But before I reveal my screen criteria, I want to show you why I believe we’re entering an important moment for small stock investors…

Right now, the market is beginning a powerful underground rally, boosting small-cap stocks close to their pre-correction highs. The Russell 2000 is up more than 11% year-to-date, easily topping large-caps in the S&P 500 and the Dow.

Small-caps are winning the race right now because they are the most potent stocks to own during the early stages of a rally. As you probably know, investors see small-caps as riskier investments. That’s why they are the first to be sold off after a long bull market.

But small-caps are also the first stocks to rise once the market has bottomed out. The rush to get back into smaller names pushes these same stocks up farther and faster than their larger counterparts.

Even though small-caps are outperforming the S&P 500 and the Dow so far this year, we haven’t seen a watershed buying moment just yet. That’s why I’m still calling this an “underground” rally. But with every passing day, I think we’re getting closer to that powerful breakout. All that’s left to do is to coax investors on the sidelines back into small stocks.

Retail investors have pulled almost $18 billion out of small-cap funds over the 36 of the last 39 weeks, according to data from J.P. Morgan. This shows us that a great deal of Main Street’s money is still in cash, waiting until the investing waters are declared safe before buying smaller stocks. All we need is volatility to remain low and the market to remain stable for these market watchers to dive back into stocks.

That’s where my 3-part screen comes into play. Follow these easy steps, and you will be able to track down the small stocks that are the best candidates to beat the market. If you do it today, you’ll even have the chance to get in on these names before the next leg of the rally begins to take off…

To begin, go to your favorite free financial website. Google Finance, Yahoo or any of the other major sites will do. If you want a more comprehensive list of screening tools, just search for “stock screeners” online. There are plenty of viable options out there. You don’t even need a subscription or any special software.

[Editor’s note: For a more in-depth piece on free stock screening sites, click here.]

Now you’re ready to begin your search.

1. First, drill down to the most viable sectors: Right now, the investing environment is most suited for consumer stocks, tech names, and pharmaceuticals. These are the types of small-cap stocks that are looking strong right now. Get rid of stocks in the utilities, energy and financial sectors. These are the names that aren’t showing strong earnings or growth at the moment. There’s no point in wasting your time sifting through stocks in a lagging sector. Cut them, and move on.

Setting up the screen is simple. Just adjust your market cap parameters to find stocks in the $300 million – $2 billion range. Then you can enter your sector of choice…

2. Find the profitable companies trading at a low price-to-earnings ratio: The next metric you need to add is price-to-earnings ratio. Investing in companies that are cheap compared to how much money they are earning is a great way to prepare for a rally. Filtering out stocks with P/E ratios higher than 15 is the perfect way to narrow your search. When stocks are moving higher, bargain hunters will swoop in and bid up these “cheap stocks” to more reasonable levels.

Now that you’ve added this second key metric, you can begin searching your selected sectors for cheap plays. Make a list of all the companies that interest you. Now you’re ready for the final step…

3. Finally, select the stocks with the most momentum potential: Your final step involves some quick chart analysis. But don’t worry—you do not have to be seasoned market technician to complete this task. Simply take your list and look at each company’s daily chart. Then ask yourself one simple question: What is the primary direction of this stock?

There are three answers to this question: up, down, and sideways. Get rid of any stock that looks like it is moving lower. That will leave you with names that have bottomed out and are moving sideways, and stocks that are moving higher. As you narrow your list, you can use these charts to separate your best ideas. If you have two stocks you really like, compare charts. Unless you have a compelling reason to pick one name over another, I would recommend going with the stock in an uptrend every time.

Here are a couple of examples I found after searching for only 10 minutes:

Iconix Brand Group Inc. (NASDAQ:ICON): Iconix owns a large portfolio of apparel brands. Its P/E comes in at about 13, and the company has proven it can steadily increase its sales and earnings. The stock has also moved steadily higher since it bottomed in early October.

Greatbatch Inc. (NYSE:GB): Greatbach is in the medical device sector. Its P/E comes in at 14. The stock is also only slightly above sales—another sign of a cheap name. GB is also recovering from last year’s slump. Shares are quickly approaching pre-correction highs.

Of course, this lightning-fast analysis just scratches the surface of these two companies. Still, you can see how a quick search yielded two strong possible investments.

Sincerely,

Greg Guenthner
for The Penny Sleuth

3 Keys to Playing the Underground Small-cap Rally was originally featured in the Penny Sleuth.

It’s the rule that every successful investor has used to build wealth. And it’s the same rule that will destroy your trading account if you fail to heed its warning.

That’s why I want to alert you to a group of stocks that could cause you a lot of unnecessary pain this year. I’m talking about the so-called social gaming sector — specifically Zynga Inc. (NASDAQ:ZNGA) — the developer of FarmVille and other fad games for Facebook and mobile phones.

It all comes down to unrealistic expectations. I saw this same story play out last year when OpenTable Inc. (NASDAQ:OPEN) and Green Mountain Coffee Roasters (NASDAQ:GMCR). Both lost more than half their market value after failing to meet outrageous growth projections. The same fate awaits Zynga. If you invest in this stock expecting a huge payout by next year, you could be in for a terrible surprise.

Here’s why you need to avoid this stock — and the entire social gaming sector…

Since Facebook formally submitted its IPO paperwork last week, analysts and investors have been buzzing about Zynga’s growth prospects, bidding the stock up nearly 40% in a little more than a week. But I don’t see this growth story playing out much longer without a serious correction.

Unfortunately, countless eager investors will probably get sucked into this stock before it crumbles. It will begin next week when Zynga will announce fantastic earnings. The company will beat estimates, predict incredible growth and win over plenty of new followers. Yet despite the hype, Zynga will eventually disappoint anyone who buys this stock right now. In fact, the entire social gaming sector is a sham. And it will quickly unravel once investors realize Zynga and its peers can’t live up to the lofty expectations…

Of course, this hasn’t stopped the financial media from highlighting some gaudy numbers. Analysts have even reverse engineered Facebook’s recent IPO filing to predict Zynga’s performance. Since Facebook reported that Zynga was responsible for 12% of its revenue, it’s easy to see that its game sales were worth $450 million to the social networking giant last year. One analyst who dissected the report even raised his fourth quarter revenue forecast for Zynga to $315 million from $300 million…

That’s a considerable amount of money. However, I don’t think the good times will last.

There are simply too many factors working against Zynga and the social gaming sector. Just because of the nature of the business, it will be incredibly difficult for Zynga to protect its current position at the top of the industry. Simply put, there’s nothing standing in the way of a garage-based start-up from destroying Zynga’s market share. It doesn’t take tens of millions of dollars to put together a game development operation and release a title.

Innovative start-ups could quickly pose major problems…

These pesky start-ups aren’t the only threat. Established video game companies are also fighting for their piece of the social gaming pie. Even video game giant Electronic Arts Inc. (NASDAQ:EA) has emerged as a Zynga competitor. As if we needed more proof that the EA threat is very real, Zynga went on the offensive last month and hired away the head of EA’s interactive division. This is the kind of poaching I expect from this sector. In the end, none of these firms will walk away with enough of an advantage to be a staying force in the industry. In the long run, they will continue to cannibalize sales from one another, leaving no possible way for the average investor to capitalize.

Furthermore, games that are popular now won’t stay popular forever. I do not believe social gamers are going to be loyal to one game developer or another. They will play the “hottest” game at any given moment, and then move on to the next-best title once it becomes available. Zynga is bound to miss the mark with one of its upcoming games. That’s all it will take for investors to head for the exits. Just one mediocre launch that falls short of expectations will send the stock into a tailspin…

Right now, analysts are betting big on Zynga’s foray into gambling-related games. But I’m not willing to take these odds. I’m seeing better opportunities (with far less risk) elsewhere in this market. I’ll highlight some of these soon. For now, steer clear of Zynga and social gaming. As investments, these stocks just don’t make a whole lot of sense.

Sincerely,

Greg Guenthner
for The Penny Sleuth

Why You Should Avoid Zynga and the Sham “Social Gaming” Sector was originally featured in the Penny Sleuth.

With the New York Giants’ win fresh in the minds of 111 million Super Bowl viewers, I guess it shouldn’t come as a huge surprise that a slew of financial media outlets are talking about the “Super Bowl Indicator”.

Here’s a bit from the Wall Street Journal:

Robert Stovall of Wood Asset Management in Sarasota, Fla., is the veteran market analyst who has popularized the [Super Bowl Indicator].

“I don’t have any particular expertise in predicting the outcome of sports events,” says the 85-year-old Mr. Stovall, but he nonetheless leans toward a Patriots win, which would mean a down year for the market. “But if the Giants win, a happy feeling should spread through the bulls.”

The so-called “Super Bowl Indicator” predicts that if an NFC team wins the Super Bowl, the stock market will have a bullish year. On the other hand, an AFC Super Bowl victory predicts a bearish year for stocks. In the last 41 years, the Super Bowl Indicator has had an 80% success rate in determining the market’s direction. The Giants’ win, then, should foretell of a bullish year for stocks. So, should you believe it?

Absolutely not…

There are some major holes in the story behind the Super Bowl Indicator (SBI) — ones that may not be readily apparent to most investors. After all, they weren’t apparent to the Wall Street Journal, the Indianapolis Star, Forbes, or scores of other major media outlets that have been gushing about this false prophet for stock performance.

When it comes to the Super Bowl Indicator, it’s important for you to realize that “correlation doesn’t imply causation”. In other words, just because there’s a correlation between two things doesn’t mean that there’s a causal link between them. Just because your cell phone stops working after a power outage doesn’t mean that the outage broke your phone. In the investing world, that’s one of the most important concepts to understand…

And just because there’s no logical link between Super Bowl winners and market performance doesn’t mean that there’s no complex relationship at play. Just because a high correlation doesn’t prove they’re connected doesn’t mean that they’re not.

Incredibly successful traders have been known to look for bizarre links between outside factors in the market. Billionaire hedge fund manager Jim Simons even admitted once that his firm researched connections between sunspots and market performance — but he wouldn’t tip his hand as to what they found out…

So, with an 80% success rate, why is the SBI a bunch of bunk?

Well, the first thing to look at is the possibility that that 80% win rate was due to luck or chance — in other words, is that rate statistically significant?

On the surface, it looks that way. With 41 games played and measured against the following year’s performance, the statistical chance of an 80% correlation being luck is infinitesimally small. But — and here’s the clincher — the SBI doesn’t follow a normal distribution. Put in plain English, there’s a very logical reason why it’s garbage…

You see, historically, the stock market has been trending higher. As a result, we’ve had more up years in history than we’ve had down years — so it’s statistically more likely for any random year in the last 41 years to be a positive year. Now, let’s look at the NFL.

Like stock market performance, the winning conference in the NFL is hardly random. Thanks to a long NFC winning streak between the 1980s and the late 1990s (in part the result of the dominance of the Dallas Cowboys and the San Francisco 49ers franchises during that time period), NFC teams have won more Super Bowl match ups than their AFC rivals. As a result, it’s statistically more likely for any randomly chosen Super Bowl year to have an NFC winner just because a couple of dynastic teams happened to be in the NFC.

When you put those two statistics together, it’s more likely that a year will be up than down, and it’s more likely that the Super Bowl winning team would have been in the NFC than the AFC. So the high correlation between up years and NFC wins isn’t a huge surprise after all…

The fact that the SBI is worthless hasn’t kept otherwise smart people from touting the usefulness of the metric. A professor at Washington & Lee University even went as far as developing an investment strategy that selects different asset classes depending on the winning team of the big game.

“When I present this you can see the smile on their faces ‘You’re not serious are you?’,” says the prof…

Of course, even the good professor hasn’t invested his own money in the Super Bowl Indicator strategy. In fact, of all of the mainstream cheering of the SBI, there wasn’t a single person who actually said that they invested real money based on the indicator — only those who “wished they did.”

That may be the biggest red flag of all — if an indicator’s biggest fans aren’t putting their cash on the line with it, neither should you.

The old joke goes that 68% of statistics are made up. Well, if the Super Bowl Indicator proves anything, it’s that even compelling statistics can be misleading when they’re not approached with mathematical rigor. Regardless of which team you were cheering for last night, do yourself a favor and avoid the indicator everyone’s talking about today.

Cheers,

Jonas Elmerraji
for The Penny Sleuth

Debunking the Super Bowl Indicator was originally featured in the Penny Sleuth.

We should continue to expect this tug-of-war between bulls and bears to continue for a while as the market approaches important areas of resistance. The emotional game has to play out — and you’ll have to wait and see what side wins over the hearts and minds of the market and its many participants.

Simply put, it is dangerous to “take sides” this early in a trend. For instance, traders were buying stock early this week as if it were their last day on Earth. Unfortunately, the buying didn’t stick, and most stocks have found lower ground. Expectations went from bullish euphoria to an almost unanimous consensus that a pullback was in order in just a few days.

None of this back-and-forth action is cause for alarm. Stocks have been climbing steadily for weeks now, so we will eventually need to see some sort of correction. This can happen one of two ways — through price or time. While there is no way to say for sure how the market will digest its strong start to the year, it appears that stocks want to churn sideways for a bit.

For now, a sideways market makes sense. Despite the strong start to 2012, I do not believe the investing public is getting too greedy at this point. But it is fairly evident that at least some level of comfort is returning to the markets. So we’ll walk the tightrope of fear while the major indexes sneak toward important areas of resistance. That’s where things will get interesting…

The Dow is already extremely close to matching its 2011 highs — and the S&P isn’t far behind. Here’s a weekly look at both indexes, with areas of resistance marked with dotted blue lines:

How investors react to these key levels will determine the strength of the rally over the next few weeks. Obviously, a clean break of the previous highs will help put the past 6 months behind us. With clear skies ahead, we should see additional interest in smaller stocks — and more trading opportunites in the small-cap and microcap universe.

What’s important right now is to train yourself to be able to see the forest through the trees. So many traders get hung up on the day-to-day movements of the market, letting their emotions get swept back and forth with every high and low. Micro-analysis like this can lead to chasing stocks, bad entries and exits, and losses. But even more importantly, if you let the tiny movements of the market get in your head — especially duing important turning points in trend — you’ll risk missing the bigger move entirely.

Sincerely,

Greg Guenthner
for The Penny Sleuth

Don’t Get Trapped By Sideways Stocks was originally featured in the Penny Sleuth.

Often, the momentum can be traced back to an obvious catalyst — fundamental improvements within the group or a well-publicized buyout in the sector. But sometimes, investors and traders trigger a furious rally pinned on nothing but the simple fact that a stock has started to move in their favor. The buying triggers even more buying — and the rally begins to feed off itself.

I’ve chronicled several interesting rallies over the past few years, ranging from coffee stocks (slightly absurd) to semiconductors (a great cyclical growth story). Eventually, these rallies run their course, and momentum traders move on to the next best thing. That might be happening right now to “The Great Pizza Rally of 2011-12.”

This pizza rally has been interesting for a couple of reasons. First, it has been largely contained within a subsection of the fast-food industry that would rarely be classified as a growth market. Also, I can see how a buyer might justify the rally in his mind. After all, the economy isn’t in great shape, so the average family might be buying more pizza. It’s a weak argument, but it makes sense to those who don’t trade using technical indicators. It’s tangible, easy to understand and act upon, and reinforced by the media.

Today, we’ll take a look at a couple of pizza players — and a few other high-flying stocks — and try to predict what the future holds for each…

Pizza Inn Inc. (NASDAQ:PZZI): This small pizza chain saw a big rally in its stock, taking shares from $3.50 in October to almost $7 by the beginning of December. Now, it looks as if the stock is stuck in the $5.50 range and possibly heading lower. The sharp uptrend that began in the fall is broken, so you shouldn’t expect more upside from this name anytime soon:

Domino’s Pizza Inc. (NYSE:DPZ): The king of pizza delivery is showing us a very similar pattern. Once again, we have a nice fall rally, lifting shares from $26 to $35 in a matter of weeks. However, 2012 has not been as kind to Domino’s. While the broad market has rallied to post-correction highs, DPZ has fallen out of favor. You can clearly see the trendline break right at the beginning of January:

BroadVision Inc. (NASDAQ:BVSN): After failing to catch a bid for most of 2011, BVSN proves that you don’t need a reason for an unannounced, triple-digit rally. This unheralded microcap started the month as a $10 stock, only to top $44 by yesterday afternoon. Not bad for a few weeks work — and absolutely no news other than the sheer power of the rally itself.

But that’s the thing with moves like this: they have to end eventually. And when they do, look out below. Check out the chart below for a very clear picture of what an unsustainable rally looks like. You should expect further downside action from here:

Apple Inc. (NASDAQ:AAPL): Finally, we turn to last night’s earning surprise from Apple. Even without vaunted leader Steve Jobs at the helm, Apple reported record earnings on stronger than expected iPhone sales. Spurred on by a 6% move this morning, Apple once again overtakes Exxon Mobile Corp. as the biggest company trading on the U.S. markets, with a market cap approaching $417 billion:

Sincerely,

Greg Guenthner
for The Penny Sleuth

Today’s Market Movers: AAPL, BVSN, and the Great Pizza Rally was originally featured in the Penny Sleuth.

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

How Investor Confidence Shapes A New Rally was originally featured in the Penny Sleuth.

As much as I want to be bullish here, I’m still a little spooked by this market and what has become the longest, more boring economic crisis in the history of mankind. As much as the slow-motion eurozone meltdown has fallen off the front page, its potential threat as a wrench in the market’s gears is still very real.

With that in mind, I’m going to take a look at several stocks fighting to break out this week. All of these names are at or near important resistance levels…

A couple of notes about resistance before we go to the charts: First, resistance is an area, not a cut-and-dry line as it’s most often depicted. Also, many stocks have multiple areas of resistance — some more important than others. For all of the stocks I’m featuring today, a resistance break could signal the start of a new uptrend. Or it could fail and knock the stock back to into its trading range.

The bottom line is that you need to prepare to go long — but also be ready for disappointment if the market tells you its gains to start the year are too much to handle right now. Don’t try to anticipate a big move — let the market come to you…

Freescale Semiconductor Inc. (NYSE:FSL): FSL has a nice look to it right now. We’re seeing a very strong move this afternoon, but the stock is pulling back from its highs. It will need to close above $14.70 to prove the buying power behind it wants shares to trade higher. Look at the long wicks poking above resistance on the chart below. These are two other attempts to hold $14 that failed in the past three months. If you tried to buy on the intraday break, you would have been stuck with a losing trade:

Oasis Petroleum Inc. (NYSE:OAS): Oasis is another name that popped at the open, only to endure a steady sell-off as the day progresses. A hold of $34 is crucial to keep this stock’s momentum intact:

Network Engines Inc. (NASDAQ:NEI): Here’s an interesting microcap to keep an eye on. A big jump from $1 to $1.25 to start the year might be weighing on shares right now. The stock consolidated for more than a week, and shares are now eying strong resistance at $1.30. I would recommend waiting for more convincing evidence that this stock is primed for another run. Look for a volume spike to coincide with any swing to the upside. If the volume confirmation isn’t there, stay away from this one:

Penny Promotions

[Editor’s note: In this section of Market Movers, we expose stocks that are currently the subject of promotional material. If you’re unfamiliar with promotions, pumps and dumps, or other penny stock scams, please take the time to read this column before continuing. Unless you are an experienced trader, we recommend that you avoid these stocks at any price.]

Stevia Corp. (OTC:STEV): Stevia has been pumped before in print mailers — and now I’m seeing the stock make yet another monster move — 150% in just 2 days. I haven’t seen the new promotional material for this go-round, but I’m all but certain Stevia shares aren’t moving that far, that fast all on their own. I would not be surprised to see this stock back below $1 in short order…

North Springs Resources Corp. (OTC:NSRS): If I never see this ticker again, it will be too soon. During the first two and a half weeks of 2012, my spam filter has nabbed countless NSRS promotions. It feels as if every pumper in the country has been assigned this stock — and they’re going to make sure the company gets its money’s worth.

Unfortunately, I don’t think this stock is going to go quietly into the night. Judging by how the chart is setting up, I’m guessing that this could be a longer-term pump — much like we saw from Jammin Java Corp. (OTC:JAMN) early last year. We’re probably in store for multiple shakeouts and re-pumps, culminating in one devastating drop. But that’s just a guess. It’s impossible to know exactly what the manipulators have in mind, which is what makes stocks like this so dangerous to trade.

Sincerely,

Greg Guenthner
for The Penny Sleuth

Today’s Market Movers: FSL, OAS, NEI, STEV, NSRS was originally featured in the Penny Sleuth.

It’s true that volatility measurements remain well above historic averages. However, the volatile action that has plagued stocks and baffled traders over the past 6 months could subside at some point this year. That means market conditions could become much more favorable to traders. Clearer entry and exit points will materialize when higher periods of volatility subsides — and fewer whipsaws will force traders to cut early losses.

Unless you’ve been living under a rock for the last year, you’ve probably noticed the huge volatility that’s been shoving the stock market in one direction then the other. What you may not have realized is the fact that individual investors aren’t the only ones affected: “…traders who used to profit from price swings are struggling as record stock market volatility shows no signs of abating,” read a recent article in Bloomberg Businessweek.

While the final numbers have yet to roll in, hedge funds are looking to post their second-worst year in history after volatility has knocked around a number of high-profile funds. Victims include John Paulson, who made $5 billion in 2008 by betting against the housing market, and Duke Buchan, whose billion-dollar hedge fund is shutting its doors after coming into the year ahead of stocks by 46% in the last decade. No one has been immune from 2011’s wild ride.

Quite frankly, I haven’t been immune from the volatility either. While my premium trading service’s portfolio booked an average closed gain of 5.39% held over 20.2 days in 2011, that performance number came in well shy of the 19.27% average gain we took home in 2010. While it’s great to beat most investors, it’s still frustrating to trade in this sort of environment.

And it looks like that will remain the case for the time being…

The chart above shows the Bollinger Bandwidth for the S&P 500 — this indicator is a statistical measure of volatility that’s a much less biased measure than popular volatility measures like the VIX. Bandwidth has been inflated lately, rising to a nearly three-year high as recently as mid-September, and remaining above its historical average now. For that reason, it makes sense to expect volatility to remain a factor.

But there is a silver lining to the volatility story we’re seeing right now. You see, market volatility is cyclical — in other words, markets oscillate from periods of high volatility to periods of low volatility.

Looking at the bandwidth chart, it’s clear that volatility has been on the downswing since those September highs.

As a result, I think that we’ll see a return to more normal levels of volatility at some point this year. Although we’ve only seen a handful of trading days in 2012, volatility is already measurably lower. Because of the abrupt drop in volatility, it’s quite possible that a volatility squeeze could pop price action back into swing mode in the near term.

As a trader, you should be watching indicators like Bollinger Bandwidth, not the calendar, to signal calmer waters in 2012. While most high-end charting packages let you apply the indicator, free services like StockCharts.com also enable investors to take a look at the market’s Bollinger Bandwidth with just a few clicks of a mouse.

If volatility does indeed subside in the near future, you should have a much easier time identifying a variety of promising trade setups.

Cheers,

Jonas Elmerraji
for The Penny Sleuth

Why Stock Trading Could Get Easier This Year… was originally featured in the Penny Sleuth.

Indecision reigns over the equity universe for now. But behind the scenes, stocks appear to be cooking up a plan to continue the positive momentum…

Industrials, Transports Confirm

In Dow Theory, an uptrending market is confirmed when both the Dow Jones Industrial Average and the Dow Jones Transportation Average each post higher highs. The thinking behind this signal is very simple: If the economy is supporting the production of new goods, and these goods are being delivered to consumers, the basic requirements for a bull market exist.

Strong closes in the industrials and transports yesterday easily best the two indexes’ October highs:

Even the Worst Performers Are Enjoying Gains

Even a stock that no one wanted at any price — Netflix Inc. (NASDAQ:NFLX) — has enjoyed a rebound since the calendar changed over to 2012. Shares have risen more than 30% since Jan. 3:

The early January rally truly has been a rising tide. Toxic stocks from December are once again in vogue (at least for now). It will be interesting to see if the new trends continue — or if these small rallies become just another wishful moment on the road to lower prices…

Pharma Predictions Already Coming True

Over the weekend, Bristol-Myers Squibb said it would pay $2.5 billion for Inhibitex, a promising small-cap biopharma heavily involved in groundbreaking Hepatitis C treatments. The $2.5 billion buy price is a huge premium for the small company, netting shareholders a quick gain of more than 125%:

In late December, I predicted that the pharmaceutical sector would outshine the market this year.

The telling statistic is that by 2016, patents are set to expire for many of the best-selling drugs on the market, totaling $255 billion in annual sales. Generics will reap the benefits, and major drug labels will be scrambling to put their cash to good use.

I expect to see several more small-cap and mid-cap pharma acquisitions during the first half of 2012…

In the meantime, we’re seeing sympathy movers from similar small-cap biotechs. Two additional small-cap hepatitis C drug developers, Idenix Pharmaceuticals Inc. (NASDAQ:IDIX) and Achillion Pharmaceuticals Inc. (NASDAQ:ACHN) both popped double-digits on the news. Other potential small-cap acquisition targets are seeing generous gains as speculators position themselves for short-term trading opportunities…

Sincerely,

Greg Guenthner
for The Penny Sleuth

Today’s Market Movers: Indexes Push Higher, Plus: NFLX, IDIX was originally featured in the Penny Sleuth.

The world of finance isn’t much different. Late December and early January is the only time of year when the financial media makes a serious attempt to look beyond the daily ups and downs of the market, instead offering serious-sounding predictions related to the fate of stocks, bonds and commodities. The predictions will be short lived. Rarely will we see a follow-up — and the regular programming of relentless play-by-plays and reports of daily market action will continue.

But right now, we can learn a lot by dissecting the 2012 forecasts. Of course, by this I do not mean following the consensus recommendations. Instead, we can use the analysis to give us a better feel of how sentiment might shape the market this year.

Bloomberg keeps track of forecasts from 12 top strategists, and notes that on average, these analysts are expecting the S&P 500 to rise to 1,348 by the end of this year. According to Bloomberg’s records, it’s the smallest predicted return in 7 years. A Morgan Stanley analyst with the most accurate 2011 prediction sees the market losing more than 7% in 2012, thanks to the continuing European debt crisis and high volatility.

Even professionals who possess a more bullish outlook — citing strong profits and positive economic data — say they are not encouraging clients to buy just yet. In fact, according to an Investment News survey, only a little more than 43% of financial advisers plan on increasing their clients’ exposure to U.S. stocks this year, compared to more than 63% who were looking to U.S. stocks for gains at the beginning of 2011.

By now, you should see how it’s all shaping up. The bears are obviously out of equities or short, while those making any sort of bullish argument are on the sidelines. Despite their bullishness, the optimists still feel that lower prices — and consequently, better entry points — are on the horizon. These attitudes certainly make sense right now. The market has battered bulls and bears alike since the August meltdown. At some level, everyone has been burned by this market, and no one is anxious to jump back in for fear of getting burned for a fourth or fifth time.

So what does it all mean? For now, we might see more of the same, choppy action we’ve come to expect. In fact, Tuesday’s action in the S&P looks a lot like other recent rallies: a strong push at the open, followed by a slow fade. Selling on strength could continue to dominate in the near future. But down the line, I see the possibility for a monster fear rally. What I mean by this is the possibility of one small spark igniting a buying frenzy…

The ingredients are already in place: Big money is underexposed to the long side and corporate profits have been strong. If the S&P can manage a convincing move higher, we could see panic buying form those worried that they could be missing out on a big move. That’s the kind of action that can jump start a significant push higher.

Of course, this scenario is not set in stone. Furthermore, it is not wise to take a contrarian position just because it exists (in our example, the potential for going long in anticipation of a panic-buying rally). There has to be a tipping point of sorts — when the consensus opinion becomes so overwhelmingly bearish that there is no one left to extend the downward trend. A small rally creates short covering, then short-squeezes, which lead to bigger rallies, snowballing into a significant upside move. Look back no further than the early October 2011 bottom for a perfect example:

Discovering this inflection point is a nuanced game at best. And for the record, I don’t think we’re near this point just yet. Look at the recent upside breakout in the S&P. While stocks aren’t totally in the clear just yet, we are seeing a few moves in the right direction. Yes, deficit politics and the eurozone will still play a large role in the market’s direction and volatility for the time being.

But I will be looking for signs of a potential rally in the near future. In these market conditions, we cannot risk anticipating big moves like the scenario I’ve explained above. We simply have to be ready to react once the market gives us the signal — and the S&P breaking above its October highs would be a satisfactory start.

Sincerely,

Greg Guenthner
for The Penny Sleuth

2012: What You Need to Look For Before Your Next Buy… was originally featured in the Penny Sleuth.