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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.

This week, we're taking a look at Small-Cap Breadth.

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.
But these shares are also more prone to short-term boom/bust patterns than larger-cap stocks. Perhaps because of the liquidity issue, we often see these stocks get sold even if there is a company-specific issue causing problems in another stock. Portfolio managers don't want to be trying to sell a stock when there is no bid – it's that whole "sell when you want to, not when you have to" thing.

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%?
To counter that, it helps to only take trades in the direction of the longer-term trend. This is a simple concept (in theory, not always in practice), but it's amazing how often it filters out those outlier trades.
What does it look like?
What's it suggesting now?

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.
This kind of mad dash has happened on 29 other days in the past decade. While a few times there was some additional short-term pressure, for the most part this kind of reading marked an exhaustion point. One month later, the S&P 600 index was positive 25 of those 29 times by an average of +5.3%.
I have some real concerns about the intermediate-term prospects in the broader market, many of which I've outlined over the past couple of months. But even if we are entering a longer-term downtrend, there will be brief pockets of true extremes that provide nimble traders with opportunities. Historically, this has been one of those times with small-cap stocks, but because of the longer-term issues we're facing, caution is warranted if trying to buy the dip here.
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No positions in stocks mentioned.

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