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

John C Burford applies his trading methods to the Russell 2,000 index to find out how far away we are from a top in the markets.

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.

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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.

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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

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

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.

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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.

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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

14-6-11-MWT-1

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

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

14-6-11-MWT-2

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.

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This story is just getting started

negative-momentum divergence

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.

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