Let me preface this by saying two things: First, I’m bullish on global stocks over even moderately long timeframes. Technicians like to call tops, but I think this bull market could have several more years in it. However, I’m also always looking for evidence that contradicts my opinions–this is a fundamental part of my investment process and how I think about markets. The Russell 2000 index has shown some behavior over the past week that should give stock bulls pause for thought.
Take a look at the daily chart of the Russell 2000 (cash) index below. Three things catch my attention here:
- A series of highs that show weakening momentum, capped by a high that does not exceed the previous high. While not a dire omen, this is clear visual confirmation of waning bullish conviction over this timeframe.
- The market trades to the lower Keltner channel, the first time this has happened since the September/October selloff late 2014. When a market trades through the lower channel, there is enough downward momentum that the first bounce often sets up a short-term shorting opportunity.
- The modified MACD has made the lowest reading in many months. This is a “new momentum low”, and also often sets up a short-term shorting opportunity.
Taken altogether, these factors are a caution to short-term stock bulls, but not a dire warning of an impending collapse. It’s important to note when market action is inconsistent with the prevailing trend. Usually–far more often than not–factors like this are absorbed and the bigger trend continues after a few days or weeks with no issues; this is what we should expect here. However, longer-term trends begin to break down on shorter timeframes, so events like this are worthy of our attention.
How will we trade this? Most likely, by looking for a “reluctant bounce”, and probably setting up a short into or out of that bounce. If the short trade fails, well, that’s potentially very good news for the longer-term uptrend. Market analysis involves these kinds of checks and balances and tradeoffs. For now, perhaps our bullish conviction must be a little bit weaker than it was a week ago.
Last, this weakness is largely a mid/small cap factor. Take a look at the S&P 500 index, which shows only a “failure to go higher”, and none of the sharp downward momentum in reaction from that failure. This is a picture of a much healthier market:
Remember, markets tend to seek trading activity, and, so, will often do whatever they can to hurt the greatest number of traders. In this case, a shakeout of weak hand longs could be healthy. We must keep an open mind, avoid emotional attachments, read the news with a skeptical eye, and, in general, seek to respond to the developing message of the market. For now, maybe the best stance is “bullish, but careful.”