Why Relative Strength In Small-Cap Stocks Is A Bullish Signal ($IWM)

Last Friday’s (July 5) rally pushed each of the main stock market indexes back above their respective 50-day moving averages. The reclamation of this key, intermediate-term trend indicator is significant because it points to the bulls regaining the upper hand in the stock market. Big-money players such as banks, mutual funds, hedge funds, and other institutions are also more confident buying stocks when the S&P, Dow, and NASDAQ are all above their 50-day moving averages.

On the following daily chart of the benchmark S&P 500 Index SPDR ($SPY), a popular ETF proxy for the broad-based S&P 500 Index, we have highlighted the reclamation of its 50-day moving average:

One of the most positive aspects of recent stock market action has been the relative strength in small-cap stocks.

Although all the major indices are back above pivotal resistance of their 50-day moving averages (which should now act as new support), most of the main stock market indexes are still trading well below resistance of their prior highs from May 2013. But one exception is the small-cap Russell 2000 Index, which has already rallied all the way back to its prior highs AND set a fresh all-time closing high last Friday. This is shown on the daily chart of iShares Russell 2000 index ETF ($IWM) below:

Keeping an eye on the performance of small-cap stocks during and after market corrections is crucial because institutional money flow into the small-cap arena indicates an increasing demand and appetite for risk among “smart money” investors.

When the stock market is being led by small-cap stocks, new leadership develops in the top stocks. This, in turn, pulls the entire broad market along with it. This is much better than market environments where leadership is among blue-chip stocks instead.

If funds are flowing primarily into Dow-type stocks, it can indicate a “flight to safety” among institutional players, which is not very confidence-inspiring for traders and investors. Moreover, such market conditions limit the number of potential trading opportunities for small and mid-cap swing traders like ourselves.

On the other hand, clear relative strength and leadership in small to mid-cap growth stocks (like we are seeing now) provides many more opportunities to profit from increasing momentum of leading stocks and ETFs.

For now, we continue “dipping our toes in the water” on the long side of the market. But as we continue to see improving price action in the broad market, as well as new breakouts among leading stocks, we will more aggressively start jumping back into the long side of the market.