After under-performing the S&P 500 for the better part of 2014, the Russell 2000 began to show some signs of life in the third quarter. Following a false breakdown of a key support level, small-cap stocks have slowly begun to outperform large-cap stocks, making higher-lows on relative basis.
The Russell ended the year on a high note, breaking out above the strong 1,208 resistance level; but that was short lived as prices have recently come down sharply, breaking below the 50-day moving average.
As we look at the sustainability of the Russell’s out-performance, it is important to look at the steepness (or in this case, flatness) of the yield curve (30-year minus 2-year yield). Looking back historically, any sustained out-performance of small-cap stocks was accompanied by a steepening yield curve. The continued flattening of the yield curve signals that investors’ inflation expectations are falling. Small-cap companies tend to favor inflationary environments as they have more leeway to raise prices relative to their larger-cap counterparts.
The spread between the 30 & 2-year yields is diverging to multi-year lows, not confirming the relative strength we have been seeing in the Russell. As we roll into 2015, investors should monitor this relationship for clues to whether the strength in small-caps is short-lived or perhaps something more substantial.