Does Small-cap Performance Predict Another Correction?

After Monday’s disappointing open, the indexes slowly climbed back out of trouble to close with a respectable loss. Stocks also sought new ground Tuesday — yet they had trouble holding onto gains from earlier in the day. Still, two days of down action after an entire week of positive price movement is not necessarily a bad thing.

That’s the good news. For now, the market appears to be more inclined to shrug off negative speculation out of the Eurozone. Bad housing data here in the U.S. also had little effect on stock prices earlier this week. This is not to say that any additional negative news is priced into stocks — quite the opposite, actually. It’s all too obvious that any concrete evidence showing an imminent Greek default could tank stocks worldwide. Market participants will need to continue to hammer out the probability of a sovereign debt collapse, recession stateside, etc. The back-and-forth in stock prices will reflect this continued battle for the time being…

The bad news, however, is that market undercurrents are telling a different story. The Russell 2000 has completely decoupled from the major indexes since Friday, posting a three-day loss of more than 2.5%, while the Nasdaq and S&P near losses of approximately 0.5%.

The Russell 2000 (green line) has failed to keep pace with the major indexes recently

Also, you should not be fooled by the performance of the Nasdaq — this index is propped up by large tech firms that have recently outperformed the market (Apple, Amazon, and Microsoft, to name a few). You should not be looking to this exchange to gather trading information on true small-cap stocks.

The fact remains that smaller stocks are hemorrhaging — and this shows us that investors’ risk appetite is simply non-existent. The Russell had managed to make up lost ground during last week’s rally. But now, the market’s back the same old tricks. Jittery action like this is frustrating — and (as I probably don’t have to tell you) incredibly difficult to trade.

If you are trading in this difficult market, I recommend taking smaller position sizes. Be prepared for false moves — but keep your stops tight. Capital preservation is key when the markets are in flux. Forget “home runs” for now. Instead, focus on small, short-term positions that do not require you to chase price extremes. There is little to no follow-through in this market. Take profits early and often or risk losing them entirely.

You should also keep an eye on the economic calendar.