With the market still running wild, and where stocks will finish out the year anything but clear, it’s time to take a look at why right now is a critical time for stocks. Here’s everything you need to know…

We’ve said it before, and we’ll continue to say it — small caps consistently lead the way out of periods of recession. But while penny stocks generally outperform the rest of the market as a class, they rarely move against it.

In effect, small caps are a lot like gain multipliers. When a major broad-based index like the S&P 500 gains 1%, small-cap stocks in our portfolio could see gains of 3%. And when the market slips, our tumbles are equally magnified.

There’s no better example of the correlation between small stocks and the market than October 2008. As stock markets all over the world shed trillions of dollars in value, more volatile small stocks took some of the biggest knocks — regardless of their fundamental soundness as investments.

And when the market began to rebound back in March, the small caps were racking up the biggest gains…

It’s that strong correlation between small stocks and the broad market that makes knowing the market’s movements so significant. And with investors riding an emotional roller coaster in October and November 2009, now’s a particularly important time to check in with what stocks are doing as a group.

When it comes to aggregate market moves, there are two main factors to consider: fundamentals and technicals.

Fundamentals include economic metrics like unemployment and retail sales, whereas technical analysis looks at trends and patterns in price charts to determine where stocks are headed. Put simply, fundamentals look at the actual health of the stocks, while technicals look at the perceived health of the market.

And while we generally focus on a stock’s fundamentals, when it’s time to look at a broad market index like the S&P 500, technicals can be invaluable in helping us determine where prices are headed…

Here’s a chart of the S&P 500 since April…

In the chart, those vertical gray and black bars — known as candlesticks — represent the price movements of the S&P 500 on any given trading day. The gray lines are the average value of the S&P over the trailing 200 and 50 days, respectively, known as moving averages.

There are a lot of factors that make fundamental analysis work — too many to go into in this issue — but the key things that we’re going to talk about today are support, the price level that stocks have trouble falling below, and resistance, the price level that stocks have trouble pushing above.

Looking at the S&P 500 chart above, the stock has been in an uptrending channel (defined by the thick black lines) for some time now. That’s a good sign because it means that the market is obedient to the channel right now — it should continue to trade within that range until some catalyst prompts a reversal.

It also means that we have a somewhat predictable range of movement that we expect the S&P 500 to move within. Depending on its direction, a break through the thick black lines of the channel would send a strong signal to either buy or sell.

But with the market’s movements still predictable right now, we can make a couple of projections for the near term. For starters, if the last two price cycles are any indication of the S&P’s trend, we should see the current upswing last until the last week or so of November, hitting around 1,150 before turning back for another two-week down cycle.

That down cycle is nothing to worry about as long as the index bounces back up off the black lines for the fifth time since August. That’s most likely going to happen in the early days of December.

There’s no question that our small-cap positions are affected by the movements of the market at large. But while many investors look at the market’s movements as random price swings, we’re going to continue to take an analytical stance by looking at the technical indicators that stocks are exhibiting right now.

Things continue to look strong in the market for the rest of the month. We’ll monitor the indexes closely and alert you to any significant changes.

Cheers,
Jonas Elmerraji

November 18, 2009

Jonas Elmerraji

A big-four public accounting alum, Jonas Elmerraji brings his readers extensive expertise in small-cap stocks and broad market moves. Elmerraji’s interest in the market started with an investing course in elementary school – today he holds a degree in financial economics from UMBC and specializes in blending fundamental and technical analysis. Elmerraji has contributed to Forbes, TheStreet.com, and Investors Business Daily among others. He is managing editor of the Penny Momentum Trader, and a co-editor of Penny Stock Fortunes.

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