Weakness in the small cap index, RUT, has reached the point where just 23% of the index's components are above their 50-dma. In the past 2 years, this has been the buy point for every rally; the only time this measure of breadth has been lower was November 14-15, 2012, right before a 60% rally. Before that, it was lower on June 1, 2012, right before a 20% rally (chart from Sentimentrader).
Bouncing off of oversold levels is what bull markets do, so this is not a surprise. The problem is these patterns eventually fail. In the chart above, observe that breadth sank well below 20% on August 2, 2011; from that point, RUT lost another 22%. It's not shown on the chart, but the same happened in May 2010 for a further loss of 10%.
Since peaking on July 1, RUT has declined over 9%. It made a lower high in September and now it has made a lower low than in August. That is the definition of a downtrend. Less than 2% lower lies a support level that has held every low since December.
That support level (1080-90) is the neckline for a head and shoulders pattern. The measured move for the pattern is a further drop of 10%.
Nothing has happened yet. But that support line has been tested several times already and a rule of technical analysis is that support tends to break after repeated tests.
The timing for a rally could not be better. There have been a number of recent articles about how strong the 4th quarter of the year should be (our take is here). And none of the other indices - SPX, NDX and DJIA - are even below their 50-dma. Their trends are still intact.
On the other hand, the length of the current uptrend is extended (chart) and, by several measures, a correction is arguably the last thing investors currently expect (chart and chart). In addition, important sources of liquidity that have contributed to high demand for equities are beginning to taper off (post).
So, to repeat the overused phrase, the markets are at an important juncture. Either the 2012-13 playbook is still relevant and RUT bottoms like in did in February, mid-May and August this year, or the pattern is set to expire.
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