Small Caps Break Down, VIX Surges. What's Next?
I've remained quite bullish on U.S. equities, and especially small caps, since the April 2025 low, but if there's one thing I never argue with, it's the combination of price and volume. The small-cap ETF, IWM, which tracks the Russell 2000, violated its neckline support of a bearish head-and-shoulders topping pattern on Thursday, and did so with a significant spike in volume. That doesn't guarantee further downside action, but it certainly increases the risk of that additional downside. Traders must manage risk efficiently to be successful long-term.
Let's look at what this breakdown might mean. To start, here's a chart of the IWM year-to-date.
First, there's the negative divergence that highlighted slowing bullish price momentum. Many times, during an uptrend, we'll see a negative divergence develop and then get what I refer to as a PPO reset. This where the PPO returns to its centerline, meaning the short-term EMA and longer-term EMA are exactly equal. Effectively, the momentum is gone, and IWM could either:
- Break down below the PPO centerline, suggesting building bearish momentum, or,
- Resume the prior uptrend.
In most cases, I expect the latter to occur. In this case, however, you'll see that the PPO experienced a bearish PPO centerline crossover just as the IWM failed at key overhead 20-day EMA resistance, and both accompanied the head & shoulders breakdown — not good. All is not lost for the bulls, as technical breakdowns can happen without further repercussions, but the time to recover is now, as in this afternoon or very early next week.
After gapping down this morning, the bulls have battled back all day long. On this blown-up picture of the last three months, I've identified the key resistance range that needs to be cleared as we close today, then move into next week.
How do we close today? And, if we do close back above 238 today, how do the bulls and bears react to start next week?
I'm a bit on the skeptical side right now, meaning that I believe that Wall Street is sending us a message that the next interest rate cut in December is not going to happen, or, at the very least, Wall Street is worried about whether a rate cut is imminent.
Why do I say that? Well, there are a few reasons.
First, the relative strength that IWM was enjoying until roughly two weeks before the last Fed meeting. Perhaps Wall Street was starting to get an inkling then. Second, money began rotating away from the large-cap IWF (ETF that tracks large-cap Russell 1000 growth) at the close on the day of the last rate cut, and discretionary stocks turned abruptly lower vs. staples stocks at almost the same time. Check all 3 out below.
This all happened roughly one year ago. Remember when the Fed put the brakes on the rate cuts last year? The last one occurred on December 18, 2024. Is this déjà vu or what?
Now I don't know if it'll unfold like last year, with an ensuing bear market to follow, but it's at least worth thinking about. When I begin seeing signals like these and a Volatility Index ($VIX) that surges above 20, I take no chances:
A VIX over 20 doesn't necessarily mean we'll see a collapsing stock market, but history tells us that the largest selloffs occur with the VIX over 20. So you should always be aware of a VIX move through 20.
I always say that a market with elevated fear does not handle bad news well. I believe the lack of a December rate cut would be bad news.
Don't take this IWM breakdown and surge in the VIX lightly. It may turn out that this is nothing more than a false alarm. If so, I'll happily re-enter the market at a higher level. But what I don't want to do is be a hero and stay invested while the market tumbles. As a trader, JOB #1 is to PROTECT CAPITAL.
Stock Fantasy Draft TOMORROW!
Could we have scripted more volatile action the week before Grayson Roze, Julius de Kempenaer, and I have to square off in a Stock Fantasy Draft that runs through the Super Bowl in early February? To add a bit more excitement, we're adding a fourth "mystery guest" to our Draft. Will we reconsider our drafting strategy given the events of this week? I know I will. My draft order just got turned upside down – or did it? I'll discuss this a lot more tomorrow morning, and I'm sure Grayson and Julius will have plenty to say as well.
Anyhow, it's a MAJOR competition between us, so let the smack talking begin! If you'd like to join us, the event will begin promptly at 10:00am ET and it's completely FREE! Simply CLICK HERE to sign up and save your seat! I'll see you in the morning!!!
Happy trading!
Tom
