Market's Fate Lands in the Small-Caps' Court

As I watched the market test the rally highs on Monday, before mid-afternoon program selling pummeled the major indices, I found myself focused squarely on the Russell 2000 index. Up to that moment in time, I hadn't fully realized the importance of small-cap stocks in the ultimate success or failure of the post-March recovery effort.

But it's clear this group holds all the cards when it comes to market direction from now into the fourth quarter. In particular, a Russell rally would bolster the Nasdaq Composite, as dozens of small-caps turn green and move higher. The same dynamic would also expand market breadth, which has weakened considerably in the last 15 months.

iShares Russell 200 Trust

Click here for larger image.

Source: eSignal

The iShares Russell-2000 Trust (IWM - commentary - Cramer's Take) shows decent upside since March, but the bearish setup is easy to see when looking at a one-year chart. During this period, the fund has bounced off two-year lows and retraced 50% of the July into March selloff. But sadly, it's still trading under the deep lows posted last August and November.

Like the Nasdaq-100 index, the Russell rallied into the Jan. 4 down gap and filled it during last week's options expiration-driven rally. Notably, this is the last big hole created by the credit-induced downtrend. It's the type of event that tends to generate a host of sell signals in the technical community.

iShares Russell 200 Trust (Detail)

Click here for larger image.

Source: eSignal

Recent price action shows intense conflict with neither side gaining the full advantage. Notably, the filled gap also corresponds with resistance from the 200-day simple and exponential moving averages. This triple barrier has induced the spiking volume we've seen in the last week.

Despite recent selling pressure, it's premature to rule out an eventual victory by the bulls. Accumulation, as noted by on-balance volume, has risen to its best levels since February. Additionally the pattern off the lows shows a series of higher highs and higher lows, so the recovery effort has been bent but not broken so far.

The greatest concern in this view is the rapidly declining price rate of change, illustrated by the rising wedge pattern that has been in place for the last month. Each high in the series show less thrust and conviction than the last one, raising the odds for a sudden breakdown marked by a wide range price bar that drops all the way to 70.

Until we see a major breakout over resistance at 75 or the vertical selloff into 70, this instrument is best suited to the skills of scalpers and daytraders, as opposed to investors and position traders. Frankly, we have to favor the bears, because waning momentum is showing up throughout the price/volume structure.

If you spend time flipping through the charts, you know the Russell 2000 index isn't the only instrument grinding through a similar bilateral setup. In particular, the S&P 500 rose above 200-day moving average resistance last week, where it stalled out and failed to print the decisive rally that would have confirmed the start of a new bull impulse.

Until we get bullish confirmation on the S&P 500 and Russell 2000 indices, investors need to walk on eggshells while traders sit on their hands and wait for better entry signals in either direction. My guts tell me the next big move will be to the downside, but I'm going to stifle that negative bias for now and just take what the market gives me.

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At the time of publication, Farley had no positions in the stocks mentioned, although holdings can change at any time.

Farley is also the author of The Daily Swing Trade, a premium product that outlines his charts and analysis. Farley has also been featured in Barron's, SmartMoney, Tech Week, Active Trader, MoneyCentral, Technical Investor, Bridge Trader and Online Investor. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks.

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