Market Insider

A warning sign? Market divergence worries traders

Beware the market's warning signs: Domm

The volatile selling in Nasdaq and small cap names is making some traders nervous, and technicians say it's a time for caution while the once sizzling names continue to burn.

The divergence between those once hot names and big caps and blue chips was dramatic Wednesday, when the Nasdaq fell like a rock but recovered toward the close to finish down just 13 points, or 0.3 percent at 4,067. But at the same time, the Dow, up 117 points, and the S&P 500 had their best day on a percentage basis in three weeks.

On Thursday, stocks were higher, with the Nasdaq in positive territory as biotechs rose.

The small cap Russell 2000 was slightly higher, after finishing down 2 points at 1,105 Wednesday, below its 200-day moving average for a second day. Whether the Russell 2000 is a red flag for the broader market or not, it could continue to feel the heat as investors trim positions in momentum and small cap names.

Stocks that had disappointing earnings news, such as FireEye were crushed, but others got smacked purely for their high valuations. Zulily plunged 30 percent Wednesday after reporting a disappointing loss. Facebook, which trades at 72 times earnings, fell nearly 2 percent. which has a trailing P/E of 31, was down more than 3 percent. Tesla lost nearly 3 percent during the day and fell another 8 percent in after-hours trading after it reported earnings and disappointing outlook.

Zulily was the only one of those names that moved higher Thursday.

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"I knew it would dislocate from the market and it wouldn't drag the market with it," said Steve Massocca, portfolio manager of the Wedbush Hedged Dividend Fund. "These ridiculous stocks are getting clobbered, but it's not having an impact on anything else. As it plays out, it will no longer have an impact on the market. There's nothing wrong with the businesses. The problem is the valuations are gi-normoulsy off base…We're only beginning the process in these particular stocks."

But the divergence between the Dow and the Russell and Nasdaq was unusual in Wednesday's trading, and some technicians warn it might be a good time to play it cautiously.

"You have the Dow and the S&P within a percent of their all-time highs. You've got social, internet, biotechs and small caps struggling to hold their 200 days. That's a big disconnect. That's got traders on edge," said Scott Redler of " You also have the bond market strong and rates bouncing along the bottom, which doesn't support a strong economic view."

According to The Wall Street Journal, there have only been five occasions since the beginning of 2009, when the Dow rose by at least a half percent and the Nasdaq fell by a half percent in a single trading day.

"It's a split tape. If you look at the Nasdaq chart, it's showing signs of a head and shoulders formation, and the Russell is too," said Paul LaRosa, chief market technician at Maxim Group. Some technicians say a head and shoulders formation on a chart is a negative sign for stocks, and LaRosa said the Nasdaq could form one if the composite breaks through what would be the neckline at 3,946.

The Nasdaq avoided such a formation last year, but there was one in March, 2011, and that was followed by the U.S. debt downgrade and a big market selloff, he said.

"I don't think the pattern triggers if the S&P and Dow continue to show the relative strength we've been seeing," Redler said. "In order for a macro head and shoulders to resolve to the downside, mostly all the stars need to align to get a clean break in the neckline. "

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Redler follows the market's short term technical trends, and he said the recent action is odd. "I've never seen so many dislocations. So many people on the opposite side of the trade and so many changes in composure—every few days. One day it feels like the market is going to break out, and the next day it feels like it's hanging by a thread," he said.

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

According to CNBC data, the divergence between the Dow and the Russell, on a rolling 60-day basis, is the widest it's been since 2009. "My feeling is it's a signal of caution," said Sam Stovall, chief equity strategist at S&P/Capital IQ. "The big blue chips tend to fall after everybody else has retreated."

"Nothing is always, but I would tend to say that is a big concern for investors," he said, noting the S&P is up a percent for the year and the Dow is basically flat. "You could almost think of the large cap stocks as treading water, but they are tethered to the small and mid-cap issues and if those issues sink, it will be very hard for the large caps to stay afloat."

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—By CNBC's Patti Domm