The One Group That Can Rescue This Tape

The major indices jumped higher last week, raising hopes of an August-style recovery. But the broad pattern doesn't favor a quick follow-through rally.

First, the selloff never dipped into the summer lows or triggered a capitulation event. Second, except for the Nasdaq 100 (NDX), the major averages haven't carved out stable bases or double bottoms.

Let's take an in-depth look at the variety of possibilities for the major indices through year-end, and there are a number of them, and then discuss the group I believe is necessary to push the market forward: the small-caps.

After the initial burst off the summer low, the S&P 500 spent over three weeks consolidating its gains before embarking on a rally back to the 2007 high. It's silly to assume a faster run this time around, given the extensive technical damage done in October and November.

The broad market faces two key December dates. The first comes on Dec. 11, when the Federal Reserve issues its next interest rate decision. The second arrives 11 days later with triple-witching options expiration. The market needs to finish its rally business by this second date, because money managers lock in annual numbers during that period.

That leaves just 15 trading days for the market to consolidate last week's rally and use available buying power to paint up the year-end numbers. Since a V-shaped recovery seems outlandish given the brutal downtrend in financial stocks, this leaves just one logical conclusion: The bulk of rally gains have already been booked, at least until 2008.

It looks like the market will price in the next rate cut ahead of the Fed meeting, given the telegraphing commentary from Bernanke and Co. last week. Friday's divergent action gave us the first wave of that discounting mechanism, but it sure won't be the last. We can expect the next two weeks to revolve around hopes and pitfalls tied to that key event.

The most likely outcome between now and then will be volatile, sideways-to-higher action that adds another 1%-3% to the major averages, but at a price. The tape will a lot more dangerous than last week's easy rally run, with sharp dips and spikes shaking out overnight positions.

We saw the beginnings of this testing process with Research In Motion (RIMM - commentary - Cramer's Take) on Friday. The session started well for the market leader, with price opening at a two-week high. A skeptical Piper Jaffrey report, issued before the open, miraculously caught traders' attention, and the stock dropped 9 points in two hours.

The selloff filled Wednesday's gap and dropped price toward a key test at 50-day moving-average support. This is routine action after a vertical run off big lows, but a growing consensus had big tech stocks charging back to 2007 highs with little or no effort. In my mind, Friday's selloff was a warning shot, telling us to lower unrealistic expectations.

This price action might be a blueprint for the broad market in the next three weeks. The technicals were sharply oversold when the rally began on Tuesday. Weak-handed short-sellers have been decimated since that time, while beaten-down bulls have mustered up the courage to re-enter positions. That has put the tape back into an uneasy state of balance.

Sharp dips and overnight recoveries from now into Christmas would follow the August blueprint, possibly setting up a broader-scale recovery in January. But I have my doubts, because stocks and indices took a real beating last month. That rout predicts more pain and testing before price resolves itself, with a cleansing rally or historic decline.

The monthly S&P 500 Depository Receipts (SPY - commentary - Cramer's Take) from the late 1990s shows this year's wicked tape as a test of the 2000 highs that remains unresolved. In fact, the entire year has carved out a triangle pattern that might continue for another six to nine months. Perhaps that's a good thing given the uncertainty about financial balance sheets across the globe.

A sideways track would give the market more time to tally up its credit-related losses, while it waits for the mortgage and housing markets to bottom out. This would support a benign outcome compared to the financial apocalypse outlined ad nauseum by Doug Kass. In any case, the yearly view tells us the bear market has been put on hold for now.

How do we make money until the market resolves long-term direction? That will be challenging, because capital needs to chase leadership that outperforms when the major indices get stuck in the mud. This brings big tech to mind, as usual, but Friday's reversal tells us to avoid this overplayed group, because it has already run up too far, too fast.

Which leaves the market with a very big problem as we head into 2008. Flip through the broad variety of sector and capitalization performance. You'll find almost no emerging leadership, outside of recession-based defensive groups. Of course, we've had retracement rallies on former leaders, as well as downtrodden financials, but that isn't the same thing.

This vacuum indicates that big money is still betting on a recession or major slowdown in 2008. Hopefully, that will change as rate-cut fever builds ahead of the Dec. 11 meeting. But frankly, I believe just one corner of the market can rescue the tape in this mixed environment, and that's small-cap stocks.

Money flow into these speculative issues would mark a real change of heart by the folks that really count, i.e. funds and institutions. Small-cap accumulation would also signify their willingness to stop fretting about the economy and assume higher speculative risk. In turn, that healthy appetite could wake up the broad market and reignite the upside.

---

At the time of publication, Farley had no positions in the stocks mentioned, although holdings can change at any time.

Alan Farley is a professional trader and author of The Master Swing Trader. Farley also runs a Web site called HardRightEdge.com, an online resource for trading education, technical analysis and short-term investment strategies. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Farley appreciates your feedback; click here to send him an email. Also, click here to sign up for Farley's premium subscription product The Daily Swing Trade brought to you exclusively by TheStreet.com.

TheStreet.com has a revenue-sharing relationship with Trader's Library under which it receives a portion of the revenue from purchases by customers directed there from TheStreet.com.