In this week's Monday Morning Outlook, I posited that: "If this rally indeed proves to have legs, I believe the small caps will begin to dominate once again, particularly with the 800 level [on the Russell 2000 Index] overcome. And my guess is the hedge funds have regurgitated a big chunk of their small cap exposure during the recent turmoil, which means [Russell 2000] investors might have a lot of fun while the hedgies scramble to re-establish their positions or risk losing even more ground to the S&P bogie."

I keep coming back to the 800 level on the Russell 2000 Index (RUT - 812.83), as I really do believe it is the most important level in the entire spectrum of broad-market indices.

On the series of charts below, note how this century level was resistance until the February 2006 rally, and how the break in July led to a huge plunge. Also observe how every rally since that first break has terminated at or very near 800, often followed by immediate plunges. Up until Tuesday's revisit of the 800 mark, it looked like we were finally seeing a break of this pattern.

How the Russell 2000 acts with respect to this level has got to be a critical piece of the "where does the market go from here?" puzzle. The fact that it finished above 800 during Tuesday's pullback was quite a relief. The next challenge for the index is its 80-day and 160-day moving averages, which the RUT is attempting to overtake in today's trading.

Also, I think a truly healthy rally off the August bottom that will be strong enough to drive to new highs needs to be led by the smaller caps, especially given the overwhelming consensus out there that "safety" is where investors should want to be. That said, I would not like to see the RUT's daily relative-strength measure versus the S&P 500 Index (SPX - 1,530.15) take out its early-August low.

Copyright Schaeffer's Investment Research http://www.schaeffersresearch.com

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