With investors refocused on the potential for terrorist attacks, and the hostilities between India and Pakistan intensifying after the assassination of a Kashmiri separatist leader, an already jittery market had a bad case of the shakes heading into the final hour of trading.

Most observers fretted over the renewed weakness for so-called major averages, despite news of a settlement between

Merrill Lynch

(DJM)

and New York Attorney General Eliot Spitzer. Furthermore, volume was noticeably heavier vs. yesterday's session while market breadth was decidedly negative.

As of 2:30 p.m. EDT, the

Dow Jones Industrial Average

was down 0.7% to 10,157.47, the

S&P 500

was off 0.47% to 1086.74, and the

Nasdaq Composite

down 1.7% to 1671.79.

In

NYSE

trading, 834 million shares had been exchanged while declining stocks led advancers 19 to 11. In over-the-counter trading, 1.2 billion shares had traded, and losers led 11 to 6.

The renewed weakness in tech names, as evidenced by the Comp, SOX and Nasdaq 100, seemed to justify the cautious comments issued yesterday by Richard Bernstein, Merrill Lynch's chief U.S. strategist.

"We believe that

last week's rally presents another opportunity to sell technology shares into strength," Bernstein wrote, expressing optimism on groups such as dividend-paying utilities, consumer staples, aerospace/defense, drugs, energy and corporate-oriented financials.

Still, to paraphrase

RealMoney.com

contributor

Helene Meisler, while investors are busy watching the Nasdaq, they're missing the deterioration that's taking place in the Russell 2000.

As of 2:30 p.m. EDT, the Russell 2000 was down 1.34% to 496.41. For those with a technical bent, trading below 500 is significant because it represents a break of the uptrend line from the Russell's September lows.

The Russell traded and closed below 500 on May 7 and continued to struggle for a few days thereafter, generating breakdown talk among some small-cap naysayers. After trading as low as 492.24 on May 10, the index rebounded smartly last week, trading as high as 513.54 intraday Thursday.

But the Russell's rally last week was a "false breakout," according to Rick Berry, formerly of Centennial Capital Management in Atlanta and now an independent analyst. Berry is among those who've recently turned bearish on small-caps, as reported here

May 10.

Today, Berry reiterated a view that the Russell 2000 is producing a "classic head and shoulders," a bearish pattern characterized by three peaks, with the middle one being highest. The troughs of the two peaks that flank it define the neckline, at about 490 in the Russell's current case.

Subtracting the 30 points between 490 and the Russell's recent highs near 520 -- which intersects the downtrend line from the Russell's highs in September 2000 -- from the neckline area, Berry reiterated a near- to intermediate-term target of 460 for the index.

"We're on the precipice," he said. "What kind of rational person would buy the small-cap index when its P/E has doubled? It's too late to be in small-caps."

Regarding the doubling of small-cap valuations, Berry referred to a point made by Thomas McManus of Banc of America Securities, as reported here

April 22: The median price-to-earnings ratio of the 1,700 stocks in the Value Line Arithmetic index was recently 21 vs. 12 to 13 in early 1999.

The big question among those concerned with the outlook for small-caps is whether their demise -- assuming it does occur -- will trigger a rotation into big-caps that have suffered in recent years or signal the demise of the last bastion of strength in U.S. stocks.

Berry is clearly in the latter camp. "The only thing the market has going for it is it's still oversold," he said. "When the Russell does break down, you're back in the full-fledged bear market we've never left. People will argue that fact, but how many people are really in those small-caps?"

Actually, mutual fund inflows suggest that a lot of retail investors are in those small-caps stocks. After taking in nearly 6% of the $57.94 billion that went into domestic equity funds in the first quarter, AMG Data reported that small-cap funds had inflows of $7.9 billion in April, or 46% of the $17 billion in net inflows for all equity funds.

The issue isn't that "nobody" owns small-caps, it's that most only recently got in.

Aaron L. Task writes daily for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks, although he owns stock in TheStreet.com. He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to

Aaron L. Task.