The market has ripped higher over the past three months.
However, there is one big warning this rally is going to end …
perhaps very soon and perhaps very violently.
Once this rally stops, the indices could easily skid 15%
lower. Also, this decline may unfold in less than a week.
The lack of volume during the August rise indicates that
institutional investors remained on the sideline. In fact, the
only time volume was above average was during down sessions,
suggesting the high-frequency trade-bots accounted for the
remaining transactions on low-volume days. Because there aren't
any real investors prepared to support prices once the selling
starts, the result could be a quick and severe sell-off.
The bulls haven't cracked yet. However, one key index warns that
the end is near and that a 15% decline is right around the
Typically, small businesses lead the way into and out of
recessions. Because many flirt with profitability, a tiny change
in costs or failure to win a key contract is magnified for a
small business. In economic booms, profitability grows quickly.
But during cyclical contractions, profitability rapidly
This volatility in earnings has an impact on fundamental
valuations, which is reflected in stock prices. Accordingly,
monitoring the prices of small-cap stocks can warn you that the
economy is about to turn sour.
The Russell 2000 is comprised of small-cap growth stocks. And
it's the perfect chart to watch for gauging the strength of the
In 2007, this index gave investors a clear warning that a shift
in the economy was taking place, topping in July. Though the
Russell 2000 came very close to making a new high in October
(blue arrows), alongside the other indices, it failed to do so.
Many, including myself, believe this failure to make a new high
in October 2007 was a huge red flag, hinting that the market was
due for a sizable correction.
SPX (black line) compared to Russell 2000 over the past
Today, the Russell 2000 and the other indices are in an eerily
similar setup that shows the same price divergences.
The Russell 2000 made its rally high in May 2011 at 868. On the
other hand, the remaining major indices made new highs in 2012.
In fact, many currently trade at new highs. In contrast, the
Russell 2000 is only now challenging its May high.
Is the Russell 2000 giving investors another warning that the
indices are about to tank?
Though the economy is far from a collapse and central banks
appear prepared to offer support to bonds, the red flag given by
small caps has merit. The indices' rise in August appeared
suspicious. It came without volume and occurred when countries
such as India, Germany and Japan reported abysmal economic data.
Given that economic backdrop, it seemed implausible the indices
would rally, yet they did. The rally was built more on the
optimism of stimulus than positive economic conditions. If true,
the indices could be headed for a major top within the next few
Small-cap stocks have correctly guided investors in the past. And
it makes sense that they did so. Small businesses tend to be
highly attuned to small changes in economic conditions, giving
investors a warning when the corporate environment has weakened.
Keep a watchful eye on the Russell 2000 this month. Caution is
warranted until it closes above 868 for an entire week. And if it
can't by the end of October, I'd be prepared to sell every share