Russell 2000 outpaces large-cap indices

Small-cap stocks wasted no time validating Friday’s big breakout move, scorching the bears with back-to-back big gains as the inflation picture brightened and the U.S. dollar remained in rally mode. The Russell 2000 (NYSE:IWM) closed up 16.76, or 2.28% at 751.06, notching consecutive daily gains of more than 2% for the first time all year.

Small caps were noticeably strong relative to other large-cap index products, with the percentage gain in the Russell more than double what was generated in the Nasdaq 100, S&P 500 or Dow. “I think small caps are strong relative to other products amid asset shifts. The drop in commodities and investors warming up to equities is helping the small-cap sector,” Nick Kalivas, vice president, financial research with MF Global, told SmallCapInvestor.com in an email interview.

“The action in the small cap sector is a positive for the entire market. I also think that overseas growth is looking relatively weak and this may be causing investors to feel more comfortable with small caps since large corporations have more international exposure,” Kalivas said.

Crude oil prices slumped once again Monday, slipping some $0.75 a barrel toward $114.45 as concerns about global demand overwhelmed jitters about the Russia/Georgia conflict potentially hampering transport. Commodity inflation has been slashed in recent weeks, with crude oil down more than 20% from the highs; today that chorus played out in the metals markets, with silver tumbling 4%, gold off 4% and even copper down 1%.

“I think the drop in commodities helped the market rally today and that some investors are feeling the need to be invested basis the drop in raw material costs. The drop in crude has become more believable and has forced money into the market,” Kalivas said.

Part of that story in commodities is closely tied to action in the U.S. dollar, as most commodity markets are priced in dollar terms (crude oil included) and when the greenback strengthens, demand and pricing structure for commodities can slip. During today’s action, the dollar remained on a serious roll against the euro, surging another 0.7%, or some 100 basis points, to the highest level since late February. The dollar was down a touch vs. the yen, but has room for a breather consolidation after scampering to 7-month highs last week.

Money flow clearly favored equities. In addition to the slide in energy and metals, the yield on the benchmark 10-year Treasury note jumped nearly 2%. There is a growing sense among traders that a stronger tone in the U.S. dollar will attract foreign investment in stocks and also outflow from “safe-haven” types of investments like bonds and notes. At the same time, the supposed unraveling of the long commodity/short dollar trade could also magnify shifts in those markets.

Retailer shares were on the rise Monday, continuing to bask in the glow of slumping energy costs, which they hope will transpire to consumer dollars spent in the store instead of at the gas pump. The S&P Retail Index jumped 4.5%, and among broad market sectors, Internet retail, department stores, general merchandise stores and specialty stores were among the best performers. Other sectors showing gains today included tire and rubber and home improvement. Investors shunned commodity themes, with coal, gold, steel and metals all taking a beating.

Individual small-caps of note included U.S. Concrete Inc. (Nasdaq:RMIX), which rallied 22%. Willis Lease Finance Corp. (Nasdaq:WLFC), jumped 22% on solid earnings news and Beazer Homes USA Inc. (NYSE:BZH) was up 20%, also tied to earnings results. On the downside, Airvana Inc. (Nasdaq:AIRV) shed 14% and Cardiome Pharma Corp. (Nasdaq:CRME) was off 20%.

Looking to Tuesday’s session, the international trade report in the morning ahead of the stock market open could be of interest to equity traders. Although this data often sparks a big response in foreign exchange trading, it seldom captures much attention in stocks, but with the recent focus on the U.S. dollar the release will likely be watched. It’s worth noting that the recent rally in small-caps has been highly correlated with the rally in the U.S. dollar, but momentum readings in FX markets are at extreme levels into Tuesday’s trade data.

From a charting perspective, the Russell basically filled the upside target on Friday’s breakout through key resistance at 726. The measuring target of that breakout was 32 handles, which corresponded to 758 and the market stalled out today just above 757. Still, momentum is clearly with the bulls, and the market now eyes a retest of the early June peak around 763. On the downside, it would take a slide back below 726 to suggest that this latest leg up was nothing but a huge false move; on a more realistic short-term basis, support is at 742 and 734.