“Dow closes at a record high, again”

“Alibaba IPO Skyrockets After Initial Offering”

“S&P at new high as dovish Fed maintains rates to stay low for a ‘considerable time’”

These were the prominent headlines of two Fridays ago. They were all unmistakably positive, but lurking underneath the surface was a nagging divergence that I’ve been commenting on all year (see most recently, Perception vs. Reality). If it feels like the movie Groundhog Day, it should. For the third time in 2014, small cap stocks are moving in a wildly different direction than the large cap indices.

We first started observing this sharp divergence back in a March, when the Russell 2000 commenced a decline that took it down over 10% by mid-May. There was only a minor 4% pullback in the S&P 500 that was quickly followed with new all-time highs.

Next, in July, the weakness resurfaced once more, with the Russell 2000 declining nearly 9% by early August. Again, there was only a minor 4% pullback in the S&P 500 that was quickly followed with new all-time highs.

Most recently, in early September, we again saw weakness in small caps emerge. Large caps staged a last gasp push to new highs on the euphoria leading up to the Alibaba IPO. We’ve since seen a minor pullback and many seem to think a repeat performance will occur and another v-shaped rally will ensue.

While anything is possible, this is not the most probable outcome in my view and we are likely closer to a breaking point in this historic divergence. The Russell 2000 finished down over 7% last quarter while the S&P 500 managed to eke out a small gain. While the two indices don’t need to trade in lockstep, it is unreasonable to think that large caps will continue hitting all-time highs when the average stock is closer to 52-week lows.

Another factor suggesting the re-sync may be with large caps catching up to the downside is sentiment. Back in June I argued that the wall of worry that persisted for much of the bull market was no more and that the consensus now believed volatility was dead and would stay low for years. More recently, we have witnessed a lampooning of anyone who still dares to question the sustainability of this rally (think of Marc Faber, Rick Santelli, and Bill Fleckenstein to name a few). This has led to a dearth of Bears not seen since 1987.

Those striking a cautionary tone are being treated like pariahs, even though the average stock is down for the year through the first nine months (see chart below). The contrarian in me is starting to think that with so many people dismissing this broad weakness, it will finally start to matter.

For the better part of the year, I have been arguing that it is already starting to matter, just not in the black or white way most view the market. With the prospect of QE3 ending in October, real money investors have been rotating out of riskier areas of the market and into more defensive areas for the entire year (see Fed Prisoner’s Dilemma).

Thus far in 2014 we have had an environment that has paid investors to play defense, not offense. This is surprising to most as all-time highs are all we have been hearing about for much of the year. But if we look at the most defensive areas of the market, including Utilities and long duration bonds, there is no denying it: crying the "diverging small-cap wolf" was so far justified.

And because no one believes this wolf will matter, as it has failed to predict a large cap correction recently, I think it's more likely now to catch many by surprise.