The Small-Cap Meltdown Is a Hidden Buy Signal

By TradeSmith Research Team

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By Lucas Downey, Contributing Editor, TradeSmith Daily

Every money manager I’ve ever respected had a process.

Whatever the market would throw at them, they would have a plan to respond.

If inflation is out of control, they might dial back their stock exposure. If markets were flashing oversold signals, maybe they’d aggressively buy beaten-down stocks.

Whatever angle they took was grounded in a framework of stacking the odds in their favor. I try to do the same.

A fisherman can’t predict when they’ll get a bite. They just keep casting out the line, waiting for the rare nibble that comes before a big catch.

The same can be said for trade setups. Sometimes you scan the market waters and it’s quiet. Other times, the data signals a prime opportunity to reel in a monster.

A recent example is Tuesday’s market meltdown after the hotter-than-expected CPI report. (Check out my thoughts on inflation’s path from last week, right here.)

Small-caps in particular, as measured by the Russell 2000 ETF (IWM), fell 4.1%… their single largest one-day fall in over a year. Turns out these big selloffs in small caps are not only rare… they offer a forward outlook you’ll want to note.

As always, don’t take my word for it.

I’ll share all the proof with you today.

But before we dive into this awesome study, let’s review what got us here to begin with.

The Biggest 1-Day Selloff in Over a Year

It’s been a while since markets saw a day like last Tuesday.

All the major indices were down, but small caps were punished the most. Below you’ll see what I mean.

With fears of rising inflation perking up again, smaller, less-capitalized firms got smacked. Fast money traders took the opportunity to sell first and ask questions later.

But I had a few questions once the dust settled:
  1. How often does IWM experience a 4% or greater drop in a day?
  2. What can we expect going forward?
  3. What’s the positive hit rate on the forward performance?
This level of detail will help us build a case for what may lie ahead for small caps.

If you’re hoping for an end-of-days, bear-fueled result, look away now!

Because believe it or not, big washout days often precede powerful rallies…

What Happens Next?

To answer these three burning questions, I pulled all daily returns for IWM and sifted for days when the fund dropped by 4% or more.

Prior to Tuesday, it’s occurred only 50 times since 2000.

After IWM falls 4% or more:
  • Small caps jump 5.8% three months later…
  • They leap 12.6% six months later…
  • And they soar an awe-inspiring 37% 12 months later.
What’s also impressive is the winning percentage, which only grows over time.

Six months after this rare signal hits, you’re staring at a 76% chance of success.

Out to 12 months, it’s an 84% hit rate.

This data tells me, loud and clear, that we should treat last week’s selloff as a buying opportunity.

While the mainstream media distracts us with inflation fears, historical evidence points to a strong likelihood of better days in the near and long-term future.

Go ahead and cast your small cap net. This study suggests the fishing is good.

Evidence-based research like this is why TradeSmith can help you navigate uncertain waters. These big dips often lead to bigger rips… But you have to be in the best stocks.

For more on that, I suggest you log into TradeSmith Finance and check out the latest in your Quantum Edge Pro subscription, a small-cap-focused investment advisory written by my good friend Jason Bodner.

In it, Jason uses his Big Money scanner to isolate the rare few small-cap stocks that major Wall Street institutions are buying in droves even when the broad market falls.

Recently, Jason recommended taking partial profits on four Quantum Edge Pro positions for an average return of 75% each… while leaving the rest on to ride with substantially less risk.


Lucas Downey
Contributing Editor, TradeSmith Daily