"Old-Fashioned" Technical Analysis Points To Caution

Technical analysis reveals divergences between the S&P 500 and the Russell 2000, as well as a divergence in new highs, suggesting the current market rally is a temporary correction within a larger downturn potentially extending into 2026; the Russell 2000 has underperformed the S&P 500 significantly over the last six months and four years, while new highs peaked months ago, signaling caution. This divergence may be attributed to small-cap companies facing challenges with debt rollover and higher debt costs compared to larger, more established companies in the S&P 500.

Analysis

Technical analysis based on historical divergence patterns suggests a cautious outlook for the broader market. A notable divergence has been observed between the S&P 500 and the Russell 2000 small-cap index, both over the past six months and extending back four years. Specifically, while the S&P 500 is nearing its February all-time highs, the Russell 2000 remains 18% below its peak, and over a four-year period, the S&P 500 has exceeded its late 2021 highs by 28% while the Russell 2000 has merely double-topped. This divergence is historically significant, recalling a similar pattern in 1972 that preceded a two-year bear market. Furthermore, a new high index divergence is evident, with the number of individual stocks making new highs peaking in February 2021 (425 stocks per day) and this divergence now being six months old, even as market averages continued upward. The article posits that these divergences indicate the current market rally is a temporary phase within a larger correction potentially extending into 2026, rather than the start of a new bull market. An economic rationale for the S&P 500/Russell 2000 divergence is offered, attributing small-cap underperformance to their vulnerability to higher interest rates due to more frequent debt refinancing, a higher proportion (approximately two-thirds) of floating-rate debt, and a greater prevalence of 'zombie companies' reliant on debt. The overall sentiment is strongly negative (-0.65), with specific negative sentiment for SPY (-0.5) and more so for IWM (-0.7), and a moderate market impact score (0.65). The analysis concludes that the market may still be in a 'topping process' and anticipates the current rally will unfold in two advancing waves before a more significant downturn.

Key Decisions for Investors

• Investors should exercise caution regarding broad market exposure, particularly in small-cap equities (Russell 2000/IWM), given the highlighted divergences and negative sentiment.
• Monitor the relative performance of the Russell 2000 against the S&P 500 and the breadth of new market highs as key indicators for potential market shifts.
• Consider the possibility of a prolonged market correction extending into 2026, and review portfolio allocations for defensive positioning or hedging strategies against a potential multi-wave rally followed by a downturn.
• Evaluate the heightened risk in small-cap companies due to their debt structures, especially if interest rates remain elevated or rise further, impacting their refinancing costs and operational viability.