Russell 2000: Collapse reminiscent of July 2006 slide

Last week’s dramatic decline in small-cap stocks was a perfect illustration of the power of technical analysis. The market was coming off an ominous double top formation on weekly studies in the midst of a bearish divergence between price and momentum peaks, and the risk for a correction lower was high.

Last week’s 7% collapse in the Russell 2000 (NYSE: IWM) marked the largest one-week percentage decline in many a new moon, but was roughly similar in scope to the 53-point, 6.4% tumble staged in February. In that correction, the market was able to forge a solid double bottom quickly (within two weeks of the slide), and it will be important for small-caps to find buyers on this dip quickly as well.

From a chart structure standpoint, one difference this go-around is that the market tumbled off a large resistance congestion zone, and a more defined selling area. In addition, the collapse through key support points and the 20-week moving average trend indicator were more dynamic. In many ways, this pullback looks more like the prolonged correction that was seen in July 2006. Last summer’s swoon eventually leveled out at a 14.7% decline from high to low, and it took the market nearly four months to climb back to the July highs. If you’re curious, I’ll save you the time on the calculator: a 15% decline for this move would put a bottom near 728.

It should be noted that the market gapped lower on the opening Tuesday, which triggered the deep spiral that was to come. A gap move on the opening that is not quickly filled often paves the way for a big move. Trading in the direction of an opening gap often yields attractive returns.

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