Don't say we didn’t warn you. To quote from last week’s column: “Looking ahead to next week, the big issue right now is to make sure that the Russell 2000 (NYSE: IWM) does NOT set up a double top on the recent highs.”

As it turned out, that is EXACTLY what took place this past week, as the sellers rose up in unison to take charge at a comfortable price zone – the same area where the market stalled back in early June. As the market rejected the previous week’s highs, the chart formation gained credibility and the shorts who sold near the highs generated equity power. Double top formations are often powerful chart signals that a market has exhausted buying enthusiasm, or that a much-needed correction is in order.

It’s worth noting that this week’s low is near the 20-week moving average, a line that has been a great support zone and trend indicator for several months. In fact, the last time the 20-week moving average was broken on a weekly close was on the big decline back in February. From a shorter-term standpoint, the Russell also cascaded through the 20-day moving average, which has been a less decisive bearish indicator in recent months.

Another caution signal can be seen in the bearish divergence between price and momentum peaks on weekly charts. Whenever a market climbs to new highs, the ideal situation is for momentum indicators (such as stochastics and the relative strength index) to also make new highs on the move. Whenever momentum readings fail to match their corresponding price peaks, it is a warning sign that the market might be rising without a strong foundation. These bearish divergent patterns were also seen into sizable pullbacks in 2005 and 2006.

The formation of these bearish signals do NOT shout that the nearly five-year bull market run in small caps has concluded, but it does suggest that caution should be used when buying in this historically high price zone until we violate the double top and momentum readings catch pace.

If the double top continues to hold, then our downside targets will become the focal point in the market. Looking ahead to the coming week’s price action, the first key test is on the big swingline at 830. A decisive breach of that support line would suggest an extension of the pullback toward the 803 area. IF we can hold 830 next week and start to recover toward the highs, then it would take some of the sting out of the topping concerns.

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