Back From the Brink?

One trading week and more than 6% in gains — that’s all it takes to get investors excited about the markets again after two nonstop months of stocks giving back all the ground gained in 2011 and more.

The rally began more than a week ago as stocks surged from the brink of new lows to impressive gains just before the closing bell. Since that day, stocks have barely paused, recording gains in five of the past six trading sessions.

However, I will be the first to admit that I remain skeptical of this rally. As much as it has been exciting (and relieving) to see stocks recover some of their losses so quickly, my mind remains in bear-market mode. Anyone looking to go “all-in” right now — while the market is overextended in the short-term and the primary trend is in flux — does so at his own risk.

Here are three things I’ll need to see over the next several days…

Small stocks need to break downtrends — If you were perusing microcap charts recently, you probably noticed a lot of V-shaped bottoms. Many of the stocks in the small-cap and microcap trading universe have established sharp downtrends since the beginning of the market correction two months ago. Obviously, this makes for dangerous trading ground for those of us looking to go long. A sharp break to the downside could easily wipe out any gains most of these stocks have posted over the past week. I want to see clear, convincing breakouts from downtrends before going long here.

Also, keep in mind that most of the small stocks posting double-digit gains during the most recent rally have been benefiting from being scooped up off extremely oversold levels. This type of buying rarely lasts unless the stock clears significant resistance levels, and I don’t recommend latching on to these names in an attempt to play them as a momentum trade. The timing has to be perfect if you want to bank significant gains, and most of the plays are far too risky to warrant consideration for a swing trade.

The market needs to move higher on bad news — In particular, I would love to see stocks shrug off universally bad news out of Europe. If stocks can move higher when the headlines are negative, you can be close to certain that there has been a drastic change in market sentiment. After all, it’s easy to expect a rally when bullish news is flying across the wire. When market participants begin to “believe” that prices will move higher, there’s little that can stand in the way of the bulls.

The Russell 2000 has to hold its ground —

I like how the Russell has popped above its 50-day moving average. The small-cap index will need to either consolidate or move higher from here to convince us that the downward momentum has stalled