What's Different About This Rare Small-Cap Signal

IWM slipped into oversold territory last Friday

by Rocky White

Published on Oct 10, 2018 at 7:00 AM
Updated on Oct 10, 2018 at 7:00 AM

The small-cap iShares Russell 2000 ETF (IWM) has fallen nearly 7% off its recent highs. The Relative Strength Indicator (RSI), which is a popular technical analysis tool, is now signaling that IWM is oversold. These popular indicators don't often hold up to scrutiny when you look at historical results. That's what I’m going to do here with the RSI and IWM. I'll look at historical oversold signals to see if the numbers do, in fact, support the notion that the IWM is oversold and presenting a buying opportunity.

First, the RSI is an oscillator that ranges between 0 and 100. An RSI reading below 30 is commonly considered an oversold signal by traders. Below is a chart of the IWM over the past few years, with markers showing times the RSI fell below 30. The last couple of signals look to have been prime buying opportunities. Before that, there were some poor signals in the latter half of 2015.

10.9 iotwchart1

Breaking Down an Oversold IWM

Since the IWM began trading in 2000, there have been 26 other times that the RSI fell to below 30, setting off an oversold signal. I only count signals where the RSI was above 30 for at least a month before falling below it. Otherwise, you can get a lot of repeat signals within a short time frame.

The table below summarizes the returns of the IWM after these signals over different time frames ranging from two weeks to six months. The second table shows typical IWM returns for comparison. The first things I look at are the average return and the percent positive. By these measures, the IWM significantly outperforms its typical returns across all the time frames, especially in the shorter time frames. Two weeks after a signal, IWM has been up an average 2%, and positive nearly 70% of the time. The typical two-week return for the exchange-traded fund (ETF) is 0.35%, and positive 57% of the time.

I also include the average positive, average negative, and standard deviation of returns in the table. This gives us more information on why it's outperforming after these signals. It's what you would expect from an oversold signal. The standard deviation shows more volatility after a signal, which you might expect because these signals occur amid pullbacks rather than in a rising market.

The bigger volatility pops, however, occur to the upside rather than the downside. When you compare the average positive after a signal to its typical average positive, it's larger in magnitude than when you compare the average negative after a signal to its typical average negative. Based on this, I wouldn't be surprised if we get a strong bounce in the near future on the IWM.

10.9 iotwchart2

Ranking The Most Recent IWM Pullback

Next, I break it down further. I mentioned how these signals occur during pullbacks. This recent IWM pullback, though, hasn't been all that severe. In fact, when this indicator signaled last Friday, the IWM was just 6.3% off its three-month high. Of the 27 total signals back to 2000, that's the smallest pullback that generated a signal. When these signals occurred after pullbacks of less than 10%, the IWM performed even better going forward. The table below shows a two-week return of more than 3.5%, and six of the seven returns positive. These two metrics are better than the typical IWM returns after signals. This is true across all the time frames in the table.

10.9 iotwchart3

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