Bearish “head & shoulders” formation in small-cap Russell 2000 Index ($RUT)

Equities closed lower on higher volume yesterday, but well off session lows. The major indices all gapped down at the open, “undercut” their April 23rd lows, then reversed to close near their intraday highs. In the May 2 issue of The Wagner Daily, and in this blog post of the same day, we stated this exact price action (an “undercut” of the April 23 lows) had a good likelihood of occurring in the coming days. Although it has been showing relative weakness to the broad market for many months, the small-cap Russell 2000 made the biggest comeback yesterday, as it nearly erased all of the day’s earlier losses. The Russell ended the session lower by just 0.1%. The S&P MidCap 400 lost 0.2%, while both the S&P 500 and Nasdaq Composite declined 0.4%.

Market internals ended the day mixed. Volume surged on the Nasdaq by 24% and on the NYSE by 20%. However, the Nasdaq’s declining volume outpaced advancing volume by a ratio of 2.2 to 1. The adv/dec volume ratio in the NYSE was negative by a margin of 2.8 to 1. Although declining volume was higher than advancing volume, the gap between the two narrowed throughout the day. Further, the sharp intraday price reversal in the broad market, accompanied by significantly higher volume, pointed to institutional accumulation on both exchanges (despite the lower closing prices).

Since February of this year, the small-cap Russell 2000 has been struggling to move to higher ground, and has now formed a “head and shoulders” pattern on its daily chart. A head and shoulders formation is considered a bearish reversal pattern (only when an established uptrend is in place), and is formed when price action in the market creates a technical pattern that visually looks like a human’s head and shoulders. In the daily chart of the small-cap Russell 2000 below, this pattern formation is quite evident:

On the chart above, notice the symmetry between the left and right shoulders. As of yesterday’s close, the right shoulder has been developing for 21 days and is now just three days shy of the 24 days it took the left shoulder to develop. Also, notice the dashed horizontal line labeled “neckline.” This line represents the final level of key support; if breached, the result could be a significant move lower in the Russell 2000 Index. Once support of the neckline is breached, the predicted decline in the index is typically equal to the distance from the top of the head down to the neckline (the blue vertical line). The projected decline is marked by the black vertical line. In this example, if the Russell 2000 loses support of the neckline at 785, the predicted selloff would be down to the 720 area. We will be monitoring the Russell carefully for potential short entry in its corresponding ETF, as its next test of the 785 level could result in the loss of major support that leads to downside follow through in its head and shoulders pattern.

Yesterday, we sold our position in ProShares UltraShort Emerging Markets ($EEV), as it hit its profit target. This enabled us to follow up our prior day’s 9% realized gain in $SOXS with a 5% gain on our 3-day hold with $EEV. Selling into strength allowed us to capture the lion’s share of the move in both $SOXS and $EEV. Now, we are completely flat (100% cash). Although Tuesday showed signs of institutional accumulation for the Nasdaq and the NYSE, the market must still prove it can hold yesterday’s lows and continue to show signs of further accumulation amongst banks, mutual funds, hedge funds, and other institutions. However, yesterday was a good first step toward restoring market confidence.

The commentary and chart above is a short excerpt from The Wagner Daily, our nightly trading newsletter. Subscribing members additionally receive our exact entry and exit prices for all stock picks and ETF trades, annotated ETF and stock charts, educational technical trading commentary, and access to our Live Trading Room. Click here to become a member for less than $2 per day (based on annual subscription). Your full satisfaction is guaranteed.