Small-Cap Investors Need To Get Selective

The market is becoming more selective, and small-cap momentum investors need to recognize that conditions have changed. The S&P 500 remains in an uptrend, but small caps have suffered meaningful technical damage and participation across the broader market has weakened. We can still find stocks worth owning, but the market is providing less help.

That is the message from three charts as of Oct. 19. The current weekly readings remain provisional until Friday’s close.

SPY, our proxy for the S&P 500, is trading at $767.71, above its rising 20-week moving average of $758.89 and its rising 50-week average of $718.84. That remains a favorable trend configuration. Based on this chart, declaring that the entire market has entered a bear market would be premature.

Even here, however, momentum has softened. MACD-V remains positive at 93.97 but has slipped below its signal line. RSI is still above 50 at 58.73, although it has also fallen below its moving average. The large-cap advance is intact, but it has lost some energy.

The small-cap picture is considerably weaker. IWM, which tracks the Russell 2000, has declined approximately 11% from its recent high and is trading at $271.24. It is below the 20-week moving average of $290.69 and slightly below the rising 50-week average of $272.84.

That puts small caps at an important technical test. A quick recovery above the 50-week average would help stabilize the chart. Sustained trading below it would increase concern that the correction is developing into a more persistent decline.

Momentum offers little reassurance yet. IWM’s MACD-V has fallen to 6.11, indicating that the earlier upside momentum has largely disappeared. Its negative histogram and RSI of 39.87 confirm the deterioration. There could be a rebound from here, but the chart has yet to show a convincing turn.

The breadth chart helps explain why an investor watching only the S&P 500 might have a different impression from someone managing a portfolio of smaller companies.

Only 40.98% of the stocks measured are above their 200-day moving averages. Approximately six out of 10 are failing that basic long-term trend test. Participation has fallen from above 60% around the late-summer peak, and the breadth indicator is below both its 20-week and 50-week averages.

Its MACD-V is negative, and RSI is near 30. The decline in participation has become stretched enough to make a rebound plausible, but there is no convincing reversal yet. Calling something oversold does not oblige buyers to show up Monday morning with their checkbooks.

Taken together, these charts suggest that strength in the large-cap index is masking considerable weakness elsewhere. They do not establish that a major market decline is inevitable. They do establish that this is a more difficult environment for small-cap momentum investing than the S&P 500 alone would suggest.

For us, that means raising the standard for what earns a place in the portfolio.

Fundamental momentum remains essential. We want improving profits, stronger margins, cash generation and a sound financial position. Those developments give a smaller company the opportunity to attract investors and sustain a meaningful advance.

However, improving earnings do not guarantee an immediately rising stock price. Expectations, valuation and selling pressure still matter. A company can report a good quarter while its shares continue falling. We need to evaluate both the business and the market’s response to its progress.

That is why the price side of twin momentum deserves particular attention here. A stock holding above rising moving averages while IWM declines is demonstrating strength relative to its surroundings. A stock making repeated new lows despite optimistic earnings forecasts requires a harder look.

There is no need to sell every smaller company because IWM has weakened. Individual leaders can continue advancing during an index correction. Those holdings deserve room to work within our established risk controls. At the same time, a substantial loss does not become a reason to keep owning a position, and a lower price alone does not create a fresh momentum signal.

New purchases warrant patience. Strong earnings followed by sustained buying would provide better evidence than a large projected growth rate attached to a deteriorating chart. Position sizes should reflect the weaker environment, and existing exit rules should carry more weight than our affection for a company’s story.

My recommendation is simple. Place a 12% stop on every stock in the portfolio, starting this week.

I do not know whether the small-cap correction ends here or turns into something worse. Neither does anyone else. IWM is sitting on its 50-week average, fewer than 41% of stocks are above their 200-day averages, and the large-cap index is carrying more of the load than it should. A stop does not require a forecast. It requires a decision made in advance, while we are calm, about how much more we are willing to lose.