U.S. stocks are contemplating the fate of the 5-year bull market as the small cap Russell 2000 diverges from the upward trajectory of the S&P 500. We look back to the previous S&P / Russell divergence in 2011 and then examine the technicals of the Russell 2000. We’ll outline our likely course of action with an options strategy to take advantage of the coming unwind of the divergence.

The bull market in equities seems to be taking a bit of a breather this summer as investors grapple with geopolitical stresses and the threat of war in various regions around the world. Also worrying investors are two key market dynamics that threaten to derail the massive bull market. First is weakness in high-yield corporate bond markets, and second is the divergence of small-caps relative to the broader stock indices. Are those fears justified, or simply another example of a bull market climbing the wall of worry? In this report we are going to focus in on the underperformance of small-caps relative to the broader S&P 500 and determine if this is a cause for concern or a short-term market gyration that will work itself out.

In healthy economies with up-trending stock markets you tend to see higher beta sectors like technology and small-caps outperform large-caps and broader stock markets. The small-cap Russell 2000 index did exactly that through 2012-2013. But in 2014 that dynamic changed and we started to see the Russell’s ETF (IWM) start to underperform the SPDR S&P 500 ETF (SPY). This created a divergence as the Russell failed to make new highs while the S&P 500 has been on cruise control headed towards 2,000. Market analysts cautioned the bulls of further advances now that the market “lost the small-caps.”

To give us some background of this intermarket correlation let’s turn to a weekly overlay chart of the SPY and IWM:

This chart plots the SPY (orange, left scale) and the IWM (white, right scale) and dates back to the low of the stock market following the credit crisis collapse in March 2009. The recovery since then has been a one-way moon shot rally of approximately 300%. And what’s most interesting is there appears to be only one meaningful pullback in the five-year rally, which was the period of April-October 2011. That period is where our story begins.

Notice the green graph below the price chart. This study is a ratio of the price of IWM and SPY. Put more simply, it’s the price of IWM divided by the SPY, or $113.30 / $ 197.80 = 0.572. Ratio analysis helps to quickly identify relative strength or weakness between two different markets. If the ratio is rising, the instrument quoted first is outperforming the instrument quoted second. If the ratio is falling, the instrument quoted first is underperforming the instrument quoted second. Applying this concept to the small-caps’ tendency to outperform the S&P in strong uptrending economies, you want to see this ratio moving higher to signal continued strength. But in April 2011 you saw that ratio stop moving higher and actually begin to move sideways. Finally, on July 29, 2011, the S&P 500 broke support and dropped another 11.81% before stabilizing at around 0.57 in October 2011. From there the uptrend regained its footing and marched to new highs.

During the rally the small-caps led the S&P higher as the ratio rallied all the way back to the 0.6350 level, the same level that triggered the sell-off in April 2011. Are we in for another stock market sell-off similar to 2011? My guess is no, at least in the near-term.

You will notice that ratio tested 0.6350 several times before finally failing and moving back down to the 0.5700 level. The ratio fell not because of weakness in the Russell, but strength in the S&P 500 (as well as the NASDAQ not shown). The ratio has already reached its expected support level without a fall in the S&P and now we anticipate the ratio to start rallying again. How can the ratio rally? Either with S&P falling at a greater rate than the Russell, or the Russell playing a bit of “catch-up” and moving higher to close the divergence, which will bring the ratio back above the 0.60 level. We believe it’s the latter.

Moving to the technicals of the IWM daily chart, we see a sideways A-B-C corrective pattern at work with technical support in place between $112.50 and $107.30. Should this support zone hold, we expect to see price to stabilize and begin to move towards the upper-end of the range.

Turning to trade strategy, implied volatility in the options markets is higher in the Russell than it is in the S&P 500 and NASDAQ following this divergence mentioned above, along with the recent sell-off. We are currently long the IWM via a $115-$118 long call vertical spread that expires in September. We are planning to use any remaining weakness within this corrective range to add to our existing long position for our research clients. We want to use that escalated implied volatility to our advantage.

We are bullish IWM while it holds above the $107.30 range support levels. However, we may see support hold but not see the follow through above the $120.60 highs as the S&P continues making new highs. Therefore we would like to use the escalated implied volatility to sell puts in IWM that expire in October and November. We will look to sell puts at $105 and below as IWM moves a bit lower and implied volatility moves higher increasing the credit received for put sales. For traders and investors who would like to limit their risk and not sell naked options, simply look to purchase lower puts for a lower premium creating a spread, which limits your risk.

In summary, the IWM / SPY ratio is at the lower-end of support and is poised to move towards the upper-end of the range. The most likely cause of this is the S&P 500 moving to new all-time highs while the Russell 2000 simply moves back to the upper-end of its range. The technicals of the IMW daily chart show tradable-support just below us in an escalated implied volatility environment. Leaning against this chart support we can sell expensive puts below chart support. The best part is we will make money if the Russell moves back towards the highs, or simply holds chart support at $107.30 and moves sideways for several months.

Todd Gordon is the founder of TradingAnalysis.com and a contributor to CNBC. He’s appeared frequently on Fast Money, Squawk on the Street, Money in Motion, Futures Now, and Street Signs. TradingAnalysis.com provides actionable market analysis and clear trading strategies in the currency, commodity, and equity markets for both amateur and professional traders.

TradingAnalysis.com and its founder, Todd Gordon, and/or its clients may hold positions in the ETFs, mutual funds or any investment asset mentioned in this article. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities.

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