Fueled by a seemingly dovish stance by the U.S. Federal Reserve, the S&P 500 broke through 3,000 for the first time ever in early July 2019. And while that may have been cause for celebration for some investors, a lot of traders are thinking the current melt-up is getting a little ahead of itself.

Exhibit A for contrarians is the current performance of the Russell 2000, an equity index comprised of small-cap stocks. While the S&P 500 is represented by large-cap companies and is making record highs, the small-cap focused Russell 2000 is well off it’s highest mark.

In fact, as of early July, the Russell 2000 was trading about 9% off its record high, achieved in August 2018.

Since equity indices such as the S&P 500, the Nasdaq, the Dow Jones, and the Russell 2000 all share a strong historical correlation, the current divergence in the Russell 2000 and the S&P 500 seems a bit curious, to say the least.

On top of this perplexing situation is the fact that the U.S. yield curve inverted earlier this year. As a reminder, the yield curve tracks the market value of interest rates going out in time and is usually presented as a chart.

A “normal” yield curve is described by a gradually rising line going from left to right on the chart—meaning interest rates are increasing along with the length of maturity. An “inversion” in the yield curve occurs when short-term rates climb higher than longer-term rates, even if only briefly.

The most recent yield curve inversion occurred in March, when the going interest rate for 10-year Treasuries dropped below the going interest rate for three-month paper. This marked the first inversion involving the the 10-year Treasuries since mid-2007, which ominously occurred right before the Great Recession spread across the United States.

This previous instance also helps illustrate why traders follow yield curve inversions so closely.

The Treasury yield curve has inverted prior to virtually every recession in the United States over the last 50 years. Only once during that period did a brief inversion of the yield curve not see a recession eventually materialize.

So if previous yield curve inversions have almost always led to economic recessions, one might reasonably wonder how stock indices have performed in the wake of yield curve inversions.

Thankfully, the tastytrade financial network addressed this question on a past installment of Futures Measures.

According to research by tastytrade, investors should keep three factors in mind about yield curve inversions and the performance of stock indices:

  1. No immediate reaction in stock valuations is typically observed.
  2. Poor economic data usually follows at some point after an inversion.
  3. Large downturns in equity indices have followed inversions, usually with a lagged effect.

Expanding on Bullet Point 3, the tastytrade team took a closer look at the elapsed time between some historical inversions in the yield curve and ensuing corrections in equity prices. As shown below, historical data illustrated that the time between an inversion and a correction can vary greatly.

The information above indicates there’s no clear historical pattern between a yield curve inversion and an eventual correction in equity prices. However, given the frequency with which such corrections have followed yield curve inversions, this is information investors need know. 

With equity prices notching fresh all-time highs, the above data may help investors and traders avoid the pitfalls of complacency, even if overall market volatility remains low. With the VIX trading in the low teens, mean reversion theory suggests that at some point the VIX will rally back toward its historical mean of roughly 19.

The fact that the yield curve inverted recently only makes that eventuality all the more probable.

Circling back to the divergence in the S&P 500 and the Russell 2000, one can’t help but speculate that pairs traders have likely zeroed in on this potential opportunity, as well. Pairs traders often seek to short the outperformer (S&P 500, SPY) and go long the underperformer (Russell 2000, RUT) in situations like these. Traders seeking to learn more about the upcoming meeting of the Federal Reserve (July 30-31) and possible approaches to trading the yield curve should find a recent installment of Futures Measures on the tastytrade financial network compelling.

Sage Anderson is a pseudonym. The contributor has an extensive background in trading equity derivatives and managing volatility-based portfolios as a former prop trading firm employee. The contributor is not an employee of luckbox, tastytrade or any affiliated companies. Readers can direct questions about any of the topics covered in this blog post, or any other trading-related subject, to support@luckboxmagazine.com.