Does This Chart Hint at a Stock Market Crash?

by Jeff Reeves | May 12, 2014 9:41 am

Does This Chart Hint at a Stock Market Crash?

Small-cap stocks are inherently different than the bigger blue chips on Wall Street. Smaller companies naturally have much more upside, since they still are in growth mode, but small-cap stocks also can carry more risk because they aren’t as established or well-capitalized.

russell 2000 300x212 Does This Chart Hint at a Stock Market Crash?
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Despite these differences, one thing remains true: Small-cap stocks and large-cap stocks generally move in the same direction over the long term.

So the fact that the Russell 2000 small-cap stock index is down about 10% since late March and the S&P 500 is slightly in the green is a big oddity.

And some say it’s even proof that a stock market crash is coming.

Here’s what you need to know about the fact that the Russell 2000 is silently in correction mode even as the S&P 500 holds firm.

Traders Bank on S&P Falling, Not Russell 2000 Rising

The Russell 2000 excludes the 1,000 largest U.S. companies based on market cap and instead focuses on the 2,000 companies that come next. So how it is possible that 500 of the largest U.S. companies could have such a dramatically different run in the past six to eight weeks?

Some traders will answer that this is not possible — or at least, not sustainable. And the natural next step is for the gap between the two indexes to resolve itself.

That could be by a big rally in small-cap stocks … but that doesn’t seem likely, given that traders are actively buying protective options[1] to prepare for a downside move. Similarly, the VIX “fear index” is at its highest level since 2007 for the Russell 2000.

Also, the Russell 2000 Index is dangerously close to the 10% decline that would signal a formal “correction” to many investors. That would mark the first double-digit run for small cap stocks since 2012.

And beyond the broader downtrend, some specific small-cap stocks are in serious trouble. This, from BusinessWeek[2]:

“About $170 billion has been erased from the value of smaller U.S. companies since March as investors fled stocks with the highest valuations. Overstock.com Inc. (OSTK[3]), Gogo Inc. (GOGO[4]) and American Apparel Inc. (APP[5]) have seen at least half their market value disappear this year.”

And for the technical analysts and chart-focused investors, there are some disturbing indicators out there. As Michael Ashbaugh points out, the Russell 2000 has already “violated its 200-day moving average, albeit on light volume.”

For good measure, too, consider that momentum stocks from biotechs to Twitter (TWTR[6]) have imploded in 2014, and the “risk-off” environment is certainly not supporting an influx of buyers into Russell 2000 small caps.

It all adds up to the liklihood of a big correction for the S&P 500. And to some bears, this is the long-awaited sign of a stock market crash after a 30% up year in 2013 that pushed stocks too high, too fast.

Nothing is a sure thing, of course, and as InvestorPlace chart guru Sam Collins points out, the Dow continues to set new highs and has a big tailwind[7].

Will it be enough to drag small-cap stocks up to parity? Time will tell. As of today, we’re seeing a little relief for the Russell via an open of less than 1% higher.

But the bottom line is that the big divergence between the Russell and the S&P 500 isn’t sustainable forever, and has already been wide for quite some time.

Jeff Reeves is the editor of InvestorPlace.com and the author of The Frugal Investor’s Guide to Finding Great Stocks. As of this writing, he did not hold a position in any of the aforementioned securities. Write him at editor@investorplace.com or follow him on Twitter via @JeffReevesIP

Endnotes:
  1. actively buying protective options: http://www.businessweek.com/news/2014-05-12/russell-2000-volatility-hits-7-year-high-as-shares-fall-options
  2. from BusinessWeek: http://www.businessweek.com/news/2014-05-12/russell-2000-volatility-hits-7-year-high-as-shares-fall-options
  3. OSTK: http://studio-5.financialcontent.com/investplace/quote?Symbol=OSTK
  4. GOGO: http://studio-5.financialcontent.com/investplace/quote?Symbol=GOGO
  5. APP: http://studio-5.financialcontent.com/investplace/quote?Symbol=APP
  6. TWTR: http://studio-5.financialcontent.com/investplace/quote?Symbol=TWTR
  7. Dow continues to set new highs and has a big tailwind: http://investorplace.com/2014/05/daily-stock-market-news-dow-theory-buy-signal-confirmed/#.U3DDOfldWWE

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