Wish Two Potent Rallies Would Spread

Surging small-caps and semis present a surprisingly sobering picture for the broader market.
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This column was originally published on RealMoney on Jan. 30 at 10:57 a.m. EST. It's being republished as a bonus for TheStreet.com readers.

Two market segments are acting much better than my recent expectations. I need to acknowledge their superior performance and update my outlook to include their considerable influence on the ticker tape.

First, small-cap stocks are on fire.

Second, semiconductors are grinding through their best bull run in several years. I no longer believe that either rally will top out at current levels.

The

iShares Russell 2000 Index Fund

(IWM) - Get Report

rallied into a two-year rising-highs trend line during options expiration and cut through it like butter last week.

This is a notable achievement that demands respect for two reasons.

First, multiyear resistance is hard to overcome. Second, rising trend lines are even harder to overcome.

This powerful breakout predicts the group is closer to the beginning of its rally than the end of it. That's quite a statement, given that the index has already risen more than 10% this month. But that's the nature of this type of bull move.

Of course, modern markets fail good-looking breakouts all the time, so I'll be watching the trend line to make sure the instrument holds support on any pullback into that level. But for now, I'd be an enthusiastic buyer if and when the fund trades down to $71.

Semiconductors have been a tough call because of

Intel's

(INTC) - Get Report

overriding influence on the broad sector. Over the years, I've tracked these stocks by following the

Semiconductor HOLDRs

(SMH) - Get Report

, rather than the Philadelphia Semiconductor Index, or SOX. My reasoning: The SMH is traded directly, so it more accurately displays supply and demand than its chip cousin.

But these two instruments aren't identical in nature, by any means. The SOX is comprised of 19 stocks, with components heavily weighted toward equipment names. The SMH is comprised of 20 stocks that are less heavily weighted toward equipment names. But the real difference lies in the methods their creators use to calculate daily values.

The SOX is a price-weighted index, while the SMH is a market cap-weighted exchange-traded fund. This variation didn't seem too important while Intel performance matched or beat industry numbers. But now the CPU powerhouse is falling apart and triggering major divergences in performance between the two instruments.

Just how much influence does Intel have in the index and ETF? Recently the stock weighed in at a staggering 21% of the SMH, while registering only a meager 3.7% in the SOX. I doubt this is what Merrill Lynch had in mind when it brought the ETF public in 2000. In fact, it could force Merrill to re-examine the SMH's weighting scheme.

Intel's influence becomes clearer from a look at the charts of these instruments. The SMH is bouncing off four-week lows after a sharp selloff that brought prices back to early December levels. The January high at $41 is significant, because it marks multiyear channel resistance I noted in a

November column.

The majority of market technicians would get tummy aches looking at this bearish chart, because it exposes obvious distribution off major resistance. But it's now clear that Intel's historic selloff is single-handedly pummeling the Semi HOLDRs. This becomes obvious after looking at the SOX index:

Note recent price action at the SOX's multiyear channel resistance. It broke out in early January, tested support twice and then leaped to new highs this week, after

Broadcom

(BRCM)

blew out quarterly numbers. This superior performance is in stark contrast to the deteriorating technicals on the SMH chart.

How far can the SOX move carry? At a minimum, the rally leg after the channel breakout should be equal in size to the recovery off the October 2005 low. This translates into a reward target above 610. More likely, the uptrend will continue and eventually reach the March 2002 recovery high at 641.

What do the potent small-cap and chip rallies tell us about the 2006 environment? Surprisingly, it presents a sobering picture. First, we're likely to grind through a stockpicker's market where blue-chip underperformance may continue indefinitely. Second, the three-year bull market probably can't survive unless blue-chips perk up and join the rally party.

Both small-caps and semiconductors show cyclical tendencies that suggest their rallies will run out of stream by the end of the first quarter. Blue-chips need to pick up the slack before this happens, or we'll step into a major mid-year decline. This isn't a bearish call as much as a conviction that sustainable uptrends are built on the back of broad participation.

But for now, let's enjoy the rally and make as much money as we can. With chip stocks signaling more upside in the weeks ahead, I'll offer my list of favorite sector picks in Tuesday's column.

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;

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