Small-cap stocks are making a big comeback of sorts.
The small-cap benchmark, the Russell 2000 index, has retraced more than half of its recent pullback. This comes as the Dow Jones Industrial Average and the S&P 500 indices both make new record highs.
But the technicals may be signaling a huge drop ahead, according to Richard Ross, global technical strategist at Auerbach Grayson.
"I don't like the small caps," said Ross, a "Talking Numbers" contributor. "I'm a seller of the Russell 2000. In fact, full disclosure, I'm short the Russell in my personal account."
Ross owns shares in ProShares Short Russell2000 ETF (RWM), which takes a short position the small-cap index.
Looking at a chart of the iShares Russell 2000 ETF9 (IWM), which tracks the index, Ross sees the potential for a second shoulder in a head and shoulders top. That shoulder is coming close to its resistance level and could fall back again, he believes. The IWM closed at $116.90 on Monday.
"If history holds here, we should rollover and retest that neckline down around $107," Ross said. "That's your critical support."
The longerterm chart "really scares me," said Ross and explains why he is short the Russell 2000. The last time it had a head and shoulders top, in 2011, it declined about 27 percent its 150-week moving average. He sees the likelihood of "technical symmetry."
"If this were a head and shoulders top as I put forth, it would be a 26 percent decline" from its recent peak, said Ross. "All we need is that second shoulder and then a rollover. We break below the neckline and we're looking at about a 20 percent drop from current levels. I would be a seller in anticipation of that big move."
Steve Cortes, founder of Veracruz TJM, is more upbeat on the Russell 2000.
"I like the small caps," Cortes said. "Over the last few months, small caps have massively underperformed the S&P 500. In fact, during the month of May, the IWM spent the entire month of May in negative territory for the year 2014 while the S&P spent the entire month of May in positive territory. That kind of a bifurcation between small caps and large is very unusual historically. I think it sets up for a flow of capital, a rotation back into the small guys."
The catalyst for a rotation away from large-cap stocks and into small caps is a stronger U.S. dollar, particularly against the euro.
"A weak dollar makes it easier for those giant multinationals to sell their globally," Cortes said. "Small caps tend to be more domestic in nature. So, they're not necessarily as sensitive to the dollar trade."
After nearing $1.40 several weeks ago, the euro is now down below $1.36, a three-month low for the currency.
"That bodes ill for the large caps," Cortes said. "It's time for rotation back into the little guys."
To see the full discussion on the IWM and the small cap Russell 2000 index, with Ross on the technicals and Cortes on the fundamentals, watch the above video.