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Sentiment among analysts has turned negative, but favorable technical signals for the small-cap sector give good reason not to rule out a potentially aggressive rally.

The recent deterioration in the market’s technical outlook improved considerably after Tuesday’s sharp gains. Still, there needs to be further gains and positive market internals to firmly shift the evidence in favor of much higher stock prices. This would help dispel the view that Tuesday was just a short-covering rally. The stock index futures were flat ahead of the opening on Wednesday.

Though the sentiment numbers from the individual investors and financial newsletter writers are not giving any strong signals currently, the big brokerage houses and financial media seem to be getting more negative.

I was surprised to see segments on how to protect your portfolio from lower stock prices through put strategies on one of the major financial TV networks last week. Also, Merrill Lynch analysts see no “Santa Claus rally” and commented that small-cap stocks are “damaged goods.” They are not expecting a strong “January Effect” for this year.

JPMorgan Chase is also “skeptical that the typical January Effect in spreads will play out this year.” The technical evidence, however, suggests that the relative performance, or RS analysis, for the Russell 2000 Index is very close to turning positive.

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Chart Analysis: The Spyder Trust (SPY) closed well above the prior four days’ highs with next resistance at $125.57, and the downtrend, line a, is at $126.40.

• Clearly the recent low at $120 is key support, and if it is broken, a drop to the November lows at $116.20 is likely
• Other than the Advance/Decline (A/D) line, my other favorite indicator that uses the market internals is the McClellan Oscillator, which is still holding its uptrend (line d) and testing its downtrend, line c
• A strong move in the Oscillator above its recent high would be very positive

The iShares Russell 2000 Index Fund (IWM) was up just over 4% on Tuesday as compared to the 3% gain in SPY. The next resistance is in the $74.47-$75.39 area.

• A move through this level is likely to signal a move to key resistance at $77
• The daily RS analysis has moved just slightly above the key resistance at line g
• A confirmed breakout would complete the base formation (line h) and confirm that IWM was outperforming the S&P 500
• The daily on-balance volume (OBV) is barely above its weighted moving average (WMA) but needs to overcome the downtrend, line i, to turn strongly positive

NEXT: 2 Promising Small-Caps to Buy on Pullbacks

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