Wall Street's trusted recession indicator just flashed red

After falling 10% from its summer peak, the Russell 2000 index of small-cap stocks has entered a technical correction—a sign that the U.S. economy may be inching toward a recession.

The index, which consists of the smallest 2,000 stocks in the Russell 3000 index, is often taken as an economic bellwether, with sharp declines often coming before or during recessions.

The Russell 2000 flashes red

The Russell 2000 suffered extremely sharp declines in both 2007-2009 and in March 2020. The former reflects the Great Recession crash, and the latter was Covid.

Most dramatically, the index dropped by around 40% between February and March 2020, when the pandemic forced much of the world to lock down.

The index’s decline over the past month doesn’t look anywhere near as serious—even if it remains down by 26% compared to the all-time high it recorded in November 2021.

Still, the sheer fact that small-cap stocks are falling out of favor signals that Wall Street is growing uneasy about the state of the economy.

“Investors tend to look for quality during times of market volatility, and that consists of stocks with strong balance sheets, significant profit margins, stable business models and growing dividends, and those are characteristics that are not typically found in the small caps space,” wrote Claro Advisors vice president Jeff Corey in a note.

“So if you put all those factors together, I wouldn’t say that the Russell 2000 is a canary in the coal mine. That being said, it’s very out of favor,” he said.

Main Street shares the hardship

Small business owners aren't optimistic about their future prospects, either.

There's a pronounced drop in small business confidence levels, as highlighted by the fact that the National Federation of Independent Business’ Small Business Optimism Index is now at its lowest level for a decade.

The federation noted that small business confidence remains “at recession levels,” with optimism declining as 23% of small business owners cite inflation as their single biggest worry.

Meanwhile, bankruptcies among smaller enterprises have been rising at their fastest pace since Covid.

Some analysts predict that the U.S. economy will enter a recession soon enough. Seema Shah, the chief global strategist for Principal Asset Management, recently suggested this could happen at the end of 2023.

“We are anticipating two quarters of negative growth [...] we’ve had incredibly aggressive central bank tightening, and not just in the U.S. but around the world, and there will be some kind of repercussion from that,” said Shah, who nonetheless added that any incoming recession may not be especially severe by historical standards.

Although recession is not currently on the Fed’s radar, research from the central bank’s New York branch has placed the odds of an economic downturn at 66% as recently as September.