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Why now may be a good time to sell the rally in small caps

The beleaguered Russell 2000 index may have rallied yesterday, but is a huge technical indicator flashing a sell sign?

Tuesday's 2.5 percent rally in the Russell 2000 means the index is getting close to breaking its key 200-day moving average, which it has been trading under since Sept. 19.

(Read: Wall St extends gains late; Russell 2000 above key level)

A break above the 200-day is often considered a buy signal for many technical traders. But one technician thinks the current levels are a screaming sell, at least when it comes to this index.

"In a selective market, you have to be selective," said Ari Wald, head of technical analysis at Oppenheimer & Co. "Investors should be staying away from ... the small caps stocks and the Russell 2000 index in particular."

Wald sees a year-long distributive top in the Russell 2000, indicating buyer exhaustion. Things started to get bad in the last selloff when the index broke below a triangle pattern. And the 200-day moving average is also showing problems, he said.

"The 200-day is slopping lower," Wald explained. "Compared to the S&P 500, this index has more resistance, less support, and much worse momentum as well. So from a risk management perspective, we would be staying away from small caps."

Wald recommends selling the Russell 2000 as it hits its 200-day moving average resistance level. "Those funds are much better used in the S&P 500," he added.

However, David Seaburg, head of equity sales trading at Cowen and Company, maintains that the Russell 2000 is headed higher, and he expects it to close 2014 in the black. "The performance gap between the Russell 2000 and the S&P 500 will close significantly into year-end, led by the outperformance of the Russell," he said. Driving that will be funds looking to reduce their risk by exiting short positions in the index before the last days of December.

(Watch: US stocks rally on earnings; Dow tops 17,000)

"Everyone expected to be long into year-end, however the forced 'de-risking' just made it happen a little sooner than anyone expected," Seaburg said. "Now that funds have a long-bias, I expect performance chasing to run its course, with the Russell 2000 being the biggest beneficiary."

That, however, may not happen, according to Gina Sanchez, founder of Chantico Global. Instead, she sees the fundamentals agreeing with the technicals.

"The fundamentals for the Russell have continued to deteriorate," said Sanchez, a CNBC contributor. "We've actually seen the P/E [price-to-earnings multiple] rising since Q2, not because the price is rising but because earnings estimates are being revised down more substantially than prices are falling. That's a terrible sign."

And about a quarter of the companies in the Russell 2000 aren't profitable, Sanchez said. "Let's keep that in mind when we're thinking about what we want to be buying. I think you're catching falling knives here. I think this is an opportunity to sell."

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