McClellan Chart In Focus: Yield Curve and Small Caps. “..the spread between 10-year and 2-year yields” By Tom McClellan

Chart In Focus

Back on August 22, I wrote here about how the spread between the 10-year T-Note yield and the 3-month T-Bill yield gives us a leading indication that is relevant for small cap relative performance.  This time, I look at the “yield curve” in a different way, via the spread between 10-year and 2-year yields.

The 10-year to 3-month spread is a leading relationship for small cap relative performance, but the 10-2 spread is a coincident one.  Sometimes analysts show that as a 2-10 spread, but it works better for this purpose as a 10-2 spread, since it matches up better to what the relative strength ratio is doing.

Or at least that has been the case since around 2008.  Before then, the correlation was not as good.  That is a curious shift point in history; there was a lot going on in the financial markets that year, as most of you remember.

The best explanation of the “why” of this relationship as it exists now is that there are a lot of banks now making up the composition of the Russell 2000.  The chart below shows data as of earlier this year in terms of the population of the Russell 2000 by S&P sector category.  Financial services is number one now at 17.1%, and it has been #1 for several years.  It reached as high as a 25.6% weighting in 2015.

Banks make their money by borrowing at short term rates (from depositors, mostly), and lending at long term rates.  So a steep yield curve is the most profitable condition for them. 

Russell 2000 Index sector weightings

But notice in the top chart above that the relative strength ratio peaks at the same time as the 10-2 spread.  So it is really a steepening yield curve that is good for small cap out-performance, not just a steep one.  And the flattening of the yield curve since 2014 has meant trouble for small cap stocks as a group. 

If the Fed can manage to get the yield curve to start steepening again, then small caps could finally turn up and start outperforming again as a group.  The FOMC already cut the Fed Funds target rate by a quarter point this week.  That cut would need to flow through to the 2-year T-Note yield in order to give small caps a continued relative strength boost. 

Tom McClellan
Editor, The McClellan Market Report

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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.