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Why there could be trouble ahead for stocks

Traders on the floor of the New York Stock Exchange.
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Traders on the floor of the New York Stock Exchange.

After the worst week in two years, stocks are vulnerable to a further selloff, technicians say.

From European bank stocks to small caps and junk bonds, there are a variety of indicators that are flashing warning signs, including the S&P 500 itself, which last week fell through an area around 1,950, an important support level, they said.

"Some pretty sizable technical damage has been done, particularly with the S&P 1,952 pivot level. We broke below pretty sizably last week, which says we have further corrective downside to 1,900," said Paul LaRosa, chief market technician at Maxim Group. He said the breadth of the market has been narrowing, with fewer new highs.

"Sometimes in these types of markets, you can tell more about the rally than the weakness. What we've seen is the rallies have been weak, not a lot of volume, not a lot of follow through and that can be more telling," he said.

The S&P was trading slightly higher after Monday, after ending last week at 1,925. For the most part, strategists have been saying they do not expect a sharp selloff this summer, or a 10 percent correction, and expect the dip could provide a buying opportunity.

But technical analysts who follow charts more than the Fed see the market a bit more negatively. Thursday's action could also be a warning.

"There was substantial damage done to individual names that comprise the whole. At some point—if more and more parts falter, the whole falters," said Carter Worth, Sterne Agee technical strategist. "We're seeing small caps, semiconductors, individual names that are coming apart. Coca-Cola, GE, Exxon —big names that are not anything other than stalwarts, acting poorly."

Worth said he's also watching the DAX for clues. Germany's stock market has been falling on fears about euro zone economy and banks, and it is now below its 150-day moving average more than at any time in the past two years. Worth said that signals a bullish to bearish reversal.

MacNeil Curry, Bank of America Merrill Lynch global head of technical strategy, says there are three markets that specifically bear watching: U.S. small caps, high-yield corporate debt and European bank stocks.

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"Euro Stoxx bank index is still pretty bearish. It carved out a six month top," said Curry, adding it could have 8 to 12 percent downside. "(It) says the problems in Europe are not limited to the BES." BES, or Banco Espirito Santo, was bailed out by the Portuguese government this weekend.

"European bank stocks have transitioned into a medium-term correction, and they have more to go," he said. Negative sentiment around European banks could weigh on U.S. markets and U.S. bank stocks, which he says are showing signs of topping.

Curry said he is also watching European peripheral sovereign bonds, which have been a popular trade and are held by European banks. "If that trade unwinds, you've got all these guys that are long that stuff—and they could find themselves in trouble," he said.

Read MorePortugal bites the bullet on bank bailout

The behavior of the Russell 2000 is also being taken as a warning, and even the Fed has picked on the index, saying it is overvalued. The Russell has been underperforming the broader market, and it is down nearly 8 percent in the past four weeks, compared with the 2.6 percent decline in the S&P 500.

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"The Russell's been the weakest of them all," LaRosa said. "I think the next major level is going to be 1,080. We have to defend that level, which we've hit a couple of times. If we close below that, we could have significant problems."

LaRosa said 1,131 on the Russell was a key number and that was broken last week. The market breadth has also been weakening.

"I'm not surprised we're getting selling. This market for several months now didn't have the characteristics of one that you would expect to continue to rise...When the market is hitting new highs and you have that backdrop, a correction is more likely and for the last three or four sessions, you're really seeing that."

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Curry said the Russell has been signaling problems for awhile. "The Russell's been in a big range while the S&P 500 and Nasdaq had been making new highs. The Russell has not, so the divergence is a concern," he said.

Technicians say the Russell could test the key level around 1,080. The Russell was trading at 1,119 Monday, up 0.4 percent.

Laszlo Birinyi, stock strategist and founder of Birinyi Associates, disputes the idea that the Russell is a warning for the broader market, or a harbinger for the economy.

"Our view continues that this is an issue primarily for those shares and small cap portfolios and has limited implications for the broader market as a whole," he wrote in a note Monday.

Another area of concern is the high-yield market, and the selloff that has been going on for six weeks, Curry said. "Credit in general was not confirming the price action in the S&P 500 which is often a precursor to a corrective environment," he said.

Worth has been negative for stocks for awhile, said the market's weakness has been masked by the outperformance of "a handful of super captialization stocks."

Stocks such as Colgate-Palmolive, Eaton, and Precision Castparts all saw big drops in the last several sessions. "There was a lot of action, not a lot of good action. You saw stocks gapping and dropping...Thursday was very serious," he said. "These are slow moving stocks that don't trade like that. That kind of selling is the definition of distribution. It's assertive, deliberate selling," he said.

Worth said the market breadth has been worsening. He said six out of 10 stocks in the Russell 3000 are now trading below their 150-day moving average, or 58.3 percent, the highest amount in two years.

Read MoreStocks could be volatile, but not in correction yet

By CNBC's Patti Domm

  • Patti Domm

    Patti Domm is CNBC Executive Editor, News, responsible for news coverage of the markets and economy.

  • A CNBC reporter since 1990, Bob Pisani covers Wall Street from the floor of the New York Stock Exchange.

  • CNBC's Senior Personal Finance Correspondent

  • JeeYeon Park is a writer for CNBC.com. Follow her on Twitter: @JeeYeonParkCNBC

  • Rick Santelli joined CNBC Business News as an on-air editor in 1999, reporting live from the floor of the Chicago Board of Trade.

  • Senior Producer at CNBC's Breaking News Desk.