McClellan Chart In Focus: Inverted Yield Curve, and Small Caps. “ very reliable effect associated with yield curve fluctuations which we can talk about” By Tom McClellan

Chart In Focus

August 22, 2019

The whole media world is abuzz lately with talk of the inversion in the yield curve, and what it means for a potential recession.  The track record is mixed there, and there is much debate among academics about whether it is “different this time”.  But there is one very reliable effect associated with yield curve fluctuations which we can talk about.

In the chart above, I’m showing the relative strength ratio for the Russell 2000 Index versus the Russell 1000.  Also in the chart is the spread between the 10-year T-Note yield and the 3-month T-Bill yield, which is one of the common ways of showing the “yield curve”.  The trick in this chart is that the yield spread’s plot is shifted forward by 15 months in order to show how the R2/R1 relative strength ratio tends to follow in the same footsteps after that lag time. 

This is relevant now because the R2/R1 relative strength line has been moving lower, indicating that small cap stocks have been underperforming large ones on a relative basis.  And the continued drop in the 10-3 spread says that this underperformance of the small caps is likely to continue for the next 15 months. 

This leading indication relationship has not always worked perfectly, and so that is a risk factor for anyone wanting to use it.  When the Fed gets really crazy, the relationship goes off track a bit.  We saw that with the Y2K spike in small caps, which was fueled by the Fed trying to stuff extra liquidity into the banking system just in case anything went wrong with all of the computers in the whole world. 

We also saw that when the Fed started the QE3 program, with massive injections of liquidity into the banking system, they were able to ward off what should have been a dip in small cap relative strength.  Once QE3 started winding down in late 2014, the relationship got back to normal.

So it is a reasonable question now about whether the Fed’s current restrictive stance on interest rates is going to skew this relationship again.  I’ll have a definitive answer to that question in about 15 months.

There is another relationship which is part of this dynamic and which is worth mentioning.  The relative performance of small caps versus large caps is also related to the movements of the price of gold, or at least that is the case most of the time.

Gold versus small cap relative strength

The two plots in this chart are very well correlated over the really long term, going back as far as there is price data on the Russell 2000 and Russell 1000.  At shorter term time scales, though, we do see disagreements with them, and that can be instructive. 

Right now, gold prices are zooming up to the highest level since 2013, and the R2/R1 relative strength ratio disagrees strongly with that action in gold prices.  So who is right? 

Most of the time, when there is a divergence like this, the R2/R1 relative strength ratio ends up being right about where both are headed.  So that would mean gold is going ridiculously off track here by rallying up above $1500.  But in 2008, gold shrugged off a similar divergence and kept moving higher (for a while), so while the normal reaction is for this sort of divergence to be bearish for gold, the rule is not without exceptions.  Still, the better bet based on history is to expect gold to wake up and realize that it is climbing up on its own, and without support from either the R2/R1 relative strength line or from what the 10-3 spread says should be happening.  That is a problem for the gold bulls.

Tom McClellan
Editor, The McClellan Market Report

Related Charts

Aug 22, 2014

Small Cap Relative Strength
Jan 30, 2014

Yield Spread Model Calls For 2014 Stock Market Low
Dec 19, 2014

Yield Curve’s Effect Thwarted By Fed’s Actions


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About the author

Sherman and Marian's son Tom McClellan has done extensive analytical spreadsheet development for the stock and commodities markets, including the synthesizing of the four-year Presidential Cycle Pattern. He has fine tuned the rules for interrelationships between financial markets to provide leading indications for important market and economic data. Tom is a graduate of the U.S. Military Academy at West Point where he studied aerospace engineering, and he served as an Army helicopter pilot for 11 years. He began his own study of market technical analysis while still in the Army, and discovered ways to expand the use of his parents' indicators to forecast future market turning points. Tom views the movements of prices in the financial market through the eyes of an engineer, which allows him to focus on what the data really say rather than interpreting events according to the same "conventional wisdom" used by other analysts. In 1993, he left the Army to join his father in pursuing a new career doing this type of analysis. Tom and Sherman spent the next 2 years refining their analysis techniques and laying groundwork. In April 1995 they launched their newsletter, The McClellan Market Report, an 8 page report covering the stock, bond, and gold markets, which is published twice a month. They utilize the unique indicators they have developed to present their view of the market's structure as well as their forecasts for future trend direction and the timing of turning points. A Daily Edition was added in February 1998 to give subscribers daily updates on their indicators and also provide market position indications for stocks, bonds and gold. Their subscribers range from individual investors to professional fund managers. Tom serves as editor of both publications, and runs the newsletter business from its location in Lakewood, WA.