With the recent methodical (and much needed) pullback in the US stock market, I have been amazed at how orderly it has been. There has not been the type of volume patterns or fearful unloading of stocks that normally occur …. Yet. The couple of days where the indexes were down big early in the day, the bulls stepped in at the end and rallied prices. The question I keep asking myself is this due to the unusually strong market (and is this as bad as its going to get) or are we biding time waiting for the other shoe waiting to drop to kick off the next, much deeper correction?
No matter where I look when I scan the market, I see the same story, overbought conditions combined with negative divergence warnings and sitting right on or just above support. Small cap stocks are no different as you can see in my chart of IWM below. At the price high in March, RSI momentum registered a divergent lower high (negative divergence). Since that time, price has formed lower highs and lower lows as it slowly grinds lower and sits slightly above (blue horizontal) support. It shouldn’t take much imagination to see this topping action is/has formed a head and shoulders pattern. Additionally, In the bottom pane, the ratio of small cap stock performance to the SP500 index shows it too, sits right on the supporting uptrend line.
If the bears take control and price breaks support with conviction to the downside, the first level of support is the 200-day moving average (T1), after that the head and shoulders pattern target (T2) is a potential place where we could find buyers reversing the trend. Beyond that if we really get a head of steam south, T3, last November’s low is where I would be looking for a counter trend bounce. I am not saying we are in for a much deeper pullback here because no one knows, but the current setup and market conditions (divergent overbought highs) almost always lead to a correction. What we won’t know until after the fact is if that negative divergence will be worked off over time (price holds support and we chop sideways) or via price (we see prices experience a much deeper pullback).
Whether it be first out of the gate higher after a selloff or the first to top out after a strong bull market run, small cap stocks can be the proverbial canary in the coal mine which is why I watch them so closely.