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Market could follow the small cap lead

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The stage seems set for more stock market gains, with small caps leading the way higher and volatility at a relative low.

The small-cap Russell 2000 hit a new all-time high Monday, while the VIX, a measure of market volatility, slid to a five month low of 11.84.

The Nasdaq joined the Russell as a standout, as the S&P 500 and Dow both slumped in lackluster trading. The Russell 2000 rose three points to a new high of 1063, and the Nasdaq, up 3, set a new 13-year high of 3692. Some analysts have been pointing to the Russell's gains, now up 25 percent for the year, as a sign of overheating, compared to 19 percent gains for the Dow and S&P.

"Small and mid-cap stocks have been leading the way," said Craig Johnson, senior technical strategist at Piper Jaffray. He said investors latching onto growth are jumping into the smaller names. "I don't know that the Russell has gone too far, too fast.

Tuesday will be one of the final busy days of the earnings season, with reports from such names as Disney, Michael Kors, and CVS Caremark.

(Read More: Stock market set to 'rip higher,' pro says)

While many strategists expect stocks to trend sideways for the rest of the month, Johnson joined the super-bullish camp Monday, pinning a high 1850 target on the S&P 500 by year end.

"I think this is another mile marker on the road to S&P 500 that we called for a year ago," said Johnson. Johnson said he had pegged 1556 and 1700 as objectives, and he has now set his sights on 1850, on the road to 2000.

"Ninety percent of our (industry) groups are above their 40-week moving average. The last time we were this high above it for this extended period of time was 1982, when rates peaked and the market took off," he said.

(Read More: Despite 'dull' market, stocks to go higher by year-end: Pros)

"The biggest challenges we're seeing is the fixed income world is the same as the year 2000 for equities," Johnson said, referencing the year stocks peaked in the tech bubble. Johnson said bond yields have bottomed, and he now expects them to rise, driving investors out of fixed income, and into equities.

He said stock valuations are still below median multiples. "We're starting to see money coming into this market. This does not feel like a market that's going down…It feels like a market that's going to get pushed higher by a flow of funds coming back to equities," said Johnson.

Traders Tuesday will be watching interest rates with a wary eye, as the Treasury auctions $32 billion 3-year notes at 1 p.m. Bonds sold off Monday, with the 10-year yield rising to 2.64 ahead of three auctions this week but rates are still well below the 2.75 percent hit last week. Treasurys also weakened on a better-than-expected ISM nonmanufacturing survey, which jumped to 56 from 52.2 in June, matching the signs of strength seen in manufacturing data last week.

(Read More: U.S. service sector growth jumps in July as new orders surge: ISM)

"It's all about taper. That's the next big news event. The news is going to be anything that you think impacts that decision," said Steve Massocca of Wedbush Securities. Therefore, comments from Chicago Fed President Charles Evans at 1 p.m. on the economy and monetary policy will be important. Tuesday is light on economic data, with international trade at 8:30 a.m. ET and job openings data at 10 a.m.

On Monday, Dallas Fed President Richard Fisher, a critic of the Fed's bond purchases, said the Fed is closer to execution mode now that unemployment has fallen to 7.4 percent. While his views are well known, any comments on when the Fed might reduce, or taper, its $85 billion a month bond purchases is key, since many traders are focused on the Fed's September meeting and believe that the Sept. 6 jobs report will be key to the Fed's thinking.

(Read More: S&P on the road to 2,000: Strategist)

Harvey Goldsmith, Treasury strategist at Cantor Fitzgerald, said the market is looking for more nuanced information. "It's the magnitude and timing of the tapering of QE. The fact of it is baked in the cake and reflected at these levels," he said.

Besides the 3-year notes, the Treasury auctions 10-year notes Wednesday and 30-year bonds Thursday. "I think auctions are always a big deal A bigger deal when the market feels kind of heavy, than when it feels elevated, and it feels kind of heavy at this point. I don't know if it will take any significant discount to where the market is to place this stuff," he said, adding rates are up sharply since the last auctions of these durations.

Before the bell, earnings are expected from Michael Kors, CVS Caremark, Molson Coors, Liberty Media, and ADM. Disney, Marathon Oil, Avis Budget, Zillow. 21st Century Fox, and Live Nation report after the close.

—By CNBC's Patti Domm. Follow here on Twitter @pattidomm.

  • Patti Domm

    Patti Domm is CNBC Executive Editor, News, responsible for news coverage of the markets and economy.

  • A CNBC reporter since 1990, Bob Pisani covers Wall Street from the floor of the New York Stock Exchange.

  • CNBC's Senior Personal Finance Correspondent

  • JeeYeon Park is a writer for CNBC.com. Follow her on Twitter: @JeeYeonParkCNBC

  • Rick Santelli joined CNBC Business News as an on-air editor in 1999, reporting live from the floor of the Chicago Board of Trade.

  • Senior Producer at CNBC's Breaking News Desk.