The performance of small caps could be saying something big about the stock market

Published Tue, Oct 27 202012:15 PM EDT

Patti Domm @in/patti-domm-9224884/@pattidomm

Key Points

Monday's sell-off was the worst since September, but the behavior of small cap stocks may be a signal the pullback is not likely to be much more severe and the stock market could soon head higher.
The Dow and S&P 500 failed to hold support at their 50-day moving average, but the small cap Russell 2000 held above that level, a sign of strength.

In Monday's blustery sell-off, the Dow and S & P 500 fell below an important trend indicator - but not the small cap Russell 2000. That gives more heft to the belief of some technical strategists that small caps are signaling a broadening of market participation that should help take the entire stock market higher. The S & P 500 , Nasdaq and Dow all fell below their 50-day moving averages, important widely-watched near-term support levels. The S & P and Dow ended Monday below their 50-day moving average which is calculated by averaging the last 50 closing prices. But the Russell 2000 held above its 50-day, a sign of strength. "The point is no damage was done on this pullback, and we think the recovery story is in play. We're expecting a broad market breakout. We expect participation to continue to broaden. Our broader theme is cyclical and beta and small caps have that," said Ari Wald, technical analyst at Oppenheimer. The Dow fell 2.5% Monday, and was about a half percent lower in a mixed, flattish market Tuesday. The S & P 500 was flat with a decline of just about of about 0.1%, and Nasdaq was higher, gaining 0.6%. The Russell was down 0.4%. Market strategists, who follow fundamentals, expect trading this week to be choppy ahead of the presidential election, next Tuesday. They expect the market to stage a relief rally once an outcome is clear. That timing fits with a market move higher, expected by Fundstrat technical analyst Robert Sluymer. "It was not a fun day yesterday. There was a lot of damage to a lot of portfolios," Sluymer said. "Anything can happen, but the pattern is that we're in a very normal short-term pullback, and they tend to last two to four weeks, and we're halfway to three-quarters ways through it." Sluymer said it would not be unusual to see the market ready to resume its climb in the next five to 10 days. He said small caps are signaling a trend that has been in place, with more and more stocks joining in the market's gains. "Their relative performance over the last month or month and a half is a sign that breadth is expanded in the market," he said. " A breakout [in the Russell] above the Oct. 12 high of 1,652, that would be a positive statement for the market." Wald said the Russell 2000 has been forming a bullish flag formation, which basically resembles a flag on a pole, formed by a strong vertical move higher after a period of consolidation. "What has not worked in recent years is world equities versus U.S., value versus growth, and small cap hasn't worked versus large caps...We could see some counter trend activity. We're particularly positive and upbeat on small cap growth, which ranks high in our momentum work," he said. "On this pullback and with most of the market settling in around the 50-day, there's very little market stress to point to on this pullback." He said the way the market is trading is similar to the period ahead of the 2016 election. The market was choppy but some stocks were moving higher under the surface. Interest rates were also moving higher. "Small caps are very important...They're a gauge for breadth.You want to see a lot of stocks working. The fact that it's not just tech and large caps anymore, and now we're seeing better action in small caps, I think is a positive," said Wald. "A market moving higher with a lot of stocks moving is a market that continues, rather than reverses."

People walk by the New York Stock Exchange (NYSE) in lower Manhattan on October 02, 2020 in New York City.

Spencer Platt | Getty Images

In Monday's blustery sell-off, the Dow and S&P 500 fell below an important trend indicator - but not the small cap Russell 2000.

That gives more heft to the belief of some technical strategists that small caps are signaling a broadening of market participation that should help take the entire stock market higher.

The S&P 500, Nasdaq and Dow all fell below their 50-day moving averages, important widely-watched near-term support levels. The S&P and Dow ended Monday below their 50-day moving average which is calculated by averaging the last 50 closing prices.

But the Russell 2000 held above its 50-day, a sign of strength.

"The point is no damage was done on this pullback, and we think the recovery story is in play. We're expecting a broad market breakout. We expect participation to continue to broaden. Our broader theme is cyclical and beta and small caps have that," said Ari Wald, technical analyst at Oppenheimer.