A big volume surge in chip stocks—much like the one that preceded the rally in homebuilders—is unfolding now, and two stocks in particular stand out as the most compelling buys.

Stocks put in another impressive performance on Wednesday, and the market internals, which turned positive in the latter part of December, have confirmed the price action by moving above the October highs. They had been lagging a bit last week.

The technical action of the mid- and small-cap stocks has also improved, as the iShares Russell 2000 Index Fund (IWM) closed above the major 61.8% Fibonacci retracement resistance at $77. The next upside targets are 3%-5% higher.

The technology sector is also looking strong, as its relative performance has been improving over the past few weeks. The daily chart of the PowerShares QQQ Trust (QQQ) has closed well above the October highs and resistance at line a. The July highs are at $59.83 with the 127.2% Fibonacci retracement target at $61.06.

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The Nasdaq 100 Advance/Decline (A/D) line broke its downtrend (line d) on December 21 and shows a bullish zigzag formation, as it has surpassed the November highs (line c) and is close to the highs from last summer. This indicates that even a sharp couple-day correction is likely to be followed by even higher prices.

Volume surged in the semiconductor stocks, as several including Micron Technology, Inc. (MU) and Photronics, Inc. (PLAB) have completed reverse head-and-shoulders (H&S) bottom formations. Both rose sharply on high volume yesterday.

A similar volume surge in the homebuilders in October led to sharply higher prices, and right now, quite a few of the semiconductor charts look very good. There are two in particular that I like best.

NEXT: 2 Chip Stocks That Look Strongest Now

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Chart Analysis: SanDisk Corp. (SNDK) completed a reverse H&S bottom formation in October when the neckline (line a) was overcome. From the October highs, SNDK held the 38.2% Fibonacci retracement support with the low at $45.51.

  • The continuation pattern was completed Wednesday, lines b and c
  • This indicates that the uptrend has continued and the flag formation has initial Fibonacci upside targets at $56 with further resistance in the $60 area
  • The relative performance, or RS analysis, broke its downtrend in September (line d) and appears to have just moved through resistance, line e
  • The on-balance volume (OBV) has been strong since mid-September and is now testing short-term resistance at line f
  • There is short-term support at $51-$51.60 with much stronger support in the $48.50-$49.50 area

NXP Semiconductors NV (NXPI) is a $4.7 billion, Netherland-based, broad-line semiconductor company. The stock traded as high as $35.32 in late-April 2011 and made a marginal new low in October at $13.06.

  • The move through the downtrend, line g, was on strong volume, suggesting that the bottom formation has been completed
  • The 50% Fibonacci retracement resistance is at $24.20 with the 61.8% level at $26.90
  • The downtrend in the RS (line i) has been broken, suggesting that NXPI is starting to outperform the S&P 500
  • The daily OBV has also moved through its resistance at line k, which is a positive sign
  • There is first support in the $18 area and then stronger at $16.50

NEXT: Volume Surge Makes This Chip Stock One to Watch

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Volterra Semiconductor Corp (VLTR) was first recommended on November 25 and surged to the upside on Wednesday, breaking through resistance, line a, on volume that was three times the average. This is a small-cap stock that bottomed in October at $18.17.

  • The completion of the weekly continuation pattern that goes back to early 2010 has targets in the $36-$38 area
  • The RS analysis also has confirmed the price action, as it has been in an uptrend from the September lows
  • The OBV has also moved through its resistance, line e, and the weekly OBV (not shown) still looks strong
  • There is first good support at $25.50-$26.50

What It Means: The bullish action in the Nasdaq 100 A/D line and the strong volume in the semiconductor sector suggests that the stocks in this sector still have good upside potential. There are quite a few mid- and small-cap semiconductor stocks that show compelling bottoming formations. Look for more on this sector in the near future.

How to Profit: For SanDisk Corp (SNDK), go 50% long at $51.68 and 50% long at $50.78 with a stop at $45.38 (risk of approx. 11.4%).

For NXP Semiconductors NV (NXPI), go 50% long at $18.38 and 50% long at $17.78 with a stop at $15.84 (risk of approx. 12.4%).

Portfolio Update

  • Buyers should be 50% long Volterra Semiconductor Corporation (VLTR) at $21.64 and should now raise the stop to $24.72
  • Buyers should be long the iShares Russell 2000 Index Fund (IWM) at $68.72 and 50% long at $66.88. Half the position was sold at $74.68 on December 28. Use a stop now at $70.44 on the remaining position
  • Buyers should be 50% long the iShares S&P SmallCap 600 Growth Index Fund (IJT) at $68.64. Raise the stop further to $71.72 on the open position
  • Buyers should be 50% long the Royce Value Trust (RVT) at $11.62. Raise the stop further to $11.92
  • From the November 25 column, buyers should be 50% long Double Eagle Petroleum (DBLE) at $6.88 and 50% long at $6.56. It is not acting as strong as I would like, so raise the stop on this position to $6.48