Successful trading hinges on the ability to spot meaningful turning points in sentiment and exploiting these important emotional periods during the beginning stages of a new trend. With the major averages flirting with key breakout levels, you need to be able to analyze how market participants will react to higher prices.

While there is no set formula that can tell you if and when a breakout has staying power, you can interpret how investor behavior might hold back a strong bull move — or aid stocks in their search for higher ground…

Switching Gears

First, you have to understand that a massive attitude shift must take place in order for stocks to alter their trend. Bull and bear trends generally are more likely to continue rather than suddenly reverse course. Think of it as you would Newton’s first law of motion: objects in motion tend to stay in motion, unless some outside force interferes.

In the case of trends, interference can be a variety of events or circumstances — and will rarely be a cut-and-dry, immediate stop-and-reverse. The market is much more nuanced than that…

Let’s take a moment here to consider the beginning of a new trend in the S&P 500:

Everything appears to be setting up favorably on the chart. We have a series of higher lows since the October bottom, and shares have finally topped 1,300 — just above the previous highs.

But have investors’ attitudes switched to bull market thinking?

Market participants need to switch their mindsets if they truly believe the market will go higher from here. Right now, for such a clean break in the S&P, we’re not seeing a lot of follow-though buying. Investors continue to sell after big moves — because they remain stuck in a bear-market frame of mind. I can’t tell you when the watershed moment will arrive, but I can tell you how to spot it: When investors begin to chase rallies, you can expect some follow-through from the market.

It’s all about fear. The fear of losing money is replaced by the fear of missing a big move higher. That’s a major ingredient in the making of a new uptrend…

What’s In Favor?

Small stocks underperformed their blue-chip peers in 2011. This isn’t so shocking when you factor in market volatility during the second half of the year. Investors were spooked over the possibility of a deeper correction — causing a flight to safety to the bigger, dividend-paying names.

In order for a new bull market to gain traction, we want to see investors begin to favor the riskier asset classes — such as small-caps. To some extent, this has already happened. The Dow is up about 3.75% to start the year, while the S&P has risen almost 4.25%. On the other hand, the Russell 2000 — an index that reflects small-cap performance — is up almost 5.5% in 2012.

This is a strong sign for the bulls. If small-caps can maintain their lead over the broad market, traders and investors will feel much more confident in the new trend.

Garbage Stocks Change Course

Another key ingredient to a broad move is the inclusion of stocks that were abandoned during the previous period of market turmoil. Analysis from Bespoke Investment Group shows out-of-favor stocks from 2011 are outperforming the names that held up well during the correction:

“The 50 S&P 500 stocks that did the best in 2011 are up an average of 2.1% so far this year. The next best group of 50 stocks in 2011 are up an average of just 1.1% in 2012… On the other hand, the 50 stocks that did the worst in 2011 are up an average of 11.2% in 2012.”

So investors are not only increasing their risk appetite with smaller stocks — they’re also loading up on the names that burned longs left and right just months ago. Ill-advised or not, picking up shares of bottom feeders and seeing them break their nasty downtrends can only help restore confidence in the stock market…

It could remain a bumpy ride in the near-term, yet I will remain cautiously optimistic that this new rally might stick. With a few clearer signals and some emotional adjustments of the investing public, the floodgates could open for a new bull market.

Sincerely,

Greg Guenthner
for The Penny Sleuth

Greg Guenthner

Greg Guenthner heads up Agora Financial’s small-cap division and is the founder of one of the only independent OTC research advisories in the industry. A graduate of George Mason University, Guenthner joined Agora in 2005 after several years as a journalist. He is managing editor of Penny Stock Fortunes and Bulletin Board Elite.

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