Small Caps Hold the Key to Market Direction in 2020 and Beyond

While equity markets swung of the dramatic global expansion of the Coronavirus, small caps and emerging markets were providing a clue and make be key to a rebound, reports Avi Gilburt.

While the S&P 500 was making new highs in February, both the iShares Russell 2000 ETF (IWM) and iShares MSCI Emerging Markets ETF (EEM) were presenting rather ominous looking patterns. And, as I was telling the members of ElliottWaveTrader.net, either IWM was going to see a strong catch-up move through the 174 level (which I would join on a break out to the long side), or it was going to drop down to the 123 region and pull the rest of the market down with it.

Moreover, as I had posted in the EEM analysis published on Seeking Alpha in early February, EEM was setting up a 1-2 downside structure which was going to be pointing us much lower in the coming months of 2020.

So, the question we were grappling with at the end of 2019 and early 2020 is which of these markets were telling the truth – IWM/EEM or the SPX?

If the SPX would have mirrored the patterns of IWM and EEM, we should not have broken out over the 3040 maximum resistance expectation. This is what threw off my analysis from November through February on the SPX, whereas the analysis on EEM and IWM remained quite consistent. And, when the SPX followed through over 3150, it was presenting a much more bullish posture, if it retained support over 3150, whereas IWM and EEM were still presenting a much more potentially bearish posture. And this is why so many of you took me to task for being wrong regarding my equity market analysis. Yet, as we see now, maintaining a cautious stance was not wholly inaccurate.

Until early February, the question remained as to which equity charts were telling the truth. And this was the question which caused me great angst during the late 2019 and early 2020 period. It certainly made me struggle in my analysis of the SPX more than I have over the last nine years. Many of you took me to task for maintaining the cash I raised around 2880 and putting it into TLT in the fall of 2018. But my money has been quite happy in TLT since that time and is now sitting in cash and available to re-deploy into the equity market.

Back in February, when the SPX approached 3400, we began looking for another pullback, with initial support at 3280, followed by support down to the 3100. When it began to break support, the SPX won the award for the “fake out-of-the-year” for both 2019 and 2020, whereas IWM and the EEM charts were telling the truth the whole time.

So here we stand with both EEM and IWM having pulled the market down and the SPX following along. In one week, the market has erased all the profits seen during the prior five months, which was the same period through which I was struggling in my SPX analysis. Moreover, in three weeks' time, we have erased a year of gains. Yet, all the profits we have earned from being in TLT have allowed us to significantly perform better than most in the equity market.

While I am certainly not here to tell you that I was right in missing the rally from 2900-3400 in the SPX, I am here to tell you that our Fibonacci Pinball mythology has kept me out of situations like this more times in the past than I can even enumerate. While there are times that I may miss a market move, the long-term track record that we have attained with our methodology has far outweighed the moves we have missed.

We are now sitting in a better posture than most in the market, as we have significant cash available to deploy, whereas most in the market simply rode this back down as they were paralyzed in their long positions.

The importance of this decline cannot be understated. It has now clarified why I have been struggling with my analysis these last several months, and it also appropriately supports my expectations for the next 3-5 years in the equity market.

You see, corrective structures take shape as a 3-wave event, which we label as an a-b-c move. The move down in IWM into its December 2018 low was the a-wave of that correction, the rally back up towards 170 was the b-wave of that correction, and we are now likely within the c-wave of this correction. In fact, I have had the 123-region as my ideal target zone for this correction in IWM for over half a year, and we are now a stones through away from that target. In fact, based upon the current structure, there is growing potential to drop as deep as the 105-111 region before this correction completes, and the action we see over the coming week will give us a better understanding of that potential.

Ultimately, this should be viewed as good news by long term investors. As it stands now, my long-term upside target for IWM is in 210-240. So, it is likely we are going to see a major buying opportunity in 2020, which is something I expected to see happen several months ago.

Those that have earned profits with our work in TLT since we called the bottom in November of 2018 are sitting pretty with that money in cash to now take advantage of the opportunity being presented to us over the coming weeks/months. And when I hear about the hedge funds that have been blowing up of late, it gives me a warm and fuzzy feeling that I have been able to keep my clients safe and out of this mess.

Avi Gilburt is a widely followed Elliott Wave analyst and founder of ElliottWaveTrader.net, a live trading room featuring his analysis on the S&P 500, precious metals, oil & USD, plus a team of analysts covering a range of other markets.