ARE SMALL-CAPS IN TROUBLE?

If you frequently look to small-caps for opportunities then you have undoubtedly been exposed to the mess that they've been in since May, with the final blow being the false breakout back in the beginning of November. Trading the bigger names were a lot more favorable the last few months and that might be the case for months to come. The chart below is the Russell 2000 index ETF with an unusual indicator that I frequently use.

The indicator plots the percentage of extension from the 50 simple moving average. I use the indicator to gauge the magnitude of a run-up or a sell-off relative to previous run-ups or sell-offs. A stock, commodity, currency,... will frequently exhibit their own maximum amount of extension before it start reversing. Some have the tendency to overextend to extreme lengths and other assets will start reversing a lot sooner. The Russell 2000 index has overextended quite a lot during the run up from March 20 to March 21 and has since just moved sideways. The extension indicator printed above 30 percent overextension which is, based on previous run-ups, the maximum overextension it can handle before it start reversing.

Of course, the reason it starts reversing is not due to the overextension, it has to do with the possible exhaustion of the buyers. When small-caps have ran up so much, there might not be enough buyers left to push it any higher which causes the sellers to get the upper hand. That's what the extension indicator tells us. The IWM chart is on a monthly scale and could be giving us a leading indicator of what's to come. It did exactly that in 2007 and in 2014, we might be seeing it unfold once again.

Does this mean we're about to see a crash? Don't worry, throwing that term around is an exaggeration, the projection is that the Russell 2000 could be trading much lower to reach the 50 monthly moving average (the blue line). So no, it doesn't mean it's about to crash... (which is a very popular term to use these days). However, chances are we could be seeing a short downtrend in the Russell 2000 for the next few weeks to months.

Here below, you find the charts for the Dow Jones, Stoxx 600, Silver, and Berkshire Hathaway showing the levels of extension and how it helps determine the potential for a run-up or sell-off.

Of course, like every indicator it won't work every time, but it comes very close to being precise and reliable. Lately though, I have seen a lot of assets reach their extreme levels of overextension yet they keep running higher. You have to keep in the mind the manipulation the markets have been in the last two years. You can not blindly follow indicators or patterns and expect them to work. You have to keep the bigger picture in mind.

If you want the indicator for TradingView or cTrader, make sure to send me a quick email via the contact form!