dot-com era. Money is flowing into the mega caps because they're perceived as safe in a world where inflation is sticky — the 10-year breakeven rate is at 2.24 percent — and the Fed is on hold. Luna: But is it really a safety play? Or is it just momentum? The mega caps have been going up for so long that fund managers are afraid to underweight them. Lucas: It's both. There's a real safety component because those companies have pricing power and global revenue streams. But there's also a huge FOMO element. The Russell 2000 is trading at roughly 15 times forward earnings, while the S&P 500 is at 21 times. Value investors would say small caps are cheap. But cheap doesn't matter if earnings keep getting revised down. Luna: And earnings revisions for small caps have been negative for six straight months. I think FactSet data had the Q2 estimate for Russell 2000 earnings down 8 percent year-over-year. Lucas: Right, versus flat earnings growth for the S&P 500. So the divergence is baked into the fundamentals. The question is: what changes this? What would get small caps moving again? Luna: My guess is either a Fed cut — which doesn't seem likely given the sticky inflation data — or a rotation out of tech that feels more structural than just a pullback. Lucas: I think you're right. The Fed is stuck. Core PCE is still running above 3 percent. The last CPI print was 334 on the index, up from 332.4 the month before. That's not the kind of data that gets Powell to cut. So the catalyst would have to come from the market itself. Luna: Maybe a recession scare would actually help small caps? Because if people think rates are coming down, they'd bid up the most rate-sensitive names. Lucas: That's the paradox. Small caps need lower rates to thrive, but lower rates would only come if the economy weakens. And if the economy weakens, small cap earnings will take a bigger hit than large cap earnings. So you're damned if you do, damned if you don't. Luna: The one bright spot I've seen is that the Russell 2000 has started to show some relative strength in the past couple of days. It's still down for the week, but it's not breaking down. Lucas: It's holding support around 3,000. That's something. But until we see a sustained move above 3,100 or 3,200, it's hard to get excited. If walking through the economy with us has made something click, the way we keep this ad-free is listener support. You can find us at buy me a coffee dot com slash fexingo. No pressure — just if you find value in the daily conversation. Luna: I second that. This show takes a lot of prep, and every little bit helps. Okay, back to the Russell — what are you watching for this week? Lucas: I'll be watching the JOLTS data that comes out later this week. Job openings ticked up to 7.594 million in May, but that's still well below the peak. If openings start to fall again, that could spook the market and actually trigger the rotation into small caps as a rate-cut play. Luna: So the same data that's bad for the economy might be good for small caps. That's the kind of twisted logic we're dealing with right now. Lucas: Exactly. And that's what makes this market so hard to navigate. The old rules don't apply. The Russell 2000 is telling us that the economic expansion is not as broad as the S&P 500 suggests. Luna: Maybe that's the real signal. The market is saying large caps are fine, but the rest of the economy is struggling. Lucas: I think that's right. And until we see either a clear path to lower rates or a pickup in small business confidence — which is still depressed — the Russell is going to remain the laggard. Luna: Alright, I'll be watching that 3,000 level closely. Thanks, Lucas. Lucas: You got it. See you tomorrow.