Latest / Bull Market Conversations with Fexingo: Rallies, Momentum, and Riding Market Strength / Why the Russell 2000 Is Outpacing the S&P 500
Transcript
- Lucas: Small caps are absolutely ripping this week. The Russell 2000 is up three point four percent in the last five days, while the S&P 500 is sitting on a relatively modest one percent gain. Luna: That's a pretty big divergence. Is this just a catch-up trade, or is something more structural going on? Lucas: I think it's a bit of both. The Russell has been lagging for a while—through most of 2024 and into early 2025, large caps dominated, led by the Magnificent Seven stocks. But the tide started turning late last year, and this week feels like an acceleration. Luna: What's the catalyst? Rates have been stable—the Fed funds rate is still around three point six percent. That's not exactly easy money. Lucas: True, but it's the direction that matters more than the level. The market's pricing in that the Fed is done hiking and could start cutting later this year. For small caps, which carry more floating-rate debt than large caps, even the expectation of lower rates is a huge relief. Their interest expense goes down, margins expand, and the earnings picture improves. Luna: So it's a rates story. But there's also a composition angle, right? The Russell 2000 is way more domestic than the S&P 500. Lucas: Exactly. About eighty percent of Russell 2000 revenue comes from inside the U.S., compared to maybe sixty percent for the S&P. So if the U.S. economy is still growing at around two percent real GDP, which it is, small caps benefit disproportionately. They're not exposed to the slowdown in Europe or China the way Apple or Microsoft are. Luna: That makes sense. And the sectors are different too. The Russell is heavy on financials, industrials, and healthcare—not so much tech. So when tech pulls back, small caps can still rally. Lucas: Right. The S&P 500 is still dominated by a handful of mega-cap tech stocks. If those stumble, the index struggles. But the Russell is more diversified across cyclical sectors that actually benefit from a growing economy. Regional banks, for example, are a big part of the index, and they've been rallying hard as the yield curve normalizes. Luna: I saw that the KBW Regional Banking Index is up about eight percent this month alone. That's a big tailwind for the Russell. Lucas: It is. And it's not just banks. Homebuilders, transportation companies, even some consumer cyclical names are all doing well. The market is essentially saying that the soft landing scenario is playing out—the economy is growing, inflation is moderating, and the Fed is on hold. That's a perfect environment for small caps. Luna: But there's a risk, right? If the economy does slow down more than expected, small caps tend to get hammered. They have less pricing power and weaker balance sheets. Lucas: Absolutely. That's the flip side. The Russell 2000 is about twice as volatile as the S&P 500. So if we get negative GDP growth or a spike in credit defaults, small caps would fall much harder. But for now, the data supports the bull case. Luna: What about valuations? Are small caps cheap relative to large caps? Lucas: They are. The Russell 2000 trades at about fifteen times forward earnings, while the S&P 500 is at twenty-one. That's a historically wide spread. Some of that discount is justified—small caps are riskier and less profitable—but it also suggests there's room for multiple expansion if the economy holds up. Luna: So the play might be to overweight small caps in a diversified portfolio, especially if you think rates are headed lower. Lucas: That's the consensus trade right now. But you have to be selective. Not all small caps are created equal. The iShares Russell 2000 ETF, ticker i w m, is up three percent this week, but within that index, the winners are companies with strong balance sheets and pricing power. The losers are the unprofitable, high-debt names that could still get crushed if rates don't fall as fast as expected. Luna: So bottom-up stock picking matters more than just buying the index. Lucas: Exactly. That's the nuance. The Russell 2000 can be a great barometer for the economic cycle, but if you're going to invest, you want to focus on quality—companies with positive free cash flow, low debt, and a competitive moat. There are plenty of those in the index, but you have to do the work. Luna: Any specific examples? I know you love digging into the holdings. Lucas: Sure. Take a company like Simpson Manufacturing, which makes wood connectors and structural fasteners. It's in the Russell 2000, has a thirty percent gross margin, almost no debt, and benefits from the housing market. Or Pool Corporation, which distributes swimming pool supplies—steady demand, decent pricing power. Both are up double digits in the last month. Luna: So the rally isn't just a macro trade—it's fundamentally justified in many cases. Lucas: I think so. The earnings season just wrapping up showed that small-cap earnings are actually beating expectations at a higher rate than large caps. According to FactSet, about seventy-eight percent of Russell 2000 companies have beaten EPS estimates, versus seventy-five percent for the S&P 500. That's a meaningful shift. Luna: It is. And it's a good reminder that the bull market is broadening out. The Magnificent Seven can't carry the load forever. Lucas: Exactly. And when leadership broadens, the rally is healthier and more sustainable. So this small-cap surge might just be the beginning of a longer trend. Luna: Or it could be a head fake. But the data right now is pretty compelling. Lucas: It is. We'll know more in a few months when the next GDP print comes out and the Fed makes its move. But for the moment, the Russell 2000 is telling us that the bull market has legs beyond tech. Luna: And that's a story worth paying attention to. Lucas: Absolutely. Thanks, Luna. Luna: Thanks, Lucas.