Hello again, Sleuths,

In my last Technical Tuesday column, I promised to discuss how you can use the Chicago Board of Options Exchange (CBOE) Volatility Index, more commonly known as the VIX, to gain an additional advantage in your trading or investing pursuits. I’ll do that in the near future.

But since today is not a Tuesday, and since the market has engaged in some pretty volatile gyrations over the past several weeks, I thought this would be a good time to stop and take the market’s temperature. That’s among the most important benefits that technical analysis can bestow upon you — to let you know what the current trend is and what action is likely to give you the greatest chance of success.

I think we’re at a very interesting juncture in the market right now. We had a bullish first third of the year, with all of the major indexes scoring solid gains. That was followed by a severe sell-off that began in early May and lasted throughout nearly all of June. That sell-off wiped out most, and in some cases all, of the hard won profits earned in 2006’s first four months.

Suddenly, stocks began to climb late in the day on Wednesday of last week — and followed through with a monster gain the next day. Then, just a few days later, equities suddenly turned tail yesterday and dropped dramatically, erasing a sizeable chunk of the week-old rally.

So where are we, and what should we be looking to do in the days and weeks ahead? As always, to try and answer these questions I took out my technical toolbox and began searching for some clues.

As you are undoubtedly aware, all of the stock market averages do not move in lockstep with one another. So, no one broad-based market index is going to be completely representative of every segment of the stock universe.

Nevertheless, since you Sleuthers are small-cap aficionados, I decided to put the Russell 2000 Index (RUT) under the technical microscope and try to determine where the small-cap market most likely is headed from here. In other words, is this a good time to buy the dips, or does it make more sense to sell the rallies?

After looking at the daily chart of the Russell 2000 Index, I believe this is a good time to use rallies to raise cash and trim back your positions. Keep in mind, if you’re a long-term investor I’m not suggesting you liquidate your core holdings.

And if you have established positions in some small-cap stocks recommended by one or more of my Agora Financial colleagues and fellow Sleuth columnists — like James Boric in his Small-Cap Strategy Report or Jonathan Kolber in his Emerging Capital Report — you might want to act in accordance with their long-term focus.

But in general, the technical condition of the Russell 2000 Index suggests that the small-cap market contains some risk over the short-term. Let me tell you why…

After topping out at 784.62 on May 5, the Russell 2000 plunged 14.6% in less than six weeks, eventually registering a low of 669.88 on June 14. That drop temporarily pulled the Index below 2005’s closing price of 673.22. Over the past three weeks, the RUT has attempted to regain its footing, rallying back 9% to Monday’s closing high of 730.80.

Unfortunately, that rally only reclaimed a bit more than half the losses sustained over the prior six weeks. And although that rally catapulted the Russell 2000 back above its key 50- and 200-day moving averages, yesterday’s nasty sell-off put the Index back below its 50-day line, after only a one-day respite.

The Russell 2000’s ability to quickly move back above its 50-day average is critical to the success of this attempted rally. That’s because that important intermediate average provided the RUT with key support on five separate occasions once the Index commenced its late 2005 rally last autumn and moved above its 50-day moving average in early November.

There’s a belief among market technicians that once support levels are breached, they begin to act as resistance. Only time will tell if the Russell’s 50-day moving average will turn out to be a significant barrier to its ascent, or merely a minor blip on the road to higher prices.

And what if the Russell 2000 Index is able to conquer is 50-day benchmark? Is the way all clear to a test of the May 5 high? I don’t believe so.

You see, another significant hurdle lies only a short distance above last Monday’s 730.80 interim high. If you look at a daily chart of the RUT, you will see that the 740-745 price-level looms large.  That’s where the Index stalled out on June 2 in its first recovery attempt after notching its May 5 high. That’s also the area where the Index successfully found support for the final time at its 50-day moving average — on April 11 — in the run up to its May 5 high.

Since that price area has acted as both support and resistance at different times in recent months, it takes on particular significance. And if that level is not penetrated soon, it will mean that the peak in the latest rally — whether completed last Monday or not — will mark the Russell 2000’s second consecutive lower high since reaching its zenith two months ago. When you couple those two lower highs with the two consecutive lower lows already registered on May 24 at 696.06 and on June 14 at 669.88, you have an index trading in a clear downtrend.

I have other reasons I think the Russell 2000 Index will have a tough time decisively penetrating the 740-745 area. Permit me to briefly share two of them with you.

First, the rally over the last three weeks has pushed the Slow Stochastics well into overbought territory. And it remains solidly overbought despite Wednesday’s 1.5% drop.

Now, just because the Slow Stochastics is overbought does not mean the Index cannot trade higher. It can. But the Slow Stochastics became overbought relatively quickly. And it did so without the 14-day Relative Strength Index becoming overbought. That suggests — at a minimum — that the RUT remains vulnerable to a deeper pullback than what we witnessed yesterday.

The second reason for skepticism is that a move to 740.79 would mark a 61.8% Fibonacci retracement of the entire decline from 784.62 to 669.88. I won’t go into a discussion of Fibonacci numbers here. However, let me just mention that 61.8 is one of the most important — and frequent — percentage moves that both market averages and individual stocks make.

While it is certainly possible the RUT could continue to rally — and soon put in a new high — with so many signs pointing to substantial overhead resistance lurking around 740-745, not to mention the 50-day moving average residing at last Monday’s high, odds favor a retreat back to at least its 200-day moving average. More likely, I would expect to see a retest of the June 14 low before a more meaningful uptrend takes hold.

If the above scenario plays out, a smart strategy would be to use any rallies to trim back on some of your positions. I think there will likely be a better time to aggressively shop for new small-cap stock purchases later this year. After all, the saying is “sell in May and go away,” right?

Trade well,

Mark Bail
July 05, 2006

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