Chip stocks

are getting ready to embark on a major recovery rally. This surprising bounce should be quite rewarding and lead to bullish calls that the group has finally bottomed out and is entering a new uptrend. But notable challenges remain for the sector in 2009, so as usual,

good market timing

will be needed to take advantage of the expected upside

Image placeholder title

In the meantime, buy signals may grow loud enough in coming weeks for this group to lead the world markets through the first half of next year. This contrary behavior makes sense because leadership after big downturns often comes from groups that were engaged in steep downtrends when stronger sectors rolled over and started to decline.

It's no secret that chip stocks have performed

far worse

than the major averages in recent years as competition grows and the world gets saturated with their high-tech products. But there comes a time when an adverse environment and diminishing value move into relative balance, and that might happen in the next six to 12 weeks.

In the meantime, interested investors can track the following charts to pick out strategies that match their risk tolerance. Just keep in mind that this remains a nervous, news-driven market and we may not have seen the bottom tick of the

sector decline

. But the turnaround should come, with early adapters profiting greatly from the big turn.

Semiconductor HOLDRs (SMH)

Click here for larger image.

Source: eSignal

The

Semiconductor HOLDRs

(SMH) - Get Report

ETF illustrates the opportunities and dangers for the sector in the next six to nine months. In review, the fund had been trading in a broad range between the upper $20s and lower $40s for more than four years before breaking down on heavy volume in September.

The plunge has now carried the instrument to an all-time low, partially because it didn't trade before 2000. Look at the structure of the selloff since May and you'll see a well-defined five-wave decline, with the last decline starting at $21 earlier this month. It looks like price is currently grinding through the fifth of five sub-waves in this leg down.

In Elliott terms, the fifth wave of a five-wave decline marks the terminal point for a decline and inception point of a countertrend rally that will retrace 38% to 50% of the prior selloff. So, if Friday's low marked the end of the broad selloff, retracement math would yield a bounce that lifts the fund to between $22 and $24.50, or a 45% to 60% rally.

In any case, it's unlikely the rally will exceed $26.50. First, that level marks the September breakdown from multiyear support. In most cases, it takes a very long time to overcome big broken trading ranges. Second, in the longer term, the fund and sector can take out 2008 support and drops into single digits.

The problem lies in the selloff that began in July 2007. The down wave from $41 to $26 is tied intimately into the subsequent decline beginning in May. Taken together, they point to a larger-scale five-wave decline, in which a bounce from now into the first quarter of 2009 will mark a countertrend fourth-wave rally ahead of a climactic fifth-wave selloff.

But for now, let's concentrate on potential profits from the countertrend rally. Of course, we can play this fund directly, or its many cousins, including the

iShares S&P GSTI Semiconductor Index Fund

(IGW)

and the

SPDR S&P Semiconductor

(XSD) - Get Report

ETF. Alternatively, here are three chip stocks that look poised to outperform the broad sector.

Broadcom (BRCM)

Click here for larger image.

Source: eSignal

Broadcom

(BRCM)

has emerged as a chip sector leader in

recent weeks

. It's still holding firmly above the October low, even though the majority of its peers have broken down.

The stock posted a bullish doji right at support last Friday and bounced strongly in Monday's session. This sets the stage for a potential double bottom ahead of a notable rally to long-term resistance in the low to mid-$20s.

Texas Instruments (TXN)

Click here for larger image.

Source: eSignal

Texas Instruments

(TXN) - Get Report

is an interesting choice for the expected rally because it's pulling into long-term support at the October 2002 low at $13.10. Resistance is sitting high in the daily pattern, up at $27.50, so a bounce might have substantial legs. The first buy signal will come when the stock rallies above $16 and breaks the six-month string of lower lows.

Nvidia (NVDA)

Click here for larger image.

Source: eSignal

Nvidia

(NVDA) - Get Report

shows a gnarly looking pattern, but overall price action suggests a more bullish tone than the majority of sector components. First, it's trading well above the lows posted in 2002 and 2004. Second, sizable buying interest has emerged after each attempt to take price under the Oct. 10 low at $6.81. Taken together, the stock could rally up to $14 during the recovery.

Alan Farley provides daily stock picks and commentary with his "Daily Swing Trade" newsletter.

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

Farley is also the author of

The Daily Swing Trade

, a premium product that outlines his charts and analysis. Farley has also been featured in

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,

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and

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. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks.

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