A Look at Small-Cap Breadth
Why just a "bounce" and not a "bottom?"
Last week, we looked at a broad-market indicator that monitored sector breadth using the Fidelity Select Funds. This week, we're going to look at breadth once again, but this time we'll focus on a specific area.
What is it?
There's nothing new here, in terms of concept. Breadth measurements are designed to allow us a look at the underlying health (or lack thereof) of any type of composite index. This is no different, but specifically we're going to focus on the percentage of stocks in the S&P 600 small-cap index that are currently trading above their 10-day moving average.
Why should we follow it?
Small stocks can be a proxy for the level of risk tolerance in the market. We would typically want to see investors willing to take on risk, as long as it's not at an unhealthy level (however you want to define that). Therefore, in order to feel more comfortable about rising prices, we should want to see investors willing to bid up some of the smaller, more speculative shares.
These mini booms and busts cause an indicator like the one discussed here to gyrate wildly. While it can seem like just a lot of noise, for short-term traders such a thing can bring opportunity. By watching the percentage of stocks in this category above their respective 10-day averages, we can get a feel for very short-term sentiment swings, and trade counter to them (usually successfully).
What are the challenges in using it?
Like any indicator that tries to measure extremes, we're always subject to the "extreme can get more extreme" phenomenon. In other words, just because only 10% of stocks are above their 10-day moving average, who's to say that tomorrow we'll see only 5% above, and the day after that 2%?
For the past two days, less than 10% of the component stocks in the S&P 600 index have been trading above their own 10-day moving averages. This is a sign of an extreme rush to the exits in these stocks, to a degree we haven't seen in more than six months, and which usually only happens once every year.
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