S&P 500 vs. Russell 2000: Which should you buy as interest rates fall?

The Federal Reserve recently cut interest rates by half a percentage point, the start of what will likely be a rate-cutting campaign through the end of the year and into 2025. The forward curve now forecasts that the federal funds rate will end in 2025. between 2.75% and 3%.

Investors, if they haven’t already, will now position their portfolios for a falling rate environment for the first time in more than four years. Falling interest rates can lead investors to take a more risk-averse approach, which can be good for stocks. However, at this point in the cycle, investors carefully assess the macro environment and look for signs of deterioration in the economy, including the labor market.

The S&P 500 index, which consists of large blue chip stocks, and the Russell 2000, which contains small-cap stocks, are two of the most common market indexes. What should investors be buying given this new economic backdrop? Let’s take a look.

Performance in recessions and declining rate environments

The future of the economy is still quite uncertain. Interest rates could fall more or less than investors expect, and eventually there could be a recession, given all the economic indicators pointing to one.

So for this analysis, I think it’s important to look at how each index performed when there was a recession and during periods when interest rates fell. I’ll only look at scripts dating back to 1984 because that’s when the Russell 2000 was released.

Source: Y-Charts.

As you might expect, stocks haven’t done so well during recessions, but the S&P 500 and Russell have performed fairly similarly, with the S&P 500 slightly outperforming.

In particular, during the brief recession since the start of the pandemic, the S&P 500 broadly outperformed the Russell. Although interest rates have fallen significantly during this period, it is not surprising to see investors flocking to safety during market panics. Companies in the S&P 500 tend to have larger and more stable balance sheets than those in the Russell.

Now let’s look at how both indices have performed during periods of declining interest rates.

Source: Y-Charts.

Once again, the S&P 500 has outperformed the Russell during declining interest rates dating back to 1984. In fact, the only time the Russell outperformed was between 2000 and 2003, after the dot-com bubble burst.

One last thing worth looking at is the current S&P and Russell ratings. The S&P 500, which has widely outperformed the Russell this year, is currently trading at about 27.5 times earnings, which is certainly at the upper end of where it has traded in the past. Russell, meanwhile, trades at about 24.4 times earnings.

Which one should you buy?

Past performance isn’t always predictive of the future, but data shows that since 1984, the S&P 500 has outperformed the Russell, on average, during recessions as well as periods of falling interest rates.

One thing I worry about is that the S&P 500 is trading at all-time highs, largely due to big tech and artificial intelligence (AI) stocks like Nvidiawhich trade at extremely high valuations. There’s more room for error in these names, which could trigger a selloff in the S&P 500 because of all the algorithmic trading going on these days.

That said, there could also eventually be a rotation into other names within the S&P 500 that don’t trade at such blood valuations. Finally, past data would suggest that the S&P 500 typically outperforms the Russell when interest rates begin to decline.

As for How to buy, Vanguard offers exchange-traded funds (ETFs) that include both the S&P 500 and the Russell 2000. The expense ratio for Vanguard S&P 500 ETF (VOO -0.20%) is a tiny 0.03%, while Vanguard Russell 2000 ETF (VTWO -1.02%) it does not charge much more, at 0.1%.