What Close Correlation to Russell Means for the S&P 500

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After a near 8% rebound in the Russell from its trough and a 7.44% uptick in Dow Jones Micro-Caps, along with a 4-sigma swing in the 10-year treasury yield, it's a prudent moment to pause and consider if the landscape has really shifted.

In the span of the past half-decade, the rolling correlation between the S&P 500 and the Russell 2000 has been consistently robust, ranging from 0.76 on the lower end to 0.95 at its peak, signaling a tight parallel movement. Presently, we're seeing a correlation around 0.86, which can fluctuate with the days and weeks. The nearer this value edges towards 1, the stronger their positive correlation becomes. The significance of this metric lies in its utility; the Russell versus S&P correlation can inform our understanding and expectations for the broader indices.

Despite recent gains, the Russell maintains a strong bearish pattern. It has bounced off its peak from January 2020, but remains in a downturn. The markets have initially welcomed Chairman Powell’s non-committal stance last week, followed by a buoyant response to lackluster ISM figures, and it was true love when investors saw the slowing ADP and NFP statistics. This dynamic where bad news is paradoxically good news is in play, yet our stance is that this will soon shift to a scenario where bad news is just that – bad news, as the market comes to terms with the fact that a Fed pause does not equate to an easing policy. If we assume the correlation endures, a dip in small caps could signal a forthcoming downturn in the larger indices as well. A recession means top-line revenues fall, business pricing power diminishes, lending standards remain tight, and unemployment rises. Assuming the correlation holds, small caps begin to decline again, and so will the larger indexes as well.

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