STOCKS

The annual fire sale of small-cap stocks may be happening several weeks early, which could give savvy investors a ground-floor entry point. But where to invest? MoneyShow.com senior editor Tom Aspray shares his recommendations.

The action early in the week leading up to Thanksgiving may have damped investors’ enthusiasm for stocks, but I continue to expect that consumers will be spending more than most expect. This would allow for stocks to rally before the end of the year.

Since 1925, market data indicates that small-cap stocks outperform the broader stock market in January. This phenomenon was first identified by Sydney B. Wachtel in his 1942 paper, “Certain Observations on Seasonal Movements in Stock Prices.”

The prevailing explanation for this so-called “January Effect” is that investors dump their small-cap losers before the end of the year to book their losses, and this pushes many of theses stocks to bargain levels. This, in turn, sets the stage for a sharp oversold rally into January.

Like many of the seasonal patterns now more broadly recognized by investors, the turn often comes a bit early. The current decline and increase in bearish sentiment with the supercommittee failure suggests that investors may be dumping their stocks now.

Also, for the first time since September, the double-dip forecasts are again hitting the financial airwaves. Though they may eventually be correct, recessionary forecasts ahead of the fact are rarely right.

There are several ways to invest in small-cap stocks, including some very liquid small-cap ETFs, a closed-end small-cap fund, or through individual small-cap stocks, where the risk (as well as the potential reward) is much higher.

The Russell 2000 is one of the broadest readings of the small cap market and has a median market capitalization of $473 million. It currently has a price-to-earnings ratio (P/E) of 16.92, with a dividend yield of 1.44%. The largest stock in the index has a capitalization of $3.65 billion.

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The weekly chart of the iShares Russell 2000 Index (IWM) is shown here, along with the relative performance, or RS analysis. This measures the performance of IWM versus the S&P 500 to identify periods when the small caps are outperforming or underperforming the S&P 500.

In September 2010 (line 1) the RS line moved above its weekly moving average (WMA) and began a new uptrend, signaling that it had started to outperform the S&P 500. The RS stayed positive until the week of May 25, when the RS lines formed lower lows (line 2).

During this period, IWM was up 26.6% compared to a 5.3% decline in the Spyder Trust (SPY). Therefore, the small-cap IWM outperformed the large-cap S&P 500 by 31.9% during the eight-month period—almost 4% per month.

From May until the first week in November, the RS analysis favored the SPY (or S&P 500), and during this period it was up 5.6% while the IWM lost 9.6%. This is a difference of 15.2% over a five-month period.

This week, IWM has declined to test initial support in the $69 to $70 area. The 50% Fibonacci retracement support is at $68.54, with the 61.8% level at $66.54. The weekly Starc- band is at $63.40.

If the IWM can move above the October high at $77, the first upside target is at $80, with additional upside targets in the $82 to $83 area.

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Tickers Mentioned: Tickers: IWM, IJT, SPY, RVT, VLTR