The Magnificent 7 was a big driver of returns since the bull market started in October 2022. In 2023 alone, those seven stocks were responsible for 60% of the S&P 500’s 24% return.

But that also meant the rest of the overall market was lagging badly.

The Russell 2000 Index (IWM) is a popular gauge of small-cap stocks. No stock makes up more than 1.5% of the index.

So if the leading S&P 500 stocks are the generals, then small caps make up a big part of the troops.

And if the troops can’t keep up with the generals, then there could be trouble ahead.

For example, at the dawn of 2008’s financial crisis, small caps broke down three months ahead of the S&P’s top… before plunging over 50%.

Now the troops are at risk of falling behind the generals once again. So today, let’s look at what this reveals about the rest of the stock market…

The Troops Are Falling Behind

Ever since 2022’s bear market bottom, IWM has struggled to achieve escape velocity, even as large-cap indexes like the S&P 500 made new all-time highs.

You can see that in the chart below.

IWM bottomed in June 2022 around the $160 level. It has come back to test that area two more times (see the arrows). The most recent test came in October last year.

Following the October lows, small caps tried to stage an impressive rally from extremely oversold levels.

But now a bearish pattern is emerging that could take small-caps down once again.

A Bearish Head & Shoulders Pattern

During the October pullback, IWM hit oversold levels.

This created a positive divergence with the relative strength index (RSI) at point 1.That resulted in a rally where IWM rose 30% by the end of March.

But bearish developments have taken place since then.

First, the RSI is lagging the price action. You can see that in the lower red dashed trendline.

That marked the recent top in IWM. And now IWM is setting up a chart pattern called a “head and shoulders” pattern.

A “head and shoulders” pattern shows a stock that could transition to a downtrend.

Let’s break down the pieces of this pattern…

The “head” in the pattern is a higher high relative to the “shoulders.” The right shoulder is a lower high than the left shoulder. And price support in the pattern is known as the “neckline.”

This same pattern showed up in mid-2023 at point A.

Take another look:

On the chart, the arches show the head and shoulders pattern, and the dashed trendline is the neckline. A breakdown below the neckline completes the bearish pattern.

So here’s what to watch at point B.

We have a left shoulder and head in place. Now we’ll watch for the recent bounce to form a lower high as the right shoulder.

The neckline is around the $190 level. That is also close to the 200-day moving average (green line).

This makes the neckline a very important support level to watch.

If IWM finishes out this pattern as anticipated, the troops are signaling bad news ahead for the generals…

Regards,

Larry Benedict
Editor, Trading With Larry Benedict