Are small caps sending off a big warning?

If history is any guide, the Russell 2000 is giving off some bad vibes.

By InvestorPlace May 8, 2014 4:24PM

Caption: Analyzing stock market from computer screen
Credit: © MicroWorks/Getty ImagesBy Anthony Mirhaydari

If you just pay attention to the Dow Jones Industrial Average ($INDU), things look peachy.

The index remains mired in a six-month-long sideways channel but continues to flirt with near new all-time highs.

The bulls have all the justifications figured out. The weather is the blame for the recent economic slowdown, in which Q1 GDP growth is on track to be revised to a -0.6 percent annualized growth rate, according to Macroeconomic Advisors.

Russian President Vladimir Putin is making diplomatic sounding noises again on Ukraine. The first-quarter earnings season has been salvaged after a rough start.

And Federal Reserve chairman Janet Yellen is coming up with new and exciting excuses to keep short-term interest rates near 0 percent -- where they've been perched going on six years now.

But a quick glance over at the small caps in the Russell 2000 -- which Janet Yellen in her testimony to the House of Representatives on Wednesday admitted were possibly trading at overvalued levels -- suggests trouble.

What's wrong with the Russell?

On Tuesday, the Russell 2000 closed below its 200-day moving average for the first time since 2012, ending an 18-month uptrend. This was a breakdown long in the making: There were no less than seven attempts during the past two weeks. The bulls simply couldn't resist the selling pressure any longer.

The dichotomy is stark. And if history is any guide, it's downright scary.

In fact, the gap that has opened up between small caps and large stocks was last seen near the very top of the past two bear markets.

According to Jason Goepfert of SentimenTrader, Tuesday was only the third time in 35 years of market history that the NYSE Composite was sitting at a 52-week high one day before the Russell 2000 dropped below both its 50- and 200-day MAs the next day.

The last two occurrences were March 12, 1999 and Nov. 1, 2007.

That's not all.

Through Wednesday, the performance differential year-to-date is quite large: The S&P 500 is up 1.6 percent while the Russell 2000 is down -4.6 percent. As a result, as highlighted by Bespoke Investment Group, the performance advantage that small caps enjoyed in 2013 has now been erased.

From the intraday high on March 4 into Wednesday's intraday low, the Russell 2000 dropped 9.8 percent. Since the bull market started in 2008, there have been two other drops of this magnitude. But here's the kicker: They selloffs didn't end until small caps suffered declines of more than 20 percent (in July 2010 and October 2011).

So far, the large caps have been resisting the selling pressure. During the 2010 selloff, small caps and large caps maintained a correlation coefficient (a statistical metric that measures how closely two sets of data follow each other up and down) of .985. That means the two were 98.5 percent aligned. In 2011, it was .992.

But right now, it's just .299, or 29.9 percent.

The $5 trillion-dollar question is: Will large caps fall to realign with small caps, or will the two go on their separate ways?

Other issues

Moreover, small stocks aren't the only area warning of trouble. Despite declarations that the economy is surging again after a harsh winter, U.S. Treasury bonds have been well-bid -- traditionally, a sign that the bond market is pricing in trouble. As a result, 10-year yields have dropped back to the 2.6 percent level, down from a high of 3.05 percent at the end of 2013.

According to Citigroup research, the market stopped following the fundamentals in late 2012. That's when bond market spreads disconnected from the amount of borrowing companies were doing. And it's when stocks stopped responding to earnings revisions.

If bond investors no longer care about the creditworthiness of the companies they are giving their money to, and stock investors no longer care about the earning of the companies they are investing in ... how is that anything other than a bubble?

Bottom line

I've been recommending investors play it cautiously with a focus on Treasury bonds via ETFs such as the leveraged Direxion 3x Treasury Bond Bull (TMF), which is up nearly 12 percent since I added it to my Edge Letter Sample Portfolio in late February.

For the more aggressive, the weakness being displayed by small-cap stocks is creating put option opportunities in stocks like Lululemon (LULU) and Coach (COH).

Put option positions recommended to clients in these names are up 240 percent and 411 percent, respectively.

More from InvestorPlace

Anthony Mirhaydari is founder of the Edge and Edge Pro investment advisory newsletters, as well as Mirhaydari Capital Management, a registered investment advisory firm. As of this writing, he has recommended TMF and puts against LULU and COH to his clients.

May 8, 2014 6:17PM

All I did is read the headline - How did I know it was you Anthony ?

May 8, 2014 6:19PM
We are not in a "Bubble" of any kind of Equities - And people are investing in Dividend Stocks for good reason - That's where the money is !
May 9, 2014 7:16AM
"if history is any guide, it's downright scary." 
A serious crash is great for investors. Here's what Buffett said in 1974 after the S&P went down over 50% when asked: "How do you contemplate the current stock market, we asked Warren Buffett, the sage of Omaha, Neb.

“Like an oversexed guy in a harem,” he shot back. “This is the time to start investing.”

The Dow was below 600 when he said that. Before we could get Buffett’s words in print, it was up almost 15% in one of the fastest rallies ever.

We called him back and asked if he found the market as sexy at 660 as he did at 580. “I don’t know what the averages are going to do next,” he replied, “but there are still plenty of bargains around.” He remarked that the situation reminded him of the early ’50s."

May 8, 2014 5:47PM
Not to whore your column, Anthony... but has anyone figured out yet that if Alibaba gets enough stupid investor money to plague the world with cheap crap, it destroys EVERY paying job in the world? There would be no need to patronize any other entity because it offers everything at prices no one else can compete with and have a payroll. Every stock share of every entity in the world is rendered worthless. It is rumored that Chinese warehouses contain 5+ decades of crap to sell to stupid business platforms that don't hire. If Alibaba does it, stupid business platforms go out of business and their executives run out of free money. 
It's spectacular!!!! Wall Street, Central banks, banksters and wealth have built a Doomsday Bomb. The ONLY survivors would be those who farm, herd, maintain and cooperate. In Michigan, the GOP Congress just passed a Bill that prohibits anyone from keeping bees or livestock in proximity to a neighbor's house. Nearly 100% of existing farmhouses, much less any suburban or urban structures-- violate the distance. 
Isn't it time to stop all of this? I think so. 
May 8, 2014 5:37PM
Keep posting these articles, Anthony. You know damn well that so much phony eventually kills the pony and THAT correction will be Biblical. I want to invest in progress as much as the next guy but I won't put a penny towards False Elitist corruption and that's all that's in play today. 
May 8, 2014 4:58PM

Posting on this guy's articles are a pain....

From a close I have in March on A Friday, the RUT is down about 8%

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