Below, you will find just one section of my Weekly Strategy Session from this past weekend. Not present are the two daily charts of the Dow and Russell that I presented. However, the bullish divergence in the small caps held true this week, and should most certainly be monitored going forward.
2. The Small Cap-Dominated Russell 2000 Index is Signaling a Bullish Divergence to the Senior Indices After Last Week’s Outperformance, Particularly Versus the Stodgy Mega Caps in the Dow Jones Industrial Average. This Relative Strength Could Easily Mean That Market Players Have Not Been Heavily Selling Into This Recent Consolidation, But Rather Rotating Down to Higher Beta Small Cap Stocks, a Sign of Healthy Risk Appetite Going Forward.
Two Fridays ago, on August 24th, the indices printed their respective lows for that week before rallying a bit into the closing bell. This past Thursday and Friday, the Dow Jones Industrial Average, the S&P 500, and Nasdaq Composite Index all slightly (or in the case of the Dow, outright) undercut those August 24th lows. However, the Russell 2000 Index remained comfortably above those lows.
Usually, when the market is making a forceful move in one direction the small cap stocks, given their high beta nature, will either lead to the upside during an uptrend or sell-off more heavily to the downside during a swoon. In the current market, the selling we have seen on the indices since the S&P 500 printed multi-year highs two Tuesdays ago has not seen the small caps selling off harder to the downside. Thus, we have what is known as a bullish divergence, especially when you consider that market rallies led by the high beta small caps tend to indicate greater underlying risk appetite and health, as opposed to rallies inching higher led by the more defensive mega caps in the Dow.
To be sure, bullish divergences are never guarantees that all of the price action must imminently resolve in a bullish manner. However, it is yet another piece of the puzzle in forming a market posture. Coupled with constructive price action in the marquee technology stocks above, seeing the small caps in the Russell 2000 not only barely flinch during last week’s selling but actually finish the week higher is a good setup for bulls looking to quickly pounce on any strength early next week.
Note the divergence below on the daily charts of the Dow Jones Industrial Average, followed by the Russell 2000. As always with divergences, the point is to see whether price resolves in favor of the nature of the divergence. In this case, the bullish divergence in the small caps has me looking for the Dow and all the senior indices to prove the divergence true next week by resolving higher.
Another point to consider with divergences is that we now have a well-defined level to trade against. In other words, should the Russell 2000 lose the lows from August 24th, that would be a sound reason to reduce long exposure and respect the bears for rendering the bullish divergence false.
3 Responses to Small Caps Remain the Key
Sometimes I get so wrapped up in ETFs and indexs, I forget how important it is to follow the top weighted of the components.
IWM has gadzooks of components but the top 10 look very healthy on the charts: ATHN PCYC DRQ HMSY WCG CBST CNL STWD UNFI PMTC