Five Small-Caps for Early 2007

This column was originally published on RealMoney on Dec. 12 at 12:05 p.m. EST. It's being republished as a bonus for TheStreet.com readers. For more information about subscribing to RealMoney, please click here.

Small-cap stocks pose unique risks often not anticipated by many traders and investors. These lesser-known plays can zoom higher under the right conditions because there are fewer tradeable shares in the marketplace. But they can also crash back to earth quickly after weak earnings or contrary news that undermines their success story.

Here's a case in point. Nuvelo (NUVO) shares fell 80% Monday (see chart below) after Nuvelo reported that clinical trials of its experimental drug alfimeprase failed to hit predetermined targets. This company is a one-trick biotech pony with a market capitalization of just $214 million. Obviously, its entire operation rested on this single pharmaceutical.

Of course, everyone wants to own the next Google (GOOG), and these small-caps give us the perfect opportunity to get in on the ground floor of emerging trends. But sadly, most of these companies will never blossom into full-blown blue-chip giants. So choose your sector plays very wisely and apply market-timing techniques to guard your risk.

On Monday I explored the likelihood of a traditional January small-cap rally and examined several trading vehicles that readers might use to benefit from that event. Today I'll follow up with a review of five small-cap stocks that could move substantially higher in the early months of 2007.

THQ Inc. (THQI) has enjoyed a great bull run this year and shows considerable upside for 2007. The stock rallied back to five-year resistance in January and sold off. It returned to this level in April and August but was knocked lower on both occasions. Price finally stabilized at $25 and completed a major breakout in mid-September.

The stock then dropped into a two-month consolidation pattern just above new support at $28. It cleared this congestion just two weeks ago and is again trading at an all-time high. The back-and-fill action above the breakout level should now support a stable rally that carries price up through $40 in the first quarter of next year.

GulfMark Offshore (GMRK) is an oil services stock that rallied into its December 2005 high in October. After pausing there for a week, it broke out on strong volume and is now starting to pull back after a five-point run. With a little luck, the stock will drop into a test at breakout support near $35 where interested parties can enter low-risk long positions.

This small-cap shows a more bullish pattern than most blue-chip names in the oil services sector. That predicts it can move higher even if crude oil and natural gas prices falter in upcoming months. The key for this stock will be its ability to hold above new support. That would set up the right conditions for a follow-through rally up to 50 bucks.

Bon-Ton Stores (BONT) hit an all-time high at $34.14 in March, then pulled back in a deep correction where it found support near $20 and started a slow recovery. The stock returned to resistance in October and just kept on going. The rally stalled out at $38.60 about two weeks later, with price dropping into a broad sideways pattern that is still in place.

I'm encouraged by this stock's ability to trade up to its 52-week high despite growing anxiety about retail weakness during this holiday season. The short-term pattern now shows a bullish consolidation that should yield a breakout in coming weeks. That move could carry price into the mid-$40s early next year.

Alexion Pharmaceuticals (ALXN) rallied to a five-year high at $39.82 in March and pulled back, finding support at the 200-day moving average and starting a slow recovery. The stock returned to resistance in October, broke out one month later and topped out at $45.73. It's been grinding sideways in a consolidation pattern for the last three weeks.

This is a bullish pattern that predicts an eventual follow-through rally that takes out last month's high. But the stock might need more time before resuming its strong uptrend. A selloff to breakout support and the 50-day moving average would flush out weak-handed buyers and present a low-risk entry opportunity.

Innovative Solutions (ISSC) sold off hard after rallying to an all-time high at $26.13 in May 2005. It finally bottomed out one year later and started a weak bounce. The stock now shows a 15-month bowl pattern with solid accumulation off the lows. This predicts the downtrend has now ended and the stock will begin an extended recovery.

This is an interesting setup with excellent upside potential. The bowl pattern is very stable and should offer solid support on any pullback into the mid-teens. Buying pressure spiked considerably last week, confirming that longs are getting more aggressive with new positions. Look for this stock to rally up and over $20 in coming weeks.

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