Why I’ve started watching the Russell 2,000 index

I will venture a little off-piste today and, at the suggestion of a colleague, cover the Russell 2,000 US stock index.

This is a very popular trading vehicle and contains 2,000 small-cap US shares. It displays some excellent tramlines, Fibonacci levels and Elliott waves, which makes it an excellent subject for my trading methods.

As you know, I have been waiting for a top in the stock markets for some time. My policy has been to wait until I get a good shorting signal and then strike. I will not just jump in and short the market just because I am feeling bearish. That is a formula for disaster.

The correct timing of trades is critical to success. I must let the charts speak to me.

So today, I’m going to look at what the Russell 2,000 index tells us about how close we are to a top in the stock markets.

The best time to leave a party

The all-time top has been elusive so far, but I have been successful in the past with this approach at finding the major interim tops. My latest campaign was the January dip of around 1,000 points.

To me, there is no doubt that optimism towards stocks is at extreme levels. However, this has been so for some time, and could continue for weeks and months. I must always keep that possibility in mind.

My task is to try to pinpoint that top. Extreme optimism is an absolute necessary condition for the formation of a major top.

Remember, there has been no stock market top in history that has not been accompanied by an extreme in bullish sentiment. A moment’s thought will convince you why this is so. And these extremes are usually accompanied by ecstatic reactions to market news. The best time to leave a party is when it is in full swing!

The evidence is piling up

With sentiment running off the scale, we have the right conditions today for such a major top. All we have to do is wait – and observe.

Here is a short list of reasons why I believe sentiment is extreme:

• Daily Sentiment Index (US financial advisors) is over 80% bullish – a near-record high.

• Junk debt of US companies is trading at record-low yields. This is the shakiest debt out there. Only a small deterioration in economic conditions would make the default rate skyrocket. Complacency rules in junk as investors chase yield down the quality scale.

• Investors are snapping up US IPOs (initial public offerings), a record fraction of which have ‘negative earnings’ (a technical term meaning they are are losing money). Again, there is extreme complacency towards a future shock.

• NYSE margin debt was at an all-time record and is now falling. Stocks are being bought with borrowed money. This is dangerous in a falling market.

• A huge divergence between small caps (shares now declining) and the large caps (shares rising). Stocks markets are fractured – a sign of ill-health.

• Declining NYSE trading volumes as the markets rise, indicating a weakening conviction in the rally. Only a small shift towards selling will produce steep falls as the market is running out of buyers. Stop-loss selling will produce huge moves.

• The AAII (US small investors) latest survey shows that, at last, retail investors are piling back into the stock market – after a rally of 162% in the Dow from the 2009 lows.

These mom and pop investors largely sat out this rally, and are now convinced it’s safe to jump back in. It is a market axiom that when the little guy finally ‘gets it’, it’s time to look for the exit.

• Latest put/call ratios on NYSE remain very low, indicating that investors are complacent towards possible declines. More call options (betting prices will rise) are being bought than puts (betting prices will fall).

• Last, but not least, I am seeing many articles proclaiming that with the US economy now looking very rosy, this is the start of a big bull market.

A glance at the charts should convince anyone that we are closer to the end than the start – already the Dow has moved up over 160% off the 2009 lows. If that is the start, what is the end for the Dow – over 50,000?

Working against this stack of evidence is the fact that many pundits have been calling for a top in recent days, which makes it less likely to occur. Watched pots never boil!

But as the markets stretch higher, the elastic band is getting tighter and tighter. The snap-back will be spectacular.


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The Russell 2,000 stock index

Let’s now turn to the charts. The first chart I examine on a new market is the weekly or monthly. Here is the weekly:

Russell 2000 spread betting chart

What stands out for me are two things: the clear A-B-C form to the rally and the terrific tramlines I can draw from the 2008 – 2009 period.

My lower line sports five accurate touch points and one pigtail cut-off, while my upper line has at least five accurate touch points with no pigtail cut-offs.

This is a tramline pair I can rely on to provide my boundaries of support (lower) and resistance (upper). Note that so far in 2014, the upper line has contained the rallies.

Also, the A-B-C form is a counter-trend pattern, which implies that when the C wave terminates, the main trend will be down. And there is one other factor: at the recent 1,200 high, wave C equals wave A to within a few points. This is a common relationship and is the wave equality rule at work.

The rally is coming to an end

Now I have an overall picture: the market is very likely in the final throes of a large counter-trend multi-year rally. It is near the upper tramline and so I expect the next major trend will be down towards the lower tramline.

I shall start to look for signs of a top now and I will zoom in on the daily chart:

Russell 2000 spread betting chart

This is the rally leg from the late 2012 low and I can draw another superb tramline pair (in green), where both tramlines have multiple touch points, making them very reliable lines of support and resistance. This tramline pair has described the trading channel for about a year.

This story is just getting started

In late 2013, the market made a series of highs on the upper tramline on a negative-momentum divergence. This is where the short-term tramline met the long-term tramline in what I call a Chinese hat, which is where the two sets of resistance levels combine. It is a powerful force that often turns the market.

And in January, a major event occurred – the market was knocked back by the Chinese hat and the lower tramline was broken. This indicates a change in trend.

Since then, the market has edged back to the lower line and is currently making a kiss on the line in textbook fashion. The tramline kiss is one of my favourite trade set-ups, and I will continue this intriguing story next time.

• If you’re a new reader, or need a reminder about some of the methods I refer to in my trades, then do have a look at my introductory videos:

The essentials of tramline trading
Advanced tramline trading
An introduction to Elliott wave theory
Advanced trading with Elliott waves
Trading with Fibonacci levels
Trading with 'momentum'
Putting it all together

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4 Responses

  1. 11/06/2014, david d wrote

    Markets do not go down till there is lower highs and lower lows. Until we see this you are wasting your time calling a top. This has been going on since the Stoxx was 20% lower. The A leg and C wave are not close to equidistant. I believe we are in the 3rd of the 3rd of the 3rd. This is the most powerful leg one can imagine. Lastly, your favorite Cot indicators are all neutral except the NASD which has been bearish for years.These seem to be omitted when they are contrary to your overall bias.Myself, I do not want to touch the short side until the structure tells me to.

  2. 11/06/2014, Fruit trader wrote

    John, please explain how it is possible to count a “counter-trend pattern” (ie your ABC, ie a correction), when the market has far exceeded the prior down move? Surely you are not suggestion this massive rally is an Elliot Wave “expanded flat” (a corrective pattern)?

    From 2003 to 2007 the Russell moved up from 300 to 800, and then dropped back down to 300 by 2009 (a 500 point move). Since then it has rallied all the way to 1200 (a 900 point move).

    How do you determine the main trend to be down? The last down move was only 500 points compared to the recent (up) trend which is 900 points?

    Elliot Wave is not as simple as sticking 3 or 5 wave counts anywhere on the chart, and then looking at the current wave count in isolation, ie ignoring the bigger picture.

    And incidentally, the 2007-09 down move could equally be counted as a 3-wave, ie ABC, ie corrective….and thus not “motive”.

    Yes, the market feels extremely frothy. Yes, it has been going straight up for a long long time. Yes, it is probably being fuelled by crazy QE and excessively low rates. Yes, I can’t make sense of the endless rally. And yes, it will definitely have a correction at some stage, which might even turn into a large correction. But to state this up move is a “counter-trend pattern” would be implying that when the (main) down trend reasserts itself, then the down move will be larger than the current rally. Is EWI is still predicting prices below 300, ie Armageddon, ie a complete and utter collapse of the western financial system and society? Are you following them?

    Predicting a correction (even a large and nasty correction) is one thing, but to say the main trend is down based on arbitrary labels, seems a bit fanciful in my mind. Maybe you could mark up a chart which shows how this 900 point rally which you are labelling as a ABC fits inside a current or future motive 5-wave down move. That might help clarify the counter-trend count.

  3. 12/06/2014, IJ1 wrote

    I too am constantly bemused by the strength of this rally, but agree with the comments here, and it may go further than even the most ardent bulls expect. I don’t believe the market is yet euphoric. It’s certainly nothing like 2000 or 2007. We still haven’t seen much participation from retail investors. Anecdotally i don’t have friends asking for stock tips as they were in 2007. The biggest buyers to date have been, and continue to be, corporates (buybacks). And yes – how can this possibly be an ABC? I’m no EW expert, and not sure i believe in it, but if i were to suspend my lack of faith i’d say we are in a very strong wave 3 of the bull market. I believe this may end very soon, probably as market starts to anticipate the end of QE and we may get the biggest correction we’ve seen since 2011 – a wave 4. But this will pave the way to new highs sometime late this year or early next. It can take a long time for markets to peak. Note that in 2007 it didn’t peak till October – about 9 months after the first subprime jitters hit the tape, and 4 months after Northern Rock!

  4. 12/06/2014, Bronco Bill wrote

    You said John, ” the best time to leave a party is when it is in full swing”.

    I would add to that and say… and always make sure you’re dancing near the door.

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