Stocks Are Slumping. You Just Don't Know It Yet

Psst…The stock market may be slipping into a correction. Pass it on.

This seems like a silly thing to say, since a “correction” is technically a 10% drop in stock prices and both the Dow Jones industrial average and the Standard & Poor's 500 index of blue chip stocks are at record highs. Not only that, the S&P 500 is up nearly 5% so far this year and 19% over the past 12 months.

But if you examine the market more closely, you’ll see some key segments that are getting close to or have crossed the 10% threshold recently.

Among them: small-company stocks, which tend to thrive when investors favor risk — or are egged on by the Federal Reserve to take chances with the availability of cheap credit. The Russell 2000 index of small-caps lost more than 9% of its value between early March and mid May before recovering a bit in last week's rally:

^RUT data by YCharts

The slump is more pronounced for small growth-oriented companies, which are favored by aggressive, bullish investors. Small growth stocks fell as much as 12% between early March and mid May and are still dangerously close to the 10% level:

^RUO data by YCharts

This is also true for the smallest of the small stocks — shares of high risk but potentially high reward tiny companies that are only embraced by the market's most aggressive lot:

^RTM data by YCharts

True, these are small slivers of the market and the broader indexes such as the S&P 500, the Dow, and the Nasdaq composite index are all up modestly so far in 2014 and up by double-digits over the past 12 months.

The recent behavior of the faltering areas of the market, though, could be a harbinger of what's to come. “A stealth correction has been unfolding,” says Craig Johnson, a managing director at Piper Jaffray, and he believes the slide will likely extend to the Dow and S&P.

Here are three reasons this is likely to happen:

1) Small stocks tend to lag as bull markets get tired. Small caps have historically been a fairly reliable late-cycle underperformer. Indeed, the last two times small stocks dramatically underperformed was in 2007 (just as the financial crisis struck) and the late 1990s (leading up to the bursting of the dot.com bubble in 2000).

2) The performance gap between large-cap and small-cap stocks is widening. Since Jan. 1, the large cap S&P 500 index has returned nearly 5% while the small-cap Russell 2000 index is down nearly 2%. “The continued divergence between the Russell 2000 index and the popular large-cap indices is a clear indication of weakening breadth and slowing momentum, and suggests investors are making an attempt to reduce portfolio risk by rotating assets toward the traditionally defensive areas of the market,” says Johnson.

In fact, he and his team at Piper Jaffray studied past periods when small stocks underperformed blue chip shares by such a wide margin and found that in years when this occurred, the broad market eventually experienced a correction that typically lasted two and a half years and cost stocks more than 12% of their value.

3) The broad market is way overdue for a correction. “The S&P 500 will soon have gone 32 months without a decline of 10% or more, versus the average span of 18 months since 1945 and a median of 12 months,” says Sam Stovall, managing director of U.S. equity strategy for S&P Capital IQ.

There have been only four other times since World War II that the stock market went longer without a serious pullback.

Alas, those stretches ended with a bear market in 1966, the Crash of 1987, a correction in 1997, and the mammoth 2007-09 bear that lopped off more than half of the S&P 500’s value.

Of course, there's no rule that says market corrections must turn into full-fledged bear markets.