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May 15, 2008

When Will Small Cap Turnaround Situations be a Buy?
by Henry To

May 11, 2008

Dear Subscribers,

Let us begin our commentary with a review of our 7 most recent signals in our DJIA Timing System:

1st signal entered: 50% long position on September 7, 2006 at 11,385;

2nd signal entered: Additional 50% long position on September 25, 2006 at 11,505;

3rd signal entered: 100% long position SOLD on May 8, 2007 at 13,299, giving us gains of 1,914 and 1,794 points, respectively.

4th signal entered: 50% short position on October 4, 2007 at 13,956;

5th signal entered: 50% short position COVERED on January 9, 2008 at 12,630, giving us a gain of 1,326 points.

6th signal entered: 50% long position on January 9, 2008 at 12,630, giving us a gain of 115.88 points as of last week at the close.

7th signal entered: Additional 50% long position on January 22, 2008 at 11,715, giving us a gain of 1,030.88 points as of last week at the close.

In our commentary from last week, we discussed the historical outperformance of small cap value stocks - and why, even with the advent of computers and quantitative methods designed to take advantage of this historical "anomaly," the long-term outperformance of small cap value stocks over small cap growth, large cap growth, and large cap value stocks should persist over the long-run. That being said, small cap value stocks have also tended to underperform by a significant margin in a general deleveraging environment such as what is now transpiring. Quoting last weekend's commentary:

Where's my opinion on this? Unless scientists can manipulate our genes that trigger emotional reactions to short-term and ultimately insignificant events, human nature will not change. That is, I believe small cap value stocks will continue to outperform small cap growth and large cap strategies over the long run. As I mentioned in our April 17, 2008 commentary, however subscribers will need to be cautious about value stocks (in particular small cap value stocks) over the next 12 to 18 months, as a general deleveraging environment has tended to hit small cap and value stocks the hardest. It is not a coincidence that the last time small cap value stocks underperformed two years in a row was in the deleveraging environment during 1990 to 1991. Furthermore, the long-term outperformance of small cap value stocks has also been well documented coming into this small cap value bull market. As the small cap value bull market matured over the last five years, many institutional investors (many of whom have traditionally ignored this asset class) also made a significant jump into this asset class - thus eliminating a significant part of its undervaluation versus small cap growth, large cap value, and large cap growth stocks. Bottom line: I expect a significant buying opportunity in small cap value stocks sometime over the next 12 to 18 months - but given that we are still in a general deleveraging environment, I also expect small cap value stocks to under perform at least for the rest of this year (homebuilders and newspaper publishers come into mind).

The most recent underperformance of small cap value stocks was also documented in Bill Rempel's recent guest commentary ("A Simple Small-Cap Value Screen"), which shows a significant drawdown of his various small cap value screens vs. the S&P 500 going back to April to May 2007. This is also the latest views of the Bank Credit Analyst. Quoting their May 8, 2008 daily commentary:

The recent bout of small cap outperformance has been primarily driven by the relative weakness in large cap bank shares, due to their outsized sub-prime-related write-downs. However, this drag should diminish going forward since the bulk of the losses have been disclosed. Moreover, bank lending standards could stay restrictive for some time to come as banks work to stem the rise in non-performing loans. Tightening lending standards have historically weighed on small cap relative performance vs. large caps, given the riskier credit profiles of small firms and the ability of large firms to secure financing from global sources. Meanwhile, sluggish domestic demand growth, persistent house price deflation and a weakening dollar continue to point to a relatively bleak operating environment for small companies. Bottom line: Stay underweight small versus large caps.

Following is the chart courtesy of BCA showing the relative performance of the S&P 600 vs. the S&P 500 and the now tightening standards for small business commercial and industrial loans:

Not only are larger firms generally able to secure financing from global sources, they are also generally more connected to Wall Street and the U.S. government, possess more financial talent, and are usually given "the benefit of the doubt" by investors - the latter of which generally allows them to raise much-needed capital even if the situation has become very dire. Moreover, many of the larger firms within the S&P 1500 derive a significant portion of their sales from overseas markets - thus cushioning the latest economic drag on domestic sales that began in the third quarter of last year - a luxury that many small cap firms simply do not have. Following is a representative list of U.S. headquartered companies that derive a substantial portion of their sales in overseas markets, courtesy of Davis Funds and Morningstar:

So Henry, assuming that small cap value stocks will continue to underperform for the foreseeable future, when do you expect the asset class to turnaround and significant overperform?

My initial timeframe of 12 to 18 months still stand. Make no mistake: Liquidity is still relatively strict despite a Fed Funds rate of 2.0%, as exemplified by the following:

1. Essentially zero growth in the St. Louis Adjusted Monetary Base on a year-over-year basis. While the Fed has reliquified a substantial part of the financial sector by swapping Treasuries for riskier assets such as AAA private label mortgage-backed securities and AAA credit card backed securities, it has been concurrently removing primary liquidity by selling U.S. Treasuries. In other words, a Fed Funds rate of 2.0% is still not low enough to induce the creation of primary liquidity.

2. Continuing write-offs from commercial banks and primary brokers, coupled with the fact that many commercial and investment banks are still stuck with about $90 billion of leveraged loans and $800 billion of subprime and alt-A loans on their balance sheets (hedge funds and private equity funds are only willing to buy these at significantly higher discounts). While banks are still actively trying to get rid of these loans from their balance sheets, they have only been able to do so very slowly. Unless housing prices start to stabilize or until the government create a RTC-like institution to take over some of these loans, these loans will remain on the banks' balance sheets - thus continuing to be a drag on liquidity creation.

3. One of the major creators of secondary liquidity over the past few years - the asset-backed commercial paper market - is still effectively shut, as shown in the following chart courtesy of the Federal Reserve. Note that the total amount of asset-backed commercial paper outstanding is now at a low not seen since 2005.

4. The near-total breakdown in the asset-backed security market is also being confirmed by the lack of worldwide ABS issuance on a YTD basis. As shown on the following chart courtesy of www.abalert.com, worldwide ABS issuance is now down by more than 50% relative to levels achieved this time last year. This dramatic decline in ABS issuance is mainly due to the effective shutdown in the home equity loan market (the asset-backed market for credit card loans is still relatively strong) - a market which has added a significant amount of liquidity to U.S. households over the last four years.

Given that general liquidity still remains tight - and given that this will disproportionally impact small cap companies (in particular small cap companies that could be potential "turnaround plays") and marginal households, my sense is that we won't see a bottom in the shares of many small cap value companies or small cap turnaround situations until: 1) we see a spike in Chapter 7 or Chapter 11 bankruptcies, 2) A further decline in many small cap value stocks, in particular homebuilders, small cap consumer finance companies, and small cap newspaper publishing companies, and 3) some kind of stabilization in U.S. housing prices over the horizon. While these could all occur sometime this year, my sense is that this will not occur until the second quarter of 2009 at the earliest. Make no mistake: If one could time this right, this could be one of the best buying situations for small cap value stocks since October 1990.

More follows for subscribers...

Henry K. To, CFA
MarketThoughts.com

Henry To, CFA, is co-founder and partner of the economic advisory firm, MarketThoughts LLC, an advisor to the hedge fund Independence Partners, LP. Marketthoughts.com is a service provided by MarkertThoughts LLC, and provides a twice-a-week commentary designed to educate subscribers about the stock market and the economy beyond the headlines. This commentary usually involves focusing on the fundamentals and technicals of the current stock market, but may also include individual sector and stock analyses - as well as more general investing topics such as the Dow Theory, investing psychology, and financial history.

In January 2000, Henry To, CFA of MarketThoughts LLC alerted his friends and associates about the huge risks created by the historic speculative environment in both the domestic and the international stock markets. Through a series of correspondence and e-mails during January to early April 2000, he discussed his reasons and the implications of this historic mania, and suggested that the best solution was to sell all the technology stocks in ones portfolio. He also alerted his friends and associates about the possible ending of the bear market in gold later in 2000, and suggested that it was the best time to accumulate gold mining stocks with both the Philadelphia Gold and Silver Mining Index and the American Exchange Gold Bugs Index at a value of 40 (today, the value of those indices are at approximately 110 and 240, respectively).Readers who are interested in a 30-day trial of our commentaries can find out more information from our MarketThoughts subscription page.

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