Trading Nation

A leading indicator could be waving a yellow flag to the markets

This corner of the market is waving a yellow flag

Just as the stock market sell-off has taken a pause, one technician sees trouble brewing on one corner of Wall Street.

Matt Maley, equity strategist at Miller Tabak, says small caps are underperforming, and they have a solid track record of foreshadowing the market's next move.

"The Russell 2000 small-cap index has been a great leading indicator for the stock market in both directions, and we saw it last year before the big decline in the stock market in the fourth quarter," Maley said Thursday on CNBC's "Trading Nation."

In September, the Russell 2000 topped out and rolled over, Maley noted. The S&P 500 followed suit in October.

"When the Russell 2000 rolled over and broke to a new lower low, that's when the whole market started to really fall out of bed, and we're seeing a similar situation right now," said Maley. "When the S&P went to make a new high [in July], the Russell failed to do so, and now it's rolling back over and it's testing its June lows."

Small caps' next move holds the key to whether the S&P 500 can rebound or continue to sell off, Maley said.

"If it breaks below those June lows that will give it another key lower low," he added. "A key lower low on the Russell 2000 would not bode well for either the small caps overall or for the rest of the market over the intermediate term."

The Russell 2000 closed Thursday's session at 1,461.65, right on the cusp of its June low.

Mark Tepper, president of Strategic Wealth Partners, says now is not the right time to invest in the Russell 2000.

"We'd much rather be in large-cap stocks — companies with good strong balance sheets, strong free cash flow, and low debt levels — and small caps don't typically check any of those boxes," Tepper said Thursday. "Roughly about a third of these small-cap companies, they don't make any money, and that's obviously not a good thing. The index as a whole is just up to their eyeballs in debt. They've got roughly three times the leverage of large caps and those are the high-debt companies that don't survive when the economy takes a turn for the worse."

Small-cap financials stocks also make up a large portion of the Russell 2000, another deterrent to Tepper. He says to steer clear of these names as the flat-to-inverted yield curve puts pressure on banking profitability. Financials make up 25% of the IWM Russell ETF.