How the small cap breakout could be short-term bearish

Posted by Cam Hui - July 17, 2024

Mid-week market update: Small cap stocks, as measured by the Russell 2000 and S&P 600, staged convincing upside breakouts in the past week. Both small cap indices are now testing key relative resistance zones against the S&P 500.

Even though this seems to be counter-intuitive, such a development could be bearish for the S&P 500.

A breakout and breadth thrust

Let’s start with the bull case. The small cap upside breakout was impressive. A point and figure chart of IWM with a 1% box size shows a measured upside target of 280, which represents an upside potential of about 25%.

What’s more, the market triggered a Whaley Breadth Thrust yesterday. This has resolved bullishly in the past, if history is any guide.

Reasons for short-term caution

I should be wildly bullish here. So why am I cautious?

I am worried about the possibility of a disorderly position unwind. The accompanying of market neutral ETF BTAL is a proxy for the factor exposure of the hedge fund and fast money crowd. The steady march upwards of BTAL was accompanied by long growth/short value and long NASDAQ 100/short Russell 2000.

Now we’ve seen a violent reversal of those factor returns of historic proportions. Undoubtedly, hedge funds are feeling pain and risk managers are forcing traders to unwind their positions. The risk is a disorderly stampede for the exits that resolves in a Volmageddon outcome. When that happens, hedge funds become forced sellers of everything, which results in a volatility spike and correlations of all assets converge to 1.

To be sure, the Volamageddon scenario is only a scenario that may not play out. But the market is already overbought, as measured by the NYSE McClellan Oscillator (NYMO) and the NASDAQ McClellan Oscillator (NAMO). Bear in mind, however, that stock prices can continue to advance when the market was overbought in the past, but they have usually resolved in either short-term weakness or sideways consolidations.

As well, the usually reliable S&P 500 Intermediate Term Breadth Momentum Oscillator (ITBM) saw a take profits signal when its 14-day RSI became overbought yesterday. At the same time, the percentage of S&P 500 above their 20 dma also reached overbought territory. None of this means that stock prices have to fall, only that upside potential is diminishing and it may be time for the stock bull to pause.

It only took an unexpected catalyst to spark market weakness. Today’s selloff in tech was sparked by the massive selloff in ASML on the prospect of further restrictions on the exports of chip making equipment to China. That’s how volatility spikes happen.

This is also consistent with the seasonal record of some price sloppiness in the second half of July.

In conclusion, the upside breakouts of small caps should be interpreted bullishly on an intermediate term basis. However, a combination of the possibility of a violent hedge fund position unwind and severely overbought conditions argue that it’s time for bulls to take some short-term profits and prepare for near-term volatility.

1 thought on “How the small cap breakout could be short-term bearish”

Intrepid Momentum Trader says:

July 17, 2024 at 1:42 pm

July 7, 2024 at 10:37 am

While no indicator is infallible here are some events to increase the odds of getting out close to the top:

1. A sharp unexplained drop in a leading stock or industry. Think NVDA or the semis.
2. A sharp increase in interest rates. The bond market has a very large drop.
3. An unexplained rise in the dollar or a sharp drop in the same i.e. in1987 the dollar was at risk because of Baker’s statement.
4, A surprise political event.
5. A sudden imposition of Tariffs which is considered a hostile act by a foreign country.
6. Spike in VIX.

Conditions 1,4,5 and 6 have been met. The market will face turbulence because the Mag 7 are companies that Trump is not a friend of. Add to the mix that the semi-conductor index is now under a cloud of trade restrictions. The above two sectors constitute 38% of the S&P 500 and a great portion of the QQQ. It is extremely unlikely that the other indexes can gain altitude while these two indexes are under extreme pressure.

Personally, for me the short side in the SOXL and QQQ’s look attractive. Then again, I am a trader and my time horizon and opinions change rapidly.

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