The Russell 2000 index generated a powerful double top on weekly charts last week, which marks the most significant bearish pattern put into play since similar double-top formations were etched in February 2007 and April 2006.

The Index was overbought on momentum readings such as stochastics after the recent climb to record highs, and a pullback is not necessarily a surprise – and is often a healthy development. However, when chart patterns accompanying the pullback are powerful topping indicators, then the correction takes on greater significance.

Another troubling element to the pullback was the sudden show of volatility at the highs. Extreme volatility at or near record highs is often a sign that the market is on the verge of a serious reversal in course. It’s worth noting that the slide off the double top pattern in February was relatively short-lived (in seven weeks, the Index made new highs); however, the slide off the decline last spring was much more extreme, and it took some seven months for the Russell to forge new highs. On that move, it took about eight weeks off the top for the low to be carved out.

Looking at the chart structure off last week’s action, we still have a dominant long-term bull market trend in small-cap stocks, with trendline support off the 2004 lows intact, and the market holding above the 20-week moving average trend indicator. If we see sustained action the next couple of weeks below the 830 swingline, and persistent activity below the 20-day moving average on shorter-term studies, then it will provide further validation of the topping pattern established by last week’s action, and suggest that further downside probing of support is in the pipeline.

If you are a long-term bull holding substantial profits in small cap stocks or index products, then this is a period to start closely watching charts and to evaluate potential profit-taking exit strategies. If you are a bull on the sidelines, you’ll want to see chart signals that either invalidate the double top or wait to buy significant dips into support points utilizing relatively tight stops. If you are a short-term bear who caught the double top this week, then you’ll want to hold out for further declines, with half stops at overhead short-term resistance points to guarantee modest profits, and the other half stops at new highs.

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