Does The Russell 2000 To S&P 500 Ratio Suggest A Coming Recession?

US DOLLAR (DXY) CORRELATION TO RUSSELL 2000 TO S&P 500 RATIO

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Correlation between DXY and RUT/SPX in blue

Tangentially, some market participants believe a strong US Dollar would result in a stronger Russell/S&P 500 ratio as fewer constituents have to negotiate fluctuating or unfavorable exchange rates. History reveals this logical reasoning carries questionable weight with the correlation between the two fluctuating considerably over time. While the relationship carries a statistically significant correlation at times, other macroeconomic themes can be blamed. In 2019 specifically, the Dollar has a negative correlation with the ratio – suggesting the Russell has not enjoyed an oversized benefit from a stronger Dollar.

ALTHOUGH POTENTIAL TAILWINDS REMAIN, THE RUSSELL LAGS

With the heralded tailwinds behind the Russell wavering but arguably present, why has the Russell lagged the S&P 500 in the most recent rally? In the year-to-date, the S&P 500 has climbed 19% compared to a gain of 15% for the Russell – despite the latter having a beta of 1.2. One possible reason for the Russell’s underperformance is the Index’s weighting by sector.

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Russell 2000 component weightings

Making up nearly 18% of the Index, the financial sector has weighed as the odds of a rate cut climb. A lower Federal Funds rate translates to slimmer margins for banks, a key profit component for smaller regional banks. Healthcare has also been troubled, falling in the crosshairs of Washington politicians. Finally, other economic indicators are flashing warning signs of their own. An inverted yield curve, deteriorating consumer confidence, and waning manufacturing data are a few examples that have spurred investor concern.

To that end, Russell 2000 constituents typically have weaker balance sheets than S&P 500 components. Should investors hold reservations about upcoming quarters, capital allocation to corporations with high levels of corporate debt is ill-advised and that could be reflected in the recent underperformance. Either way, it would be an exaggeration to suggest the weakening ratio between the two US Indices constitutes a clear-cut recession warning and is more likely just a coincidence that the ratio has aligned with 2008 levels. Still, other warning signs are flashing, so the relationship should not be entirely dismissed.

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