What the Russell 2000 Can Tell Us About the U.S. Economy

At a Glance

  • As engines of job growth, small and mid-size companies like those found on the Russell 2000 can provide economic forecasting.
  • A new, smaller futures contract tied to the Russell could change the way traders approach the index.

The Russell 2000 Index is the list of small and mid-size companies from the United States and includes stocks from all types of industries: retail, housing, technology and finance, just to name a few. This inclusion is more representative of the entire U.S. economy and is one of the reasons why the small cap index is said to be an economic barometer for the U.S. economy.

Engines of Growth

Because the Russell 2000 covers a large breadth of stocks that have not hit “macro cap” this also lends the Russell to its powerful forecasting abilities. The NYSE has mostly large companies and the NASDAQ is heavily weighted in the technology space. Small and mid-size companies are the engines that fuel growth and they can signal what’s in store for the economy.

The Russell 2000 has rallied almost 17 percent in 2019 which is the third best start to a year since the index’s inception, however this index has stalled of late and many see at this as a precursor to what’s to come:

Source: Yahoo Finance

Small caps are more closely aligned to the still-growing U.S. economy while large caps tend to have exposure to Europe and emerging markets where economic forecasts have lately been revised lower and financial conditions are tenuous at best.  Small caps would also be riskier in an increasing interest rate environment or as wage growth expanded because these companies are more sensitive to labor costs.

Another very closely watched characteristic of the Russell 2000 index is its correlation to GDP.  Typically, as GDP expands, small cap stocks tend to outperform large cap stocks.  Additionally, small cap stocks outperform large caps for the four quarters following the official end of a period of contracting economic activity.  Conversely, small caps underperform large caps in periods of falling GDP. GDP declined in the last two quarters of 2018.

In addition, the market closely monitors trading activity, specifically the investment rotation between large and small cap stocks. These rotations usually occur just ahead of a perceived change in market conditions.  When market sentiment is overly bullish there is typically a flip from large caps into small caps as fund managers look to increase their “beta” or maximize returns for their clients.

Access Through Futures

CME Group offers many avenues to trade the major indices including the Russell 2000 index of small caps.  In fact, beginning in May , CME will launch its Micro E-mini Futures, which are 1/10th the size of the typical E-mini contract.  The Micro E-Mini Russell 2000 contract will require less cash to enter the market with lower margins and provide the same benefits of E-mini futures, just in a smaller sized contract.  The contract size will be $5 x Russell 2000 Index. The dollar value will be $.50 per contract and will settle to cash at the Final Settlement Price.

This new contract brings tremendous value to the individual active trader.  Since the notional value of the major indices have risen dramatically, the amount of capital needed to access the futures market has become too large for many individual traders.  Traders will now be able to control a large contract value with a small amount of capital, with no expense ratios.  Additionally, the new Micro E-mini future are offset eligible versus their E-mini counterpart at a 10:1 ratio.  The bottom line is this new product will allow ease of access to the futures market for any size trader or budget.

Greater access to the market only adds to the power of the Russell as an economic barometer. In the coming weeks, it will be an index to watch, especially if economic data comes in below expectations.

 

Scott Bauer graduated with honors from the University of Illinois Business School, Urbana Champaign, in 1988 with a B.S. in Finance. Bauer began floor trading in 1991 and formed BOTTA Capital Management in 1995. Scott traded equity options, S&P options at CME and was employed by Goldman, Sachs & Co. as Vice-President, Equities Division. He is currently CEO of Prosper Trading Academy and appears regularly on CNBC, Bloomberg Financial and Fox Business as a guest commentator.

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