What are Small Caps Telling Us?

Has the market recovered? Is the bottom in? Are we going to double dip on the economy? I could go on and on with all the questions relative to the market and its future. At times like this I prefer to look at pictures versus listening to pontification on what was, what is and what will be. Below is a chart of the S&P 500. I shared a similar chart recently on the resistance and support for the major index. The purpose was a simple statement on risk management. Some of the feedback tells me investors still fight risk management. We are more fearful of missing out on the upside by getting stopped out of a position, than we are fearful of losing money. This explains why so many lost so much when the market fell more than 30% last year. It also explains the fact that greed is a greater motivator than fear when the market sentiment is positive. Just as fear is a greater motivator when the market sentiment is negative. Risk management is a challenge for investors every day and emotions are the biggest enemy.

The price action in small cap stocks are a key indicator for the end of a bear market trend. Below is the chart of the S&P 600 Small Cap Index. The point of focus here are two parts of the chart. The first is the period from March 9th through May 8th. Small caps stocks were are key part of the leadership to the upside off the bottom. In other words without the appeal of growth to investors or the willingness to take risk the markets struggle to change trends. The sharp downtrend from September 2008 through March 2009 was fear motivated from the financial collapse. The 50% rise off the lows for the Small Cap Index was an indicator investors were willing to accept risk again. Acceptance of risk is a key factor for the uptrend to continue.

The second uptrend came from the consolidation or digesting of the first trend higher. The 20% gains off the support of the trading range in July was key part of the catalyst to the upside. Again, investors willingness to accept risk. This leaves us with the primary question of what happens now? Even if I had a crystal ball for the future I wouldn't tell, it would ruin the surprise. But, back to KISS, the initial support is the 20 day moving average. Resistance is the 312 mark and 275 is the key point of support for the current uptrend off the March low. Therein lies about 70% of what you need to know to develop a strategy for the sector.

If you are invested in small cap stocks stops should be at 292 or 275 which ever fits your risk tolerance. The entry point to add to positions would be a break above the resistance point at 312. You can add other technical indicators on top of this for confirmation to the entry and stop points. You can research fundamental data as well for confirmations. The point being developing trading and investing strategies aren't as difficult sometimes as they seem.

As far a small caps are concerned watch the index for clues on the investor appetite for risk and use them as a guide for investing.