*** I told you on Tuesday to pay attention to the Russell 2000. It had just experienced its sharpest decline in a month (falling 11 points in a day) and was poised to go lower. After all, hedge fund managers and institutional investors just finished yanking $639 million out of IWM — the iShares Russell 2000 Index, the small-cap ETF that tracks the Russell 2000 — on Monday.

Well, since I last wrote to you, the Russell 2000 did fall lower. In fact, it broke through both the 636 and 621 marks (its two previous lows from the month of December) that I warned you about. And now it is trading for 616.

Here’s what to look for in the coming days…

I expect the Russell 2000 will test the 612 mark next — its low from Nov. 22. My guess is it will either bounce off that support level or plunge to about 590 — an old resistance level it took three tries to bust through in 2004.

Of course, we’ll have to wait and see what happens. But based on the amount of people buying puts and calls on IWM (which trades for roughly one-fifth of the Russell 2000), it seems most people think it will fall. Check it out…

Open interest on IWM February 2005 $123 calls is fairly moderate, at 1,447. In other words, there are 1,447 people betting the IWM (and ultimately the Russell 2000) will rise in the short term. And on the other side of the fence, open interest for the IWM $120 puts is a whopping 18,345!

Translation…

About 12 times more people are betting the Russell 2000 will fall further in the next few days. Hmmm…

Usually, when the majority of folks think the same thing at the same time, they are wrong. So I would be careful about running with the herd. While I do think the small-cap market is due for more of a correction, I wouldn’t be surprised at all to see it rally for a couple of days — knocking a lot of aggressive bears out of the water. In fact, I’m going to go out on a limb and predict that the bears will lose between now and Friday — when I write the next Sleuth.

For the record…

As I type, the February $123 calls are trading for $2.90 a contract. And the February $120 puts are going for $2.35 a pop. I’ll report back to you on Friday with up-to-date prices…to see who wins this tug-of-war battle between the bulls and the bears. Stay tuned…

*** By the way, I do think the small-cap market is going to struggle in 2005 — no matter what happens in the next seven days and despite what all the talking heads are forecasting in the news right now. And on Tuesday, I’ll lay out my argument showing you why this may not be a banner year for most small-cap stocks.

Until then, this is not a time to panic. Rather, this is a time to be very picky. If you are holding stock in companies with almost no cash, tons of debt and poor fundamentals, I’d be worried. Those are the kinds of stocks I expect will get pounded in 2005.

But as I will remind you again on Tuesday, there are over 4,000 small-cap stocks on the major exchanges right now. And my friends, hundreds of them will rise big. That I guarantee. Heck, look at the top performers of this week (when the markets all lost ground)…

– Franklin Capital Corp. (FKL:AMEX) rose 60.3%
– StemCells, Inc. (STEM:NASDAQ) rose 36.6%
– Tarragon Corp. (TARR:NASDAQ) rose 28.6%
– KVH Industries (KVHI:NASDAQ) rose 24.9%
– New River Pharmaceuticals, Inc. (NRPH:NASDAQ) rose 23.8%
– Flamemaster Corp. (FAMEC:NASDAQ) rose 23.7%
– Perficient, Inc. (PRFT:NASDAQ) rose 22.7%
– Education Lending Group, Inc. (EDLG:NASDAQ) rose 22.0%
– Western Wireless Corp. (WWCA:NASDAQ) rose 21.8%
– Keryx Biopharmaceuticals (KERX:NASDAQ) rose 20.3%.

Notice that nine of the top 10 performing stocks on the market this week were small caps with a market cap under $1 billion. The only large cap in the group was Western Wireless — and it has been the subject of buyout rumors all week.

As an investor, you will have to be selective to find winners like these. You have to put your money in companies with products and services that are in demand…that have enough cash to thrive in a market in which rising interest rates and inflation will continue to emerge…and that aren’t overloaded in debt.

If you stay tuned to Penny Sleuth, we’ll point you in the right direction — at least, we’ll try. We’ll tell you what to watch out for (which most people don’t do). And we’ll also tell you about special buying opportunities when they arise. You have my word.

*** Finally, I want to invite you to warm and sunny Phoenix, Ariz., on Feb. 21 and 22. I will be speaking at our quarterly Traders Conference — giving anyone who will listen many trading ideas surrounding the small-cap market. I always love getting on stage and sharing my ideas with you. So it would be great if you could make it. (Plus, wouldn’t it be nice to get away and enjoy the warmth for a while?)

A 48-Hour Profit Window

On May 25, 2004, shares of Alanco Technologies, Inc. were trading for 93 cents. But something was brewing behind the scenes at this supplier of radio tracking systems for prisons — and it was something big. Anyone who recognized it knew that this stock would rise any minute. Sure enough, less than 48 hours later, it did. On May 27, the stock was up to $1.22. In two days, investors walked away with an impressive 25.8% profit.

The same thing happened with Bally Total Fitness. On Monday, July 12, the stock closed at $4.75. Once again, a major event was in the works. And the handful of investors who saw it happening couldn’t buy enough of the stock. They knew it was about to jump. Then on Wednesday, July 14, the stock popped to $5.09 — up 7.2%.

Around the time that Bally spiked, the same thing happened to Greenbrier Cos., a supplier of transportation equipment and services to railroads. On July 13, it closed at $19.85. The next day, the stock surged to $22.10 — an increase of 11.3%.

So what did these three companies have in common that gave small-cap investors such a big return within 48 hours?

They were targets of hostile takeovers. In other words, the current management and directors refused to sell their company. Over time, hostile takeovers can be agonizing and rife with internal dissent at the target company. But one way to show unity against the aggressor is by adopting a poison pill.

While a poison pill is designed to give corporate raiders a massive case of indigestion, it also can present investors with a 48-hour profit window.

Here’s how a poison pill works…

It is a strategic move by the takeover target to make its stock less attractive. Poison pills come in several flavors.

In one flavor, a company may issue a new series of common stock that gives shareholders the right to redeem it at a premium AFTER the sale — meaning that the acquiring company has to pay above-market price to a select number of shareholders…making the takeover financially unsound.

Another flavor of poison pill entitles the entire management team of the takeover target to resign immediately — leaving the new owner without experienced leadership…dramatically reducing the value of the acquisition.

But under the guise of a so-called “shareholder rights plan,” a poison pill can turn a quick profit for investors.

A shareholder rights plan is corporate speak for a poison pill. What I discovered is that within 48 hours of a press release announcing a shareholder rights plan, the stock spikes — before retreating. And the reason its public disclosure sends the stock up is because it means that someone is interested in buying the company.

Obviously, with a 48-hour window of profitability following the poison pill announcement, you need to get a first-move advantage. And that starts with getting your hands on the press release.

Don’t think that companies are particularly eager to let you know they’ve adopted a poison pill. Most of the time, companies like to play those cards close to the vest. But the rules for disseminating information are different for public and private companies. Since shareholder rights plans can have a large impact on the stock price, they fall into the “material information” bucket: information that’s important enough to be distributed to the marketplace in a timely manner. And often the best way to do that is via a press release.

So given that you only have 48 hours to get a near-term hit on a poison pill, the clock starts ticking with the distribution of the shareholder rights plan press release.

In order to find those press releases, here’s what you need to do…

The two biggest distributors of press releases are Business Wire and PR Newswire. Just about every newspaper, TV station and business magazine subscribes to them to track breaking business news. You can visit the Web sites for free at www.bizwire.com and www.prnewswire.com. Both services have decent search capabilities that you should use to the max.

Google also has a free news alert service. I use it all the time. When you go to www.google.com, click on “News,” above the search field. That will take you to a page where you can enter search criteria for a phrase such as “adopts shareholder rights plan.” This news can even be delivered to you in real time — as soon as the press release is distributed to the media.

While you want to take advantage of the poison pill, you don’t want to use it to commit financial suicide. Act fast, but act smart. Make sure you’re well informed before you hit the “buy” button.

Happy investing,

Irwin Greenstein

A 48-Hour Profit Window was originally featured in the Penny Sleuth.