Still Time to Go Long on Small Caps

07/16/2010 9:18 am EST

Focus: STOCKS

The Russell 2000 has just completed a successful 38% retracement of the March 2009 to April 2010 bull run, and now, two volume-based indicators suggest that this key small-cap index may have another few weeks to run higher.

True, the long-term bear market probably has a lot more ground to cover on the downside, but all we as traders have to work with is the here and now. It's usually best to put predictions aside and focus on what current price action is telling us. And what the current technical configuration of the Russell 2000 is saying is this: "More rally likely to come." Here's why this may very well be the case, unexpected as it may be.


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FIGURE 1: R2K, WEEKLY. Volume is a frequently overlooked market factor. This chart clearly shows bullish volume and money flow divergences from two unique technical angles.

Most technicians know that every major trend has periodic retracements that occur between the powerful impulsive waves that do the heavy work involved in driving prices. The stronger trend phases have relatively shallow retracements in most, but not all cases. Finally, the trend terminates, sometimes in spectacular fashion, with a reversal move that is obviously more than a regular garden-variety retracement.

Clearly, this was the case a couple months ago when the R2K topped and then headed south with a vengeance (Figure 1). Some bears believe this to be the top in this index for the year, while others subscribe to the idea that at the very least, a significant A-B-C correction needs to play out before the Russell begins to turn higher. I am of the latter persuasion, and what we are witnessing now may be the start of the B wave higher, a wave that is likely to terminate somewhere near the 50% to 62% retracement of swing XA, probably between 675.00 and 695.00.

There are several reasons this may be the case, among them being:

1) The reversal higher from the major Fibonacci 38% support near 584.00

2) The bullish divergence on the Barry Taylor Better Momentum indicator, a momentum tool that uses volume to better help traders determine the validity of divergence patterns. From my experience, it seems to do a good job of identifying tradable divergences. It certainly appears to have called this reversal in fine fashion

3) At the bottom of the chart, note the strong bullish divergence of the Chaikin Money Flow (CMF) (21) indicator compared to the weekly bars on the chart. Clearly, the smart money has been viewing the rapid decline from 745.00 to 584.00 as another opportunity to load up for another rally attempt

Finally, take a look at that textbook-quality bullish wedge/flag pattern that has formed on the chart. It's almost like waving a red blanket in front of the bulls in this market, daring them to create sufficient buying thrust to take prices back up toward the 675.00 to 695.00 area again.

How to play further strength in the Russell 2000? Here are a few techniques that small-cap stock traders might find useful:

1) Scan your charting package's database for strong relative strength stocks (a 13-week rate of change calculation against the R2K is one way to find these)

2) Once you've found the stocks, scan for technical breakouts above the 21- and 55-day price channels, preferably on heavy volume

3) Make sure the stocks that clear both scans are also above their respective 50- and 200-day exponential moving averages (EMAs)

You're certain to find at least a handful of interesting small-cap names that come through all screens, and if you're really serious, you'll also want to make certain that the stocks you choose to buy have steady earnings growth projections for the next year or so.

For those of you already using proven mechanical trading systems, your job is actually that much easier as you won't have to agonize over where to place your buy orders for such stock positions. Mechanical system or not, you'll be surprised at how much better your trading results will be once you factor in the relative strength and earnings growth rate projection wildcards into your trading regimen. A good trading system for stocks can become a great one, just by faithfully applying these two basic barometers of equity strength into your own unique trading equation.

By Donald W. Pendergast, Jr. of ChartW59.com

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