Today I want to focus on the relationship between small cap stocks and the overall market. I like to see small cap stocks take the lead, as it tells me investors are increasing their risk appetite and is a good sign for the longevity of a rally. I have used price level support/resistance and relative strength between the IWM and SPY to get a good gauge on price action during the past several months.

On August 15, I noted that the IWM/SPY relative strength line was trading near multi-year support area, presenting a good buying opportunity. Fortunately, during the next month the IWM rallied more than 8 percent. On September 12, I once again discussed how the IWM/SPY relative-strength line was trading near upper channel resistance. In addition, I noted that the IWM was trading below major price-level resistance. The market rallied for a few days, but ultimately declined more than 9% during the next two months.

Well, after rallying from the November low, there has been a critical development in this relationship that nobody is talking about. As you can see in the IWM/SPY relative strength chart below, we have finally seen a breakout above the upper channel resistance line. This is a very encouraging sign.

Taking a look at the IWM chart below, I see a couple interesting things. IWM was just rejected by resistance near the $84 area, but there has been another major development. On November 29, IWM broke above a descending trend line, which also coincided with former price resistance near the $81 area. From a short-term perspective, it is trading near $82, which was the site of a congestion area during the past couple weeks. Aggressive traders may look to enter here, but a retest of the $81 level is still a definite possibility.

So, what’s the bottom line? Taking into consideration price support just below and the key development on the relative strength chart, I think IWM could be a nice buying opportunity over the next month or two.