Small-Cap Weakness Could Presage Larger-Scale Correction

The iShares Russell 2000 ETF (IWM) has reversed at the .618 Fibonacci retracement level of the 2018 decline and sold off to a three-week low, exhibiting relative weakness compared with the S&P 500 and the Nasdaq 100. This marks a bearish turn of events because small caps led broad benchmarks higher in January and February and are now leading to the downside, predicting that larger-cap peers indices will follow suit in the coming sessions.

Positive seasonality that has underpinned small-cap leadership tends to wane between March and May, giving way to weak relative performance throughout the summer months. That's an important observation right now because the sector got sold more aggressively than large-cap stocks in last year's second half swoon. As a result, it's logical to assume that the broad market will head much lower if small-cap weakness persists into the second quarter.

IWM Long-Term Chart (2007 – 2019)

The Russell 2000 ETF topped out at $85.20 in July 2007 following a multi-year bull run that posted a series of all-time highs. An orderly pullback escalated into a full-scale panic during the 2008 economic collapse, giving up all but two points of the long-term uptrend before bottoming out at $34.26 in March 2009. The subsequent recovery wave unfolded in two broad buying waves that completed a round trip into the prior high in April 2011.

Sellers took control into 2012, but price held well above the prior low, completing the handle of a multi-year cup and handle breakout pattern. The fund finally cleared resistance in 2013 and took off in a strong uptrend that lost steam above $120 in 2014. It then entered a stealth correction, grinding sideways for 15 months before turning sharply lower into the first quarter of 2016. A two-and-a-half-year low in the low $90s marked the bottom, ahead of a bounce into the presidential election.

The fund and index broke out to new highs in November 2016 and eased into a shallow rally trajectory one month later, with IWM posting gains into the June 2018 high at $170.20. It rallied above that resistance level in August, added three points and trapped bulls in major decline that dumped the fund more than 27% in less than four months. It bounced at a two-year low into 2019, recouping more than half the loss into early March.

IWM Short-Term Chart (2016 – 2019)

The on-balance volume (OBV) accumulation-distribution indicator posted an all-time high with price in August and entered an aggressive distribution phase that reached a 13-month low in December. Buying interest into March has been proportional to price gains, generating neither bullish nor bearish divergence. All in all, this contributes to a neutral outlook and an expectation for range-bound action into the foreseeable future.

A Fibonacci grid stretched across the uptrend that started in 2016 shows the 2018 decline stretched across the .50 retracement into the .618 retracement level in December, yielding a V-shaped recovery wave that completed a 100% retracement into the October swing high (upper blue line) on Feb. 25. The fund reversed at that resistance level in the following session and has now undercut the 200-day exponential moving average (EMA).

Watch the lower blue line at $145 if selling pressure continues in the coming weeks because a strong bounce starting near that level might carve the right shoulder of an inverse head and shoulders pattern, with a breakout targeting a new bull market high. Conversely, there are few support levels below that line in the sand, increasing the odds that a breakdown will generate downside into the 2018 low.

The Bottom Line

Bearish Russell 2000 price action has issued preliminary sell signals that could presage a larger-scale correction into the second quarter.

Disclosure: The author held no positions in the aforementioned securities or their derivatives at the time of publication.