The Russell 2000 may have predicted the stock market crash

The stock market is like a collective crystal ball, in which investors value stocks by what they expect companies to do in the future, using the immediate past to support their hunches. But when shares have plummeted, the hardest question to answer is also the most pressing: When will we be past the worst?

And on this point, there’s one corner of the market that may offer some clues.

A group of analysts, advisers, and investors point to the Russell 2000, which comprises small-cap and midcap companies, as important to track. The Russell has often presaged a crash, or blow-off top, and on the other side of a bear market indicated when conditions were again turning favorable.

“Not many people pay attention to that, but that’s how many bear markets start, with the smaller and midsize companies,” said Steven Jon Kaplan, CEO of True Contrarian Investments. “Hardly anybody reports on a story how the Russell 2000 did on a particular day or week or year.”

“In most correction cycles, small-caps tend to lead the charge on the way down,” said Dan Wantrobski, associate director of research at Janney Montgomery Scott.

The Russell 2000 began to indicate potential danger 18 months ago when it started to dip after hitting its high back on Aug. 31, 2018. Meanwhile, the S&P 500 would continue to climb for another year and a half. The divergence continued until the broader market crashed in February 2020.

Then, when things really turn around (versus a short-term bump, followed by another fall), stocks on the Russell frequently lead the large-caps. When this happens, it tells you “investors are moving back into the riskier areas of the equities market,” Wantrobski said. “You’ll know we’re getting close to a bottom when we see small-caps starting to outperform large.”

Getting the theory

To understand, it helps to look at the foundation on which Russell stocks operate.

“Small-caps are domestically focused: 80% of the revenue of the index comes from the United States,” said Nathan Moser, senior vice president and portfolio manager of the Pax World Small Cap Fund. That compares to about 40% among the S&P 500, he noted.

As a result, “the Russell 2000 is more directly exposed to GDP growth in the United States than either the S&P 500, Dow, or Nasdaq,” said Stephen Mathai-Davis, CEO of fintech company Quantalytics AI. Swings in the domestic economy have a bigger impact on Russell companies. Large-caps, which are generally more geographically diversified, are more likely to weather U.S. Economic downturns.

Large-caps also have more access to financial resources to manage difficult conditions. Small-cap stocks, on the other hand, are less able “to secure funds, such as bank credit lines,” said Dr. Tenpao Lee, a professor of economics at Niagara University, in a note to Coins2Day.

In addition, the business cycle for small-cap companies is typically shorter than that of the economy’s overall business cycle. “As a result, when the economy is turning into a recession, we will observe negative signals from small stocks first, such as revenue and profit declines, layoffs, and even bankruptcies,” Lee noted. He also pointed out that Russell-type companies are more flexible, so they can and will make faster adjustments like laying off employees, making economic impacts more obvious than with slower big businesses.

For example, during the rally at the start of Donald Trump’s presidency, “for every one unit gain in the S&P 500, the Russell 2000 was going up nearly one-and-a-half times,” Mathai-Davis said.

But 2019 was a very different story. “The S&P and Dow kept posting new highs,” said Wantrobski. “It was never confirmed by the Russell 2000 or the SmallCap 600. We were cautious. In any healthy bull market, you have to see breadth.” Even without the impact of the pandemic, assuming a continuation of a bull market was becoming riskier.

Now that we are firmly in the grips of a bear market—and likely a recession—some experts will be looking again to the Russell 2000 companies for signs that the worst is over. As in the past, finding the real change is a day-to-day search. At some point, or so goes the theory, the Russell 2000 will be growing faster than the S&P 500, Dow, and Nasdaq indexes, although there’s no way to know when that might happen.

Analysts caution, however, that we are in uncharted economic waters, and small companies may have a harder time than usual bouncing back. “Small-caps haven’t done themselves any favors by leveraging their balance sheets,” Moser said. “Equity investors may be concerned that you can’t refinance the debt coming due or that refinancing will be much costlier.” The uncertainty will translate into greater caution toward smaller and more heavily leveraged companies.

According to data provided by FactSet to Coins2Day, on a trailing 12-month basis, the S&P 500 overall shows a total debt to assets ratio—a measure of leverage—of 31.2 while the S&P SmallCap 600 index is at 40.4.

“It will be something that we’ll be watching for in the days or weeks ahead,” Wantrobski said.