McClellan Chart In Focus: Small Cap Underperformance Is Not Over – By Tom McClellan

 

Chart In Focus

Small cap stocks have been underperforming large ones since mid-2018, and this underperformance should continue until the end of 2020.

This week’s chart shows a relative strength line (green) for the Russell 2000 Index versus the Russell 1000.  It is a very simple calculation, dividing the R2’s index value by the R1’s.  When the line is rising, that means small caps are outperforming on a relative basis.  That outperformance can mean going up faster, or going down more slowly.  If you are an investor in small cap related stocks or ETFs, you want this line to be rising.

Also included in this chart is a measure of the yield spread between 10-year and 3-month Treasuries (black line).  That plot is shifted forward by 15 months to help us see how its movements tend to get repeated in the R2/R1 relative strength line.  It does not always repeat perfectly, especially when the Fed puts a thumb on the scale.  But generally speaking, the relative strength line echoes the dance steps of the yield curve.

That is important because on a monthly closing basis, that yield spread bottomed in August 2019.  Counting 15 months forward, we get November 2020 for when the relative strength line should ideally find its own bottom.  That means around 10 more months of small cap underperformance from here.

This 15-month lag is also important in other ways.  Here is that same spread between 10-year and 3-month yields, compared to the quarterly change in GDP, once again using a 15-month forward offset:

10-3 yield spread versus GDP

Everyone already knows that an inverted yield curve is a warning sign of an economic recession.  But what is really interesting is that if we run a Pearson’s Correlation Coefficient for these two plots in real time, they only have a +0.05 correlation factor.  In other words, no correlation at all, according to that statistic.

But if we adjust that calculation for the 15-month lag, then the correlation jumps up to +0.29.  That’s far from a perfect correlation, and the somewhat low correlation score comes about because sometimes the magnitudes of the two plots’ movements are not equal.  But what we care about is the direction of movement, and when GDP growth turns negative.  On that basis, the periods of inversion have a really good track record.

Perhaps the most interesting point about this 15-month offset is that the timing of the August 2019 bottom for this yield spread means that November 2020 is when small cap relative strength and economic growth should be bottoming out.  And that is when the U.S. will hold its next presidential and congressional elections.  So watch for the topics getting debated among the candidates to start shifting to economic growth themes.

Tom McClellan
Editor, The McClellan Market Report

Related Charts

Aug 22, 2014
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Small Cap Relative Strength
Mar 08, 2019
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Yield Curve Really Does Matter for Unemployment
Jun 13, 2019
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When Underperformance Reaches An Extreme
 

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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.