Shorting Small-Caps

Steve Strazza
April 16, 2020

From the desk of Steve Strazza @Sstrazza

In January and February, we cautioned that we wanted to be selling stocks, raising cash and buying bonds due to bearish divergences and deteriorating market internals. At the same time, many major indexes and sectors had achieved our upside objectives and were at logical levels of potential resistance.

The Global Equity Market collapsed and the S&P 500 fell 35% soon after, blowing a hole in the long-term uptrend in most major indexes around the world.

In late March we wrote about bullish breadth divergences and the key levels of interest that made us want to err on the long-side over the near-term.

That ended up being the tradeable low we were looking for as stocks gained 30% and retraced more than half of their recent drawdown in just 15 days.

A historic selloff followed by a record-setting rally... that's the backdrop bringing us to today.

Presently, we're not seeing much improvement in market internals, defensive sectors are showing leadership, and despite the huge move from stocks, safe-haven assets such as treasuries and gold are making new multi-year highs on both an absolute and relative basis. None of this supports continued strength from equities.

Oh, and did I mention we're once again bumping up against some very logical levels of potential resistance?

For these reasons, we still believe this was a dead-cat bounce, albeit a very strong one, and that the recent bear market rally has run its course. While there are areas of the market we still like, particularly Large-Cap Growth and Technology, there are plenty more that we don't like... like Banks, Transports and Small-Caps to name a few.

Speaking of Small-Caps, the Russell 2000 has been the weakest of all the major averages for several years now. Similar to how we look to the Nasdaq for leadership and long opportunities in environments where we want to be buying stocks, now that we're bearish we want to use the Russell 2000 as a leading indicator of impending weakness and opportunities on the short side.

Click on the chart to enlarge view.

Here is a daily chart of the Russell 2000 showing just the weakness we're looking for, as prices are failing at a key level of interest at the 2015 highs and 2018 lows.

We are seeing similar patterns in the Stoxx Europe 600, German DAX, and other important global markets which are also stalling at these key levels.

Small-caps have been crushed by their large-cap peers for years now and we see no evidence of that improving anytime soon. As you can see in the chart, this relative trend has only accelerated year-to-date as the Russell 2000 recently collapsed to its lowest level since 2003 relative to the S&P 500.

We'll discuss this in more detail in today's Mystery Chart Reveal post.

Here is IWM, zoomed in to show price trapped beneath that level of former support at the 2018 lows.

Notice how conveniently this level coincides with the 38.2% retracement of the recent drawdown as well as potential resistance at the gap formed on March 12th. Long story short, there is a confluence of resistance in the 124-126 zone and we want to be short as long as prices remain below it.

For you pattern fans out there, this can be interpreted as an Island Reversal, but when prices resolved higher above 120 they formed a much smaller Island Top, resulting in a failed breakout and potential fast move lower from here.

When patterns fail like this, they tend to result in stronger follow-through moves than they otherwise would. It is one of price actions many subtle ways of giving us an extra heads up.

The bottom line is that after a vicious bear market rally, the reward/risk has shifted back in favor of the bears. Just as we were legging into longs as the S&P 500 reclaimed its 2018 lows, we now want to be scaling out of them and testing the waters on the short side as the market runs into an area of significant overhead supply.

If you don't have the luxury of being able to hold large cash positions, we've highlighted the strength in mega-cap tech stocks that continue to work on an absolute and relative basis. On the short side, we're focused on the weakest area which is small-cap stocks, and in line with our top-down approach, we want to be betting against the individual laggards within the space as well.

As such, we are doing a deep dive into the Russell 2000 to identify some of the weakest stocks to offer trade ideas for our premium members.

In the event of continued market volatility and choppy action, our theme of betting on the strongest large and mega-cap names while fading the weakest small-cap stocks should serve us well as these relative trends remain very much in our favor.

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Allstarcharts Team

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