Small caps have entered their most seasonally positive time of year, but that's little solace after a horrendous 2018 that dumped the Russell 2000 Index more than 12%. Even worse, mid-year price action delivered a massive head fake, with a rally to new highs followed by nearly 28% downside into December. Both metrics suggest that it will be a long time before pummeled investors trust this corner of the market universe in their retirement accounts.
However, many small-cap components have hit deeply oversold levels that could generate multi-month recovery waves or at least bounces to resistance that can be used to lighten up or eliminate remaining exposure. Either outcome beats more downside if you're stuck in these radioactive positions while offering fresh opportunities for position traders and the fast-fingered crowd.
Positive seasonality will last into July according to EquityClock.Com, with the period into April posting the strongest Russell 2000 gains in the past 20 years. However, January returns have been mixed over this period, with buyers often coming to the rescue after an early-month swoon. In turn, this suggests that the index hasn't hit bottom yet, perhaps waiting for a broad-based selling climax similar to early 2016.
IWM Monthly Chart (2002 – 2018)
The iShares Russell 2000 ETF (IWM) bottomed out in the low $30s at the end of the 2000 to 2002 bear market and turned higher, entering a healthy uptrend that topped out in the mid-$80s in July 2007. It relinquished nearly 100% of bull market gains during the 2008 economic collapse, finding support just two points above the 2002 low, while the subsequent bounce took more than two years to complete a round trip into the mid-decade high.
The fund completed a five-year cup and handle pattern and broke out in January 2013, entering a powerful advance that stalled above $125 in April 2015. A deep slide pierced the 50-month exponential moving average (EMA) into 2016, marking the third violation of this long-term support level since 2009. Buyers then took control, generating a breakout to new highs following the presidential election. The uptrend eased quickly into a gentle slope, gaining ground into August 2018's all-time high at $173.39.
The subsequent pullback has folded in two broad selling waves, with the December swoon breaking the 50-month EMA for the fourth time. Lows from 2009, 2011, 2015 and 2018 can now be connected with a rising trendline, suggesting the start of an intermediate uptrend, but long candle shadows through support predict whipsaws for more than a week or two before buying signals support long-side entry.
Bearish Longer-Term Outlook
The longer-term outlook is less constructive because 10-year price action has carved an Elliott five-wave rally pattern that could now signal the end of the small-cap bull market. Even worse, the current sell-off may be drawing the third wave of an Elliot five-wave decline that eventually completes a 100% retracement of the prior fifth wave (third rally wave). In turn, that would add 40 points to current downside, dropping the fund into the lower $90s.
The %K line of the monthly stochastics oscillator has just touched the oversold line, while the slower %D line could take another month to get there. This doesn't bode well for a quick turnaround because convergence in the oversold zone is also known as the "stochastics pop," a pattern first described by Jake Bernstein in his 1995 book, "The Compleat Day Trader." Modified by David Steckler in a 2000 "Technical Analysis of Stocks and Commodities (TASC)" article, this set-up often precedes the most bearish price action of an entire sell cycle.
The Bottom Line
The Russell 2000 has reached 10-year trendline support that could generate an oversold bounce, but timing factors haven't aligned with price, telling market players to stand aside for now, awaiting more constructive signals.
Disclosure: The author held no positions in the aforementioned securities or their derivatives at the time of publication.