The Federal Reserve recently cut interest rates by half a percentage point, the beginning of what is likely to be a rate-cutting campaign through the end of the year and into 2025. The forward curve is now forecasting that the federal funds rate will end 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 prompt investors to take a more risk-on approach, which can be good for equities. However, at this point in the cycle, investors are also carefully assessing the macroenvironment and looking for signs of deterioration in the economy, including the labor market.

The S&P 500 index, which is comprised of large blue chip stocks, and the Russell 2000, which contains small-cap stocks, are two of the most common indexes in the market. Which should investors buy given this new economic backdrop? Let's take a look.

Performance in recessions and falling-rate environments

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

So for this analysis, I think it's important to look at how each index has performed when there has been a recession and during times when interest rates have fallen. I'm only going to look at scenarios dating back to 1984 because that's when the Russell 2000 was launched.

Source: Y-Charts.

As one might expect, stocks have not fared so well during recessions, but the S&P 500 and Russell have had fairly similar performances, with the S&P 500 slightly outperforming.

Notably, during the brief recession at the onset of the pandemic, the S&P 500 widely outperformed the Russell. Although interest rates fell significantly during this time, it's not surprising to see investors flock 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 indexes have performed during periods of falling interest rates.

Source: Y-Charts.

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

One last thing worth taking a look at is the current valuations of the S&P and Russell. Currently, the S&P 500, which has widely outperformed the Russell this year, trades at about 27.5 times earnings, which is certainly toward the higher end of where it's traded in the past. Meanwhile, the Russell trades at about 24.4 times earnings.

Which should you buy?

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

One thing I do have some concern about is the fact that the S&P 500 is trading at all-time highs, largely due to a handful of large tech and artificial intelligence (AI) stocks, such as Nvidia, which are trading at extremely high valuations. There is more room for error in these names, which could trigger a sell-off in the S&P 500 due to all of the algorithmic trading that goes on these days.

That said, there could also eventually be a rotation into other names within the S&P 500, which aren't trading at such nosebleed valuations. Ultimately, past data would suggest that the S&P 500 typically outperforms the Russell when interest rates begin to fall.

As for how to buy, Vanguard offers exchange-traded funds (ETFs) featuring both the S&P 500 and the Russell 2000. The expense ratio for the Vanguard S&P 500 ETF (NYSEMKT: VOO) is a minuscule 0.03%, while the Vanguard Russell 2000 ETF (NASDAQ: VTWO) doesn't charge much more, at 0.1%.

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Bram Berkowitz has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Vanguard S&P 500 ETF. The Motley Fool has a disclosure policy.

S&P 500 vs. Russell 2000: Which Should You Buy With Interest Rates Falling? was originally published by The Motley Fool