Small-Cap Decline Could Offer Seasonal Buying Opportunity

The Russell 2000 index hit a two-month low on Tuesday and is flashing warning signs across the broad market. Analysts have interpreted the decline as a rotation out of domestic issues in reaction to the new North American trade agreement, but that news should have had a broadly positive effect. The surging U.S. dollar has added to this confusion because a strong greenback should also underpin small-cap buying interest.

Seasonality offers the most logical explanation, with 20 years of data compiled by research firm EquityClock.com showing that Russell 2000 returns tend to fall sharply between mid-September and mid-October, ahead of exceptionally strong price action that continues into year end. Observant market players may wish to use these contrary statistics as a trade entry tool, looking for an intermediate low in the next one or two weeks. (See also: An Introduction to Small-Cap Stocks.)

IWM Long-Term Chart (2007 – 2018)

The iShares Russell 2000 Index Fund ETF (IWM) topped out in the mid-$80s in 2007 and sold off to the mid-$30s during the 2008 economic collapse. It completed a round trip into the prior high in the second quarter of 2011 and eased into a sideways pattern that carved the handle of a multi-year cup and handle breakout pattern. The fund cleared resistance in 2013, entering a powerful uptrend that stalled above $120 in April 2014.

A 2015 breakout failed to stir buying interest, adding nine points before turning tail in a multi-wave downtrend that hit a two-year low in the low $90s in the first quarter of 2016. The subsequent recovery wave broke out above the prior high after the presidential election but stalled immediately at a rising highs trendline (red line) going back to 2014. It finally mounted that barrier in October 2017 and continued to post gains into August 2018's all-time high at $173.39. That peak has tagged the third high in a rising trendline (black line) going back to 2011.

Red trendline support in the mid- to upper $150s should curtail selling pressure, but the current decline may not reach that low in the coming weeks, given upcoming positive seasonality. Meanwhile, the monthly stochastics oscillator crossed into a sell cycle in September 2018, but the complex indicator pattern since 2016 shows unusual support at the blue line of lower lows. It probably won't reach that line until 2019, even if selling pressure continues in the fourth quarter. (For more, see: IWM vs. VTWO: Comparing US Small-Cap ETFs.)

IWM Short-Term Chart (2017 – 2018)

The on-balance volume (OBV) indicator has barely budged since topping out in June 2018 and is still holding the four-month range. This indicates little fear in the current downtick, suggesting that the fund will reach a tradable low quickly. However, that could change quickly if the decline stretches into the 200-day exponential moving average (EMA), which has a well-deserved reputation as a volatility generator and market shakeout mechanism.

Price action broke a three-month rising channel on Tuesday, confirming a 50-day EMA breakdown and resistance between $167 and $169. The first bounce into this level will set off a sell signal, while a buying thrust above $170 will restore the bullish technical outlook. On the downside, the .382 Fibonacci retracement of the rally leg starting in August 2017 should offer support near $160, reinforced by the May breakout and 200-day EMA. That price zone looks like a perfect spot to build intermediate to long-term positions. (See also: Small Cap Research Can Have a Big Impact.)

The Bottom Line

The Russell 2000 and small caps are selling off but could find their lows quickly and rally into year end. The start of third quarter earnings season could provide the catalyst for that turnaround. (For additional reading, check out: 3 Overlooked Small Caps for a Fast-Growth Portfolio.) 

<Disclosure: The author held no positions in aforementioned securities or futures contracts at the time of publication.>