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Russell 2000 performance in the first half of 2011 has matched that of the S&P 500 perfectly, with both indices rising slightly more than 2%. This is an acceptable if unremarkable number, yielding an annual return well under 5%. Despite this lockstep behavior, world events predict that small-caps will outperform blue chips from now into year's end, so the actual return may exceed current expectations, perhaps significantly.

Logically speaking, the tight correlation between these divergent indices makes little sense, because small-caps should lag badly in a weak U.S. dollar environment, which favors the S&P 500's currency-sensitive international operations. But that hasn't been the case in the first six months of 2011, so we need to look elsewhere to understand this unexpected alignment.

Of course, the answer lies in the risk-on/risk-off trade that became the dominant hedge-fund play after the implementation of QE2. Dollar downswings since that time have generated buying pressure across the entire spectrum of U.S. equities, tossing small- and big-caps into the same basket. On the flip side, dollar bounces have triggered massive sell programs that dump equities like hot potatoes and park cash into fixed income.

This derivative-driven convergence has defied the typical role of small-caps as risk-appetite instruments, drawing in speculative capital from investors who are seeking out higher-than-average returns. Fortunately, it looks like this correlative strategy is finally coming to an end, with commodities taking the long, slow ride to lower ground while market players refocus their attention on economic issues and individual stock plays.

Dollar Index Daily Source: eSignal

In addition, currency fluctuations should underpin small-caps in the second half of the year, because the U.S. Dollar Index (DX0) is undergoing a long-term bottoming process. That instrument hit a new low for the decade in 2008 and then bounced strongly. The recovery attempt stalled under five-year resistance in the low 90s, yielding a lower high and deep retracement that found support just above the bear market low.

Last year's bounce also failed to print a higher high, ending near 88 and giving way to a sharp decline that triggered the risk-on/risk-off trade. However, the instrument has now returned to support at the 2009 low, spending the last two months grinding out a basing pattern. Although recent price action shows little upside, it favors an eventual turnaround and rally that challenges the two-year high.

This uptrend should initiate a virtuous cycle for small-cap stocks that carries into the first quarter of 2012. Realistically, though, it's unlikely that battle-weary investors will step forward and bid up the Russell 2000 components until a nervous world eases the throttle off the continuous crisis mode we've been stuck in since the Japanese earthquake more than three months ago.

However, it isn't too early to put together a watch list of small-cap favorites that could shine brightly in the second half of the year. To assist you in that noble task, I've run a set of proprietary scans on my Russell-2000 database and pulled up three top prospects that should perform well, even in a tough market environment.

CPHD Daily Source: eSignal



is a Silicon Valley-based molecular diagnostics company that focuses on genetic and biothreat testing. It sold off from $33 to $5 during the bear market, turning higher in March 2009. The recovery returned to the high in May of this year, with price dropping into a tight consolidation pattern that yielded a breakout to an all-time high earlier this week.

The stock is now consolidating at new support between $32 and $33. Accumulation has a strongly bullish tone, with many clusters of buying pressure, interspersed with orderly selloffs that posted lower-than-average participation. Once price stabilizes near the current price zone, look for a steady uptrend that lifts this superior small-cap into the $50s.

MSTR Daily Source: eSignal


(MSTR) - Get Report

, a Virginia software provider, was a tech bubble darling that fell from grace at the start of the millennium, dropping in a pre-reverse split decline from $3,330 to $4. It bounced to $133 at the height of the last bull market, returning to that level in March of this year and entering a rising channel pattern that yielded a high volume breakout last week.

The stock is trading at a 10-year high after a five-day vertical rally. It's short-term overbought and needs to rest, so I don't think it's wise to chase the upside. Instead, sit back and wait for an orderly pullback to the red line near $150. That price level should mark an excellent buying opportunity, ahead of an uptrend that could hit $180 in coming weeks.

TRCR Daily Source: eSignal


Transcend Services

( TRCR) converts physician voice recordings into electronic medical record documents. It peaked in $25.08 in 2007 and entered a decline that bottomed out in single digits one year later. The stock returned to three-year resistance in March of this year and broke out in May, lifting to a 14-year high at $28.45 earlier this week.

The bullish volume pattern shows a steady stream of buying interest and very little profit-taking. This is a good sign that predicts even higher prices. The company is also in the right business at the right time, with the medical industry undergoing a digital revolution. As a result, look for this uptrend to continue in coming months, with a longer-term target at the 1996 high above $60.

Please note that due to factors including low market capitalization and/or insufficient public float, we consider TRCR to be a small-cap stock. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.

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

Alan Farley is a private trader and publisher of

Hard Right Edge

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

The Daily Swing Trade

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





Tech Week


Active Trader




Technical Investor


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. He has written two books:

The Master Swing Trader


The Master Swing Trader Toolkit: The Market Survival Guide

, 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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