Wednesday, May 7, 2014

Small Caps Close Below Its 200-dma

On Tuesday, RUT closed below its 200-dma for the first time in more than 360 trading days, one of the longest such streaks ever.

On Wednesday, RUT fell further, to a strong level of support extending back seven months, and then reversed.

If you like to buy support, this is an attractive set up, with an eye for RUT to at least back test its 50-dma about 4.5% higher (see below).

The trend, on the other hand, is unattractive: under the 200-dma and the 50-dma is now trending down. Below the 1080-90 level (lower blue line) and the pattern looks like a head & shoulders top with a measured target to the 980 area, 11% lower.

It's worth recalling the set up at the March high two months ago. 

At the time, investors of all stripes favored RUT to continue to outperform SPX. The prevailing meme was that RUT outperformance was bullish for all equities. RUT has since fallen 10% (chart from BAML survey of fund managers; yellow lines are recent lows in equity markets).

In early March, RUT was trading 40% above its 200-wma. That set up has negative return expectations up to year out. 3 months later (i.e., June) RUT is typically positive just 11% of the time and down 5.7%; a year later, down 16% and positive just 15% of the time (chart from Ryan Detrick). 

The 3-month stats imply a level of 1145 next month, 3% higher from today. The 1-year stats imply a level of 1018, 8% lower from today.

In the past, when RUT has closed below its 200-dma after a long run higher, it has made a long pierce of its 200-dma and then either bounced or, more often, formed a long consolidation before making a sustained move higher. This concurs with the stat table above. 

Note, this does not preclude an immediate bounce from today's low in the days ahead, like in 1994 or 1996, both of which backtested the 50-dma (arrows) before going lower. 

But the bigger picture is this: after closing below its 200-dma, the ultimate low was at least 5% lower each time in the past 20 years. This implies a minimum of 1050-60 in weeks ahead. That would be equivalent to the August 2013 level.

For investors in SPY, note that every time RUT has closed below its 200-dma after a long run higher, SPY has also retraced to its 200-dma in the weeks ahead. This implies at least 6% downside for SPY. This is overdue and increases the likelihood that the current lows will be exceeded in the weeks ahead (post).

Taken together, there's a nice short-term set up here for a bounce in RUT to its 50-dma, but the trend is unfavorable and the odds suggest that this is not the end of its correction.