The Russell 2000 has joined its large-cap brethren at new rally highs this week, but upside progress in this small-cap-centric instrument is likely to be sporadic in the first quarter, despite the seasonally favorable bias. This lagging performance could drag on the broader market as it attempts to regain price levels from 2007 and 2008.

This isn't to say I wouldn't buy individual small caps showing bullish patterns this month, especially where the red hot China plays are concerned. Rather, I think the group as a whole is headed into murky waters, perhaps weighed down by a relapse in the dollar as we discover the U.S. economy isn't as strong as many analysts now believe.

In fact, the commodity markets' recent resiliency, including precious metals and crude oil, suggests the dollar's December strength may have been an aberration ahead of a new wave that lifts the euro well above $1.50. Personally, that would break my heart, with a European trip coming up in March, but it makes sense given the turnaround we're seeing in related cross-markets.

As we know, small-cap stocks were held hostage to the dollar carry trade through 2009 because their domestic-focused revenue couldn't compete with multinational big caps. So, although the group has come roaring out of the gate in the new year, the good vibes might be short-lived. Sadly, there's support for this argument in the daily and weekly index charts.

The Russell 2000 weekly chart highlights the steep bear-market decline between 856 and 344. The index bottomed out in March of last year, then shot higher in a two-wave rally, with a 50% retracement of the entire decline in September. It then dropped into a corrective pattern, until this week's breakout to a fifteen-month high.

Note the index faced major resistance between 650 and 700. This price level marks the 62% retracement of the 2007-2009 decline, as well as the 78.6% retracement of the September 2008 to March 2009 decline. Now, take a look at what happened in October 2008 when the index dropped to the triple lows carved out between January and July of that year.

The index broke through that support level and dived, joining other market groups in the credit-driven crash. The recovery that began last March is now approaching this breakdown level, marking the third barrier converging in the relatively narrow band highlighted in the green box.

The current price-thrust also marks the fifth wave of the rally off the March low. In Elliott Wave lore, trends unfold over a total of five waves -- three in the direction of the primary trend and two opposing consolidative patterns. Once this wave structure is complete, the instrument is vulnerable to an opposing trend that can retrace at least 50% of the prior rally.

The overall pattern indicates the Russell 2000 will enter a steep correction by the second quarter, dropping as low as 500 to 550. For now, however, the index has just broken out and is enjoying its third and final rally wave. My advice, given the mixed dynamics, is to make hay while the sun shines, then get out of the way.

Hopefully, the index will rise into the more generous target, near 700, before the larger-scale reversal kicks in. Such a rally would fulfill a price move equal in length to the second primary wave, which unfolded between July and September. It would also roughly correspond with the slope of the higher lows in place for the past six months.

In any case, price action should give us ample warning before the small-cap rally ultimately fades into an extended correction. For now, I would continue to buy the sector until the 600 level is broken. Please note: That line in the sand is converging and aligning with the 50-day moving average and trend-line support.

To be truthful, my bearishness about small-cap stocks is in line with my equally cautious outlook on the major averages, which I believe will stall in the next few weeks, then spend a good part of 2010 consolidating last year's outsized gains. However, I don't intend to head for the caves early and miss whatever opportunities this early January market might offer.

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

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

Alan Farley is a private trader and publisher of

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, a comprehensive resource for trader education, technical analysis, and short-term trading techniques. He is also the author of

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. He has written two books:

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

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