When the US stock market is in consolidation and the trend is in question, I like to pay particularly close attention to the message small cap stocks, IWM, are sending. The main reason is because small caps tend to lead the overall market and can provide an early warning both in/out of consolidation and at beginning a new trend. As you can see in the chart of IWM below (bottom pane of ratio of sp500 index to small cap stock index), the small cap index started to decline first at September’s stock market peak and rallied greater than the broad market from December’s low.

The market loves symmetry and as you can see in the middle pane of IWM price movement, the rally from December’s low, the index stopped rising at the same point it failed in the past (look left). At that point, small caps have not only lagged the overall market but started to consolidate (red shaded area) in an attempt to digest December 24 oversold rally’s gains. Notice also, how the falling 200-day moving average acted as resistance as the index failed in its two most recent attempts to move above it. This is normal behavior of stocks in a downtrend. Because of symmetry, I would expect the index to chop around in the consolidation zone for at least a week or more before we know which way we are ultimately headed.

Bulls want to see the consolidation zone hold and the small cap index rally back above the blue horizontal, preferably on larger volume. This would allow the 200 day-moving average to catch up and turn higher. A break higher the first upper target is back at last August’s highs. Beyond that, a much higher target, based upon the inverse head and shoulders pattern, is some 40 points above where we closed yesterday. Bears want just the opposite … a flush down to the bottom of consolidation, followed by a rug pull on greater volume. That downside target would be a retest of last December’s low.

Either way and whichever way it resolves, the overall US stock market will likely soon follow suit.