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Small caps are sounding alarm for stocks: Technician

Small cap stocks could be running into some big problems.

Despite a mild rally early Monday, the Russell 2000 is still down more than 6 percent from its high hit in late June. In contrast, the S&P 500 is down less than 2 percent from its recent high in May. And according to one noted technician, that divergence could be sounding the alarm for the broader market.

"Small caps have tripled the performance of the S&P 500 [going back to the year 2000]," Carter Worth said Friday on CNBC's "Options Action." In the past 15 years, the Russell 2000 ETF, the IWM, is up 155 percent while the S&P 500 ETF, the SPY, is up 45 percent in the same period. "That's part of the problem."

For Worth, that outperformance likely won't continue. His work suggests that a combination of poor technicals and diminishing fundamentals signals further weakness in the space. "After breaking out, [the IWM] has started to falter and it's not ideal to see it give back that quickly," said Worth, head of technical analysis at Cornerstone Macro.

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Looking at a long-term chart of IWM dating to 2011, Worth noted that the ETF appears to be heading—at the very least—back to its uptrend line, which comes in around $115. "That's going to give us something at the minimum of 5 or 6 percent [decline]," he said.

Worth added that earnings expectations in the space have greatly decreased in the past year. He noted that a year ago, the consensus was that the index would earn $55.90 a share, and it has been revised down more than 20 percent to $43.90.

"The most important thing [for the Russell] is these earnings revisions. There's a lot of expectations built into the second half as far as earnings," RiskReversal.com founder Dan Nathan said Friday on "Options Action." Nathan noted that the Russell 2000 has less exposure to the dollar than the S&P 500, which in theory should be positive for the index. "I think the selling we've been seeing [in small caps] suggests that people just don't see the pickup in earnings," he added.

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"The Russell 2000 is the same price as it was 16 months ago, having made no progress," said Worth. "The S&P 500 is trading in its tightest-ever range at this point in any calendar year going back to 1927. Something has to give."

The S&P 500 was up 1 percent and trading at 2,100 early Monday while the Russell 2000 was up the same amount and trading at 1,219.

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