Trading Desk: The Russell Will Save Us

Major indices have now cracked their June lows, wiping out all the hard-won recovery they made across the summer. With macro news flow weakening in the interim, it’s not hard to understand why. But one area of the market is actually holding up. Let’s focus on it.

The Russell 2000 is the best benchmark for stocks too small to qualify for membership in the NASDAQ or S&P 500, much less the elite Dow industrials. As such, it tends to better reflect the ground-level economy, where the real dynamism of American enterprise happens.

And at least for now, it’s holding onto its June low. I think that’s because there aren’t any trillion-dollar giants crowding everyone else off the Russell . . . obviously enough, since this is a “small”-capitalization index, there aren’t any trillion-dollar giants here at all.

There isn’t a lot of room on the Russell for massive concentration of any kind. With 2000 stocks to track, the biggest holdings weigh in at a slender 0.40% position. They’re little companies as well, with the biggest weight barely clearing $10 billion.

They haven’t had a great year. When giants stumble, smaller names tend to crumble. But this summer, they bounced 5 percentage points more than the S&P 500 and still have a little support beneath them where the bigger benchmarks have already broken down.

It’s remarkable to see theoretically “vulnerable” companies without the vast cash reserves or commanding market share outperform their gigantic counterparts. I think there are two reasons for this.

First, investors with vision recognize that somewhere in the small end of the market the giants of tomorrow are being born. This is where disruption happens, where new industries get started.

The Silicon Valley names that made a previous generation rich are now mature, even defensive. They aren’t really dynamic or disruptive any more. They’re the ones with something to lose now . . . the vulnerable ones.

The future belongs to the disruptors. Many will not make it along the way. They’ll go broke, fade into obscurity or get bought out and absorbed into a bigger company. But enough will succeed to reshape the market.

Right now the mature names are looking a little stagnant. Their growth curves have gone as far as they can without getting dragged down by their own gravity.

And that’s the second factor driving money toward the small end of the market right now. The future looks bright . . . and the stocks reflect an exaggeratedly gloomy view of the recent past.

The Russell already tested its pre-COVID peak in June and is hovering around that level now. Digest what that really means. Small stocks have given up all progress they’ve made as a group across the pandemic era.

I know the pandemic was rough on a lot of little companies, but it’s frankly insulting to the people running them.The Russell closed 2019 roughly where it is now and was valued at a historically reasonable 20.5X forward earnings then.

Here at 19.6X forward earnings, the index is 5% cheaper on a fundamental basis than it was three years ago. There’s not a lot of net growth there across the pandemic, but these companies are still moving in the right direction.

I’d rather be in the Russell than whole sectors of the S&P 500 right now. And I’m starting to think that the big benchmarks, overweight as they are in Big Tech, still have a long way to go before the fear evaporates.

The NASDAQ is still 14% above its pre-pandemic peak. The S&P 500 has 10% left before it tests that level. Even the “old school” Dow has 2% to show for the last 2.5 years.

A lot of that gain comes from a handful of names like Apple (AAPL), Tesla (TSLA) and Microsoft (MSFT). If they crumple this earnings season, the Russell might shudder in sympathy, but the fundamentals look more attractive with every lurch to the downside.

Sooner or later, these will be the stocks that lead the recovery. Look toward the future. The present may be miserable, but the real misery is waiting for shareholders who refused to deviate from the biggest winners of the past decade.

The market wheel always turns. Personally, I’m eager to see it happen. We need fresh leadership and new energy in the market. The Russell is where we’ll see the change.