The 3rd Times (NOT) the Charm

I always keep an eye on small cap stocks as they tend to lead the overall market both in up and down markets. As you can see in the daily chart below, IWM, the small cap ETF, each time it has attempted to cross above the 169.5 level it has failed. Yesterday’s failure had a different look than the others as it was marked by relatively large volume and a bigger price swing (size of candle) than the prior attempts.

While its normal to have prices stall and reverse more than once when approaching prior breakout levels, yesterday’s failure nothing to be alarmed about. But it is nothing to ignore either and requires a cautionary approach in case it turns out to be more than just a minor pullback. We know the markets are capable of just about anything.  On the plus side price is above a rising 200 day moving average, it has formed and within a well formed cup and handle continuation pattern while RSI momentum is still in the bullish zone and has no divergence.

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So why the cautionary approach? When following price movement it’s not just about specific levels and where it’s headed but, more importantly, where you have come from. In the case of small cap stocks they have risen 12% in less than 3 months, which is really too far, too fast. They need a breather. Why do I say this? A good way to recognize this possibility is to look at how far they are away from their 200 day moving average (dma) and how they have reacted in the past to that level. The further they are from their mean (the 200 dma) the higher the chance and often the greater the size of the pullback towards that mean will eventually occur. You can see that each time price has been above the 200dma by high single or double digit percentages, IWM has had a pullback. Don’t get me wrong, this is not they only warning flag with stock prices right here and why I am currently erring on the side of caution. This is just one piece of a weight of the evidence approach. With respect to IWM, we are not too far away from finding out whether the current consolidation will be worked through by further sideways movement or a deeper pullback. If I were a betting man, I would be looking for a deeper pullback, which will lead to a nice buying opportunity allowing investors the opportunity to capitalize on the expected year-end rally