January's No 'Gimme' for Small-Caps

This column was originally published on RealMoney on Dec. 11 at 2:00 p.m. EST. It's being republished as a bonus for TheStreet.com readers. For more information about subscribing to RealMoney, please click here.

Market-watchers expect small-cap stocks to shine in January as investors clear out old winners and make room for more speculative issues.

But the sector has racked up a spotty first-quarter performance record in recent years.

So there are no guarantees these stocks will follow traditional wisdom and outperform their big-cap cousins early in 2007.

The Russell 2000 index rose dramatically in January and the first quarter of this year.

But this small-cap index fell hard a year earlier, posting a sharp decline in the first quarter of 2005.

Its 2004 performance matched traditional expectations, with a 6% gain in the first quarter, compared with the S&P 500's meager 1% rise.

The stakes are high as the markets move toward January 2007. Small-cap stocks lagged the broader indices in the early phases of the post-summer rally but have played a good game of catch-up in the fourth quarter. Despite the recovery, the Russell 2000 index is still struggling with the all-time high it printed in the second quarter of this year.

This is a major concern because the Dow Industrials, S&P 500 and Nasdaq indices all have cleared similar price levels by a wide margin. A failure by the Russell 2000 to move higher right here could have dire implications for the broader market, because its falling components might start a chain reaction.

Russell 2000 Index	January Gain/Loss	First-Quarter Gain/Loss
2004	4.30%	6.10%
2005	-4.10%	-5.50%
2006	8.90%	13.60%

The first sign of failure would be a sharp selloff that dropped the index back to its 50-day moving average, currently at 768. That decline would break the four-month trend line and encourage short-sellers to take aggressive positions on any bounce. But we're getting ahead of ourselves, because the index is still trading very well at the old high.

This bullish action favors an eventual rally that would carry the index up and through 800. The long-awaited move would confirm the breakout over the May high and set the stage for healthy small-cap performance in early 2007. In the meantime, let's wait for price action to tell us whether bulls or bears will have the advantage heading into January.

There are several ways to build small-cap exposure on either side of the market. The highly liquid iShares Russell 2000 Index Fund(IWM Quote) mimics index performance, step by step.

A better choice might be the iShares Russell 2000 Value Index Fund(IWN Quote), which includes components that have lower price-to-book ratios and lower forecast growth.

iShares Russell 2000 Value Index Fund is a long-side pick in The Daily Swing Trade. The ETF is outperforming the broader index by a wide margin, clearing its May high decisively in November. This relative strength places the stock in an excellent position to book higher percentage gains if the small-cap rally arrives on schedule next year.

Finding top-performing small-cap stocks is a job made tougher by the fact that January tends to be unkind to the prior year's biggest winners. Investors avoid selling highly profitable positions until January to manage capital gains on their tax filings. This phenomenon often triggers a sharp downdraft in the group's leadership stocks.

So we need to uncover small-cap stocks that have high reward potential but subdued relative performance. To this end, I pulled up the Russell 2000 components and sorted them by relative strength. First I tossed out all issues that were sitting at extreme highs. Then I examined their charts, looking for interesting ramping patterns and bullish accumulation.

Align Tech(ALGN Quote) leaped higher in late September after it settled longstanding patent litigation with a key competitor. The stock has held its price well in the last two months and currently trades just above the opening price on the breakout bar. The advancing uptrend is now approaching the October high at $15.33.

Look for upside momentum to escalate sharply once the stock clears that high. The chart shows little resistance from that level until the stock starts to approach the 2004 peak near $23. Small-cap strength in January could provide the spark for Align to rally strong into that reward target, where profits should be taken quickly.

Wet Seal(WTSLA Quote) shows excellent progress since the summer low at $4.18, and just rallied into multiyear resistance over $7. This is the third time since 2004 the stock has traded up to this key level. Buying pressure looks solid here, so the time may be ripe for a major breakout that reaches the midteens in the first quarter of 2007.

This single-digit stock could use a little help from bullish holiday sales reports that lift the entire sector. But that supportive data might not be forthcoming, as I noted in a recent column. However, the bullish technicals are undeniable at this point, so the breakout could happen in spite of shopping-mall weakness.

My Russell 2000 component review uncovered a big stack of small-cap stocks that fit my criteria for superior 2007 performance. But I've run out of space for now, so I'll take a close look at these potential winners in Tuesday's column.