This column was originally published on RealMoney on March 22 at 12:03 p.m. EDT. It's being republished as a bonus for TheStreet.com readers. For more information about subscribing to RealMoney, please click here.
Small-cap stocks are headed for a mediocre first quarter, with the Russell 2000 index trading just above where it opened at the start of January. It's been a roller-coaster ride for the entire group during the tumultuous tape since the late-February selloff.
The weak performance is frustrating, given the encouraging run to new highs just days before broad selling pressure hit the market. Unfortunately, the opportunity lost in the subsequent trip back to the flat line will be felt again when investors review fund-performance sheets next month.
That realization could weigh on small-caps well into the summer, despite this week's encouraging rally. Frankly, I'm not sure what to expect in the small-cap universe in upcoming months, but I do have a firmer opinion about upside potential, which I believe is limited right now, despite bold calls to the contrary.
What are the chances that the Russell 2000 will run up to new highs in the next few weeks, given the improving tone of buying pressure in recent days? I have a firm rule when looking at charts, like the one for
iShares Russell 2000
: Breakdowns remain broken until they regain all of their lost territory.
The exchange-traded fund, which corresponds to the price and yield performance of the Russell 2000 index, rallied above nine-month resistance in February, hitting $82.48 before selling off with the broad market. That move dropped price under the January swing low at $76.21. This constituted a first failure signal, or 100% retracement of the last rally wave. It's an early warning signal I've been using for years to establish trend changes.
Admittedly, the chart doesn't look too bad in the weekly view. While the recent pullback has been deeper than desired, many technicians will argue that price has successfully tested the breakout and is setting up for a firm run to new highs. That might be true, but the odds now stand firmly against the resumption of the strong uptrend.
Three observations keep me from buying into the bull case. First, I'll fall back on my prior comment that breakdowns usually stay broken. I can't tell readers how much money this single concept has saved me over the years. Everyone, including myself, has a strong tendency to believe in the upside, despite strong chart evidence to the contrary.
Standing aside until the original breakout is re-established through positive price action causes me to miss a few points of profit, but it still lets me trade the uptrend at greatly reduced risk. Of course, someone else will get bragging rights for early buying signals, but I'll be sleeping better at night and not worrying about taking on dumb money risk.
That brings me to the second reason why I can't trust the Russell 2000's recovery right now. Simply stated, I don't believe in V-shaped recoveries. This is another risk-based issue for me. Looking at tens of thousands of charts has driven home the simple fact that these types of rallies are extremely rare.
Vertical selloffs, like the one in late February, are defining moments that signal a marked shift in investor sentiment. A V-shaped recovery requires the initial shock to be matched by an equally sized shock in the other direction. Of course, it can happen, but the odds are greater that the Russell 2000 will now print a lower high and continue on its downward slope.
I survive by playing the highest odds in every scenario and managing my risk religiously. That rules out any position that anticipates an immediate resumption of the Russell 2000's uptrend. Of course, this forces me to keep my fear of "missing out" in check, but that's one reason why I'm still playing the markets after all these years.
Finally, let's move to my third and final reason for being skeptical about the Russell 2000 recovery rally. I noted earlier the recent downdraft marked a 100% retracement of the last rally wave. This type of downthrust is a key component in the evolution of many topping patterns, including the well-known head-and-shoulders reversal.
It doesn't take years of experience to connect the lines and come up with the possibility of a head-and-shoulders pattern. All that's required is for the current rally to ultimately fail within a point or two of the November to January congestion high. A selloff from that level would complete the bear reversal when price drops back to the mid-$70s.
I'm not saying that's how it will all work out when we look back a few months from now. But holy heck, Batman, what's the rush? I'm not the only trader who sees this possible topping pattern. At a minimum, the current price structure will invite waves of short-selling that upset positions taken in hopes of an easy ride back to new highs.
At the time of publication, Farley had no positions in the stocks mentioned, although holdings can change at any time.
Alan Farley is a professional trader and author of
The Master Swing Trader
. Farley also runs a Web site called HardRightEdge.com, an online resource for trading education, technical analysis and short-term investment strategies. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Farley appreciates your feedback;
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