Russell 2000: Pullback likely

Kevin Pendley | May 18, 2008 12:05pm EDT | Comment

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I’ve got good news, and I’ve got bad news...On the “good news” front, small cap stocks broke out to the upside last week, with the Russell 2000 Index notching the highest close on weekly charts since last December.

What that means is that all the short equity in small caps for the last six months – be it from outright selling stock short, or bearish positions in shares that post options, or shorts among index products and futures – is at a big loss. The shorts are stuck between the proverbial rock and a hard place and may have already been forced to cough up more margin money or buy their way out of bad trades. That is a positive for the market, especially if small caps can continue to press higher in the coming days.

Also on the good news front, the Russell 2000 (NYSE:IWM) finally stormed through 735/731 resistance with conviction. Yes, the market had breached that zone on an intraday basis several times since late April, but until last week the move was never convincing. With that zone now conquered on a closing basis, small caps can turn chart attention toward the next big resistance area, which runs from 743 to 750.

Which brings us to the “bad news” portion of this message. That resistance zone from 743 to 750 is every bit as important as the old double tops were at 731 and 735. In fact, from a long-term perspective, 743 to 750 is a BIGGER hurdle to overcome. As you can see in the SUPPORT/RESISTANCE table below, 750 represents the 50% Fibonacci retracement line of the entire bear market collapse, while 743 marks the old August 2007 collapse low, and the downside gap zone off the January employment report.

The market also has to take recent advances in small-cap shares with a grain of salt. That’s because volume on the latest leg higher in the Russell 2000 (and in large caps too), has been anemic. Light volume moves are always suspect, and this time around the rise comes at the tail end of a three-month recovery move and now enters into the teeth of more dynamic resistance.

Looking at daily charts, we also see topping patterns popping up on two of the last three sessions in the Russell. On Wednesday, we saw a “tombstone doji” pattern, and luckily for the bulls that formation was quickly set aside by a rally on Thursday. However, we saw yet another topping signal on Friday when the market made new highs on an outside move, but closed lower on the day. When the market makes new highs, but closes lower, it raises a caution flag that the bulls might be getting exhausted, and that new shorts might be ready to pounce on any sign of further weakness.

Also, on the “bad news” front, the volatility index in options has tumbled to the lowest level since last October. Volatility readings signify fear and complacency in the marketplace when they reach extreme readings. In this case, an extreme low suggests that investors are complacent – perhaps they are maybe a little too comfortable and confident in the recovery rally. It’s also sobering to realize that the last time volatility readings were this low was back in October 2007, which coincided with a major market peak.

Given all those caution flags, and the topping pattern from Friday, the most likely course of action this week would be a pullback. If the market does start to falter, a range from 745 on the upside to 708 on the downside seems reasonable. If something takes place to smash 750 with conviction this week, then all these “bad news” caution flags will take a backseat, and we’ll start to consider a course toward the 61.8% retracement target.

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
- 775.03   61.8% Fibonacci retracement of the Aug. 2007 peak-Mar. 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
- 749.88   50% Fibonacci retracement of the Aug. 2007 record peak-Mar. 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
> 741.17   May 16 close
- 731.24   recent double top in Feb ’08; now support
- 724.27   20-day moving average
- 701.98   20-week moving average; nice trend support for bull run; smashed on
            July/August 2007 collapse
- 700.00   “figure” swing line; no monthly close below here since Dec ’05 until Feb ‘08
- 685.00   20% decline off 2007 record highs; breached Jan. 2008
- 680.94   mild reversal low on daily charts Jan. 28; near 50% of the March ’08 bounce
- 668.58   July 2006 low; important bottom for summer correction
- 660.00   short-term downside target on wedge breakout; support zone
- 650.00   previous 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.

The economic calendar is tame this week, highlighted by Tuesday’s PPI release. This should free up the market to focus on money flow, earnings numbers, world events and chart patterns.

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

RISK FACTOR REPORT/ITEM (all times Eastern)

1                   Leading Indicators (Mon., 10:00 a.m.)
4                   PPI (Tues., 8:30 a.m.)
1                   Fed’s Kohn on the economic outlook (9:00 a.m.)
2                   FOMC Minutes (Wed., 2:00 p.m.)
0                   Fed’s Warsh “using the fed funds rate” (Wed., 1:00 p.m.)
2                   Weekly Claims (Thurs., 8:30 a.m.)
0                   Fed’s Kroszner “preparing mortgage market recovery” (9:00 a.m.)
2                   Existing Home Sales (Fri., 10:00 a.m.)