Watching for a Surge in Small-Caps

 | Mar 28, 2012 | 4:00 PM EDT
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This article originally appeared earlier today on ETF Profits.

Traders have fully exploited the bullish trends in many of the larger-cap leadership and high relative strength names at this point in the rally, and the risks of exhaustion have increased significantly in these areas. The bulls are starting to rotate money into other areas of the market that have not yet been exploited, which means the secondary and tertiary names. Finally, traders are coming around to the small-cap stocks.

Money is flowing down the capitalization ladder toward small-caps in a predictable fashion. The only unusual thing we've noticed is that the process of liquidity trickling down toward the small-caps has developed more slowly in this rally than in the past. We believe this is due to a sluggish change in bullish sentiment considering the strength of the rally. Nonetheless, the opportunity seems to be to get ahead of the process and move toward bullish small-cap names right now.

The S&P 600 and Russell 2000 have mimicked each other technically, but the S&P 600 has been a bit stronger. We expected to see stronger relative strength from the S&P 600 as the 1400 smaller-cap names in the Russell 2000 lag the larger-cap names in the group. Both indices have broken the falling resistance line created by the large consolidation phase, which developed in the small-cap indices over the last 10 months.

S&P 600
Source: MetaStock

The consolidation within the uptrend and the breakout above resistance puts the indices back on the offensive and shows the bulls in control of the price action. The oversold signal in the Russell 2000 40-day SARSI indicator last year plus the retest of the lower end of the uptrend channel confirms the strength of the bullish cyclical rally.

Russell 2000
Source: MetaStock

The missing ingredient in the bigger picture is a confirmation of breadth. We would have liked to have seen a leading breakout in the liquidity line to confirm a strong bullish undercurrent to the group. Unfortunately, the breadth line has only managed to climb back for a retest of the prior highs. We still need to see a bullish surge in liquidity levels to carry the sector higher and confirm that money is starting to flow freely into the group.

S&P 600
Source: MetaStock

Strength in small-caps is really an issue of sentiment and traders' willingness to increase speculation. We see sentiment swinging decidedly bullish by all measures, despite the fact that this change has taken longer than expected. Traders may have gotten all they can get from the current leadership names on the upside, and, at this point, it's a matter of diminishing potential .

We are in the later stages of the current rally phase and expect to see a burst of speculative energy start to develop. Look to get in front of this change on the long side of the small-cap indexes. Our preference for a trade on the long side is to use the S&P 600. It has shown good relative strength and seems to be moving ahead of the Russell 2000.

The iShares S&P SmallCap 600 Index ETF (IJR) (XTF rated 8.6) is a large liquid fund ($7 billion in assets under management), and traders should have little problem trading the fund. Enter IJR long at $76, and look for the primary uptrend to resume from this point. A breakdown below $72 in IJR would signal to us that the bulls have lost traction, and some bullish elements we're currently observing have been nullified. Traders can use the $72 as a quick stop loss on this trade. IJR should be a good way to capture any sort of speculative surge that develops in the late stages of the current rally.

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we like this chart here, it appears ready to move higher. BOUGHT BZUN OCT 35 CALL AT 3.40
Large-cap, high-quality McKesson (MCK) is too cheap now, at $147.51 or so. The stock hit $243.60 more than 2.5...



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