Russell 2000: Reversal pattern emerges

Kevin Pendley | Mar 15, 2008 10:11am EDT | Comment

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By most accounts, it was another brutal week for the stock market, and for investors in small-cap stocks. Yes, the Russell 2000 (NYSE: IWM) eked out a meager 0.42% gain for the week, but in the process the index tumbled to the lowest point since October 2005, and is now down almost 25% from last year’s record peak. Toss in more economic bad news, bailouts of investment houses and record lows for the dollar, and it’s a bleak picture, right?

Ah, but here’s the beauty of technical analysis. Believe it or not, the Russell 2000 left a nifty little bullish reversal pattern on candlestick charts. The formation is known as a long-legged doji, and although it has a reputation of being much more powerful at highs versus lows, it is still a formidable pattern that offers a glimmer of hope for a sea of sad stock market sacks. The last time we profiled a long-legged doji formation on weekly charts was back in early October 2007, when I warned in this column that an ominous topping formation had emerged – and indeed that week marked a major peak in front of the relentless slide. (If you’re curious, a long-legged doji has a large wick, which reflects that new move lows were rejected—and remember, it carries more power at a top than at a bottom).

Regular readers of this column might ask: “But what about that breach of 650 support from the January low?” It’s a fair question...after all, persistent price action below 650 opens the door to an extension of the bear market move, with the next big targets at 614 and 591. However, I like what happened this week in that we slipped just through 650 to trigger any stops from weak longs and to reassess that point as true value. From there, the decent recovery move and subsequent long-legged doji pattern are at least somewhat encouraging.

Here’s what has to happen to keep the long-legged doji in play as a potential reversal signal: the market must move northward this coming week, and MUST hold above 650 (preferably 660), or else this was just a head fake in the ongoing market quicksand. I am starting to believe that it is crucial for the market to build a base from here to rally, or risk sinking toward an eventual decline in the 40-50% range, which would fit with the troubling chart patterns we discussed at the first of the year.

OK, now that we’ve discussed this week’s chart structure, I thought it might be interesting to veer into a different direction for a change. There is an ongoing debate about whether the U.S. economy has tumbled into a recession, or is heading toward one. Regardless of whether we slip into the textbook definition of a recession (which is a decline in GDP or negative real growth for two or more consecutive quarters), it’s fair to say that times are rough, and that these difficult times have taken a toll on investors and stock market values.

For what it’s worth, I lean toward the side that says we are on the threshold of a recession, and it truly scares me that so many pundits are quick to dismiss those concerns. When I studied stock market behavior in recession time frames, one thing stood out like the proverbial sore thumb: the stock market tends to take a beating during a recession, and the stock market has already suffered some severe body blows during the recent collapse off record highs.

Since 1970, there have been four noteworthy recessionary periods in the United States, which are outlined below:

• 1973-1975: Oil prices quadrupled and government spending from the Vietnam War spurred stagflation; the dollar slumped as the currency was removed from the gold standard. (Dow loses about 47% from pre-recession peak to move bottom)

• 1981-1982: Iranian revolution spikes oil prices, and tight monetary policy sends economy spiraling. (Dow loses about 50% from pre-recession peak to move bottom)

• 1990-1991: Industrial production and manufacturing slump. (Russell loses about 20%; Dow loses about 22%)

• 2000-2001: The dot-com investing bubble bursts and the 9/11 terrorist attacks spark a “non-textbook” recession, as the economic retreat occurred in Q3 2000, Q1 2001 and Q3 2001. As far as I’m concerned, that is pulling hairs. It was a recessionary period for growth and for the market. (Russell 2000 loses 47% from pre-recession peak to move low, 39% during recession time frame; S&P 500 loses 50%)

The current collapse off record highs in small cap stocks amounts to a 24.8% decline, which fits into the 1990-1991 recession decline parameters. However, when I look at the cause of these previous recessions, the “news” this time around seems to fit more in line with the 1973-1975 recession, which was stoked by soaring energy prices and a slumping dollar (take note the dollar hit a record low against the euro this past week, and a 13-year low against the yen). I’m not an economist, and I realize that the world is a much different place in 2008 than it was in 1973, but as a person who likes the study of patterns, the fact that three of the last four recessions saw Dow declines in the 50% zone is a startling (and sobering) piece of information. It makes me even more concerned that the Russell 2000 needs to establish value around the 650 area quickly, or risk moving toward that 50% retracement at 591.

The table below contains support and resistance points for the Russell 2000 to keep in mind heading into this week’s trading. For long-term traders, some of these key levels may remain in place for weeks...even months at a time. Those with a short-term horizon will lean toward levels that are more immediately in play. As time passes, we will build upon this table with levels that come into focus as important testing zones for trend analysis, and to act as road mark indicators for key reversal patterns.

From a trading perspective, I always keep a printout handy each day of my key support and resistance points for any stock or market I’m trading. It helps remind me of key areas to watch for signs of trend exhaustion, and also for potential entry/exit points for trades.

TECHNICAL ANALYSIS SUPPORT/RESISTANCE POINTS FOR RUSSELL 2000

- 890.16   upward channel resistance on monthly charts off 5-year run;
            also fits with potential upside breakout of congestion zone
- 860.00   projected “figure” resistance off 15-handle testing zones on the ’06 rally
- 856.48   record intraday high set July 13
- 855.77   July 13 close; record high daily and weekly close
- 852.06   Oct. 11 high; bearish reversal peak on daily charts
- 830.01   previous high from the February 2007 peak; key swing line of note
- 815.00   key swing line
- 801.00   congestion resistance zone from November-December 2006
- 777.00   61.8% Fibonacci retracement of the Aug. 2007 peak-Jan. 2008 collapse
- 760.06   March correction low; key approximate double bottom formation support;
            Near 50% Fibonacci of July ’06-’07 bull run; violated in November ’07;
            Key swingline to watch
- 753.50   50% Fibonacci retracement of the Aug. 2007 record peak-Jan. 2008 collapse
- 743.49   previous Aug. ‘07 collapse low; short-term support violated, now resistance;
            Also near chart gap left by Jan. 2008 employment report news
- 734.40   previous key slide low; now resistance on a bounce
- 731.24   recent double top in Feb ‘08
- 729.00   38.2% Fibonacci retracement of the Aug. 2007 peak-Jan. 2008 collapse
- 723.24   20-week moving average; nice trend support for bull run; smashed on
            July/August 2007 collapse
- 712.17   support zone on weekly charts; reversal low in Oct. 2006; now resistance
- 700.00   “figure” swing line; no monthly close below here since Dec ‘05
- 687.06   20-day moving average
- 685.00   20% decline off 2007 record highs; breached Jan. 2008
- 680.94   mild reversal low on daily charts Jan. 28
- 668.58   July 2006 low; important bottom for summer correction
> 662.90   Mar. 14 close
- 660.00   short-term downside target on wedge breakout; support zone
- 652.00   38.2% Fibonacci retracement of 2002-2007 bull run
- 650.00   bear market move low set Jan. 22, 2008, critical support zone
- 643.35   recent move low set Mar. 10, 2008
- 614.76   October 2005 bottom; next major chart related downside point
- 591.00   50% Fibonacci retracement of the 2002-2007 bull market run

In addition to the printout of support and resistance points to watch, I also like to keep in mind where sudden volatility can spring into the trading mix from the typical release of economic data and Federal Reserve activity.

Although the economic calendar is fairly light in terms of volume this week, it still packs quite a punch, highlighted by Tuesday afternoon’s FOMC announcement, where the Fed is expected to slash another 50 basis points off the funds rate, down to 2.50%. In addition, the PPI and Housing Starts data Tuesday morning could get Tuesday off to a volatile start. There are no Fed speakers on the docket this week, but the policy makers will likely be out on the speaking circuit again the following two weeks.

The table below highlights calendar event risk for this week, with the emphasis on various economic reports. Our table below has a special “Risk Factor” designation, which is simply my assignment of risk to that event, ranging from 0 to 5, with 5 marking the highest risk for volatile market swings.

CALENDAR EVENT RISK ASSESSMENT

DAY REPORT/ITEM (all times Eastern) RISK FACTOR

Monday      NY Manufacturing Survey (8:30 a.m.)                 2
Monday      Current Account (8:30 a.m.)                             0
Monday      Industrial Production (9:15 a.m.)                        3
Tuesday     PPI (8:30 a.m.)                                               3
Tuesday     Housing Starts (8:30 a.m.)                                3
Tuesday     FOMC Announcement (2:15 p.m.)                       5
Thursday    Weekly Claims (8:30 a.m.)                                 1
Thursday    Leading Indicators (10:00 a.m.)                          1
Thursday    Philly Fed Survey (10:00 a.m.)                            2