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Small Cap Value Stocks and the U.S. Dollar

May 4, 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 428.20 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 1,343.20 points as of last week at the close.

I finally received my 2008 copy of the Ibbotson SBBI Classic Yearbook on Saturday. This book is published by Morningstar (which had acquired Ibbotson) and is a must-read for market historians, especially for those who would like to get a better sense of where U.S. stock market returns ranged during the 19th century as well as how small cap growth and small cap value stocks performed prior to the inception of the Russell 2000 indices. One of my favorite data series is the annual returns of U.S. large cap value, large cap growth, small cap growth, and small cap value stocks from 1928 to the present. Besides the age-old question of small caps vs. large caps, the question of value vs. growth has also always been a difficult one. For readers who are just starting to invest in individual stocks, it is imperative to know the historical relationship and performance of large cap growth vs. large cap value vs. small cap growth, and vs. small cap value. Following is a chart (all data courtesy of Ibbotson Associates) showing the relationship and cumulative returns (with dividends reinvested) of these four different asset classes from 1928 to 2007 (note that LG = large cap growth, SG = small cap growth, LV = large cap value, and SV = small cap value):

Cumulative Returns of Large Caps vs. Small Caps - Source: Ibbotson Associates

Note that the above chart also shows the cumulative returns of one dollar invested in 1928 for the years preceding all the major small cap cycles (outperformance of small caps over large caps) over the last 50 years.

Moreover, over the last 80 years, small cap value stocks have outperformed the next best asset class - large cap value - by a factor of 6.4. The performance of small cap value stocks is even more impressive compared to small cap growth and large cap value, as its outperformance stretches further to a factor of 31.4 vs. small cap growth and a factor of 42.5 vs. large cap growth. In addition, small cap value has been the number one performer (on a cumulative basis) on this list since 1945, and had been the worst performing asset class among these four asset classes only on 10 separate occasions since 1928 - with the latest year being last year (and prior to that, 1998). Small caps have also had a tremendous run since 1998 - with a cumulative return of 204.1% vs. 77.1% for small cap growth, 45.4% for large cap value, and 27.3% for large cap growth.

While the "small cap effect" has been well documented and is well understood, the jury is still out on the "value effect," especially the "small cap value effect." Quoting the Ibbotson SBBI Yearbook:

Readers of Graham and Dodd's Security Analysis, first published in 1934, would say that the outperformance of value stocks is due to the market coming to realize the full value of a company's securities that were once undervalued. The Graham and Dodd approach to security analysis is to do an independent valuation of a company using accounting data and common market multiples, then look at the stock price to see if the stock is under- or overvalued. Several academic studies have shown that the market overreacts to bad news and under-reacts to good news. This would lead us to conclude that there is more room for value stocks (which are more likely to have reported bad news) to improve and outperform growth stocks, which already have high expectations built into them.

Possibly a larger question is what does the future hold as far as growth and value investing goes? Advocates of growth investing would argue that technology- and innovation-oriented companies will continue to dominate as the Internet changes the way the world communicates and does business. Stalwarts of value investing would argue that there are still companies and industries that continue to be ignored and represent long-term investment bargains. Only time will tell.

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).

Let us now get on with our commentary and discuss the U.S. Dollar Index. We last discussed the U.S. Dollar Index in our January 6, 2008 commentary ("Identifying Short and Long Term Trends for 2008 - Part II"). At the time, I had mentioned that while the decline in the U.S. Dollar Index was "getting long in the tooth," it definitely wasn't a buy just yet. Things have now changed - I am now bullish on the U.S. Dollar Index at least over the next couple of months, even though the bear market in the U.S. Dollar is probably not over just yet. Let us first take a look at the growth in foreign reserves held in the custody of the Federal Reserve. The growth in foreign reserves - while still high - has decelerated over the last few months, signaling that there may not be "enough U.S. Dollars" in the system. Indeed, with the initiation of additional swap lines to the European Central Bank and the Swiss Bank last Friday, the Fed is implying that there is a shortage of U.S. dollars Western Europe. At the heart of it is a classic USD carry trade but it is hard to pinpoint in what instruments. Many of these institutions may have borrowed in USD to buy subprime securities on leverage - which would have made sense when the Euro was appreciating and the Fed was lowering interest rates. Given that many European banks have still yet to realize subprime losses on their balance sheets, chances are that there will be a continuing demand for U.S. dollars to cover their subprime losses over the next few months. The corollary is that the USD should continue to gain strength.

For readers who have not been with us for long, we first discussed the high (negative) correlation between the change in the rate of growth in the amount of foreign assets (i.e. the second derivative) held in the custody of the Federal Reserve and the year-over-year return in the U.S. Dollar Index in our May 1, 2005 commentary. In that commentary, I stated:

Studies by GaveKal (which is one of the best investment advisory outfits out there) have shown that, historically, the return of the U.S. Dollar Index has been very much correlated with the growth in the amount of foreign assets (which is pretty much all U.S. dollar-denominated) held in the custody of the Federal Reserve. By my calculations, the correlation between the annual return of the U.S. Dollar Index and the annual growth of the amount of foreign assets held at the Federal Reserve banks (calculated monthly) is an astounding negative 61% during the period January 1981 to February 2005! That is, whenever, the rate of growth of foreign assets (primarily in the form of Treasury Securities) held at the Federal Reserve banks have decreased, the U.S. Dollar has almost always rallied. This is very logical, as an increasing growth of U.S. dollar-denominated assets mean an increasing growth of the supply of U.S. dollars - thus depressing its value.

Since our May 1, 2005 commentary, this inverse relationship has more or less has held. More importantly for us, the growth in foreign reserves has slowed down significantly over the last six months, as evident by the following monthly chart showing the annual change in the U.S. Dollar Index. vs. the annual change in the rate of growth (second derivative) in foreign reserves:

Annual Change in U.S. Dollar Index vs. Annual Change in Rate of Growth in Foreign Reserves (Monthly Chart) - The divergence between the annual change in the dollar index and the second derivative (rate of change) in foreign reserves is now getting *long in the tooth,* suggesting that the period of *maximum weakness* in the dollar is now over. Given that the fundamentals in the Euro Zone are now deteriorating, chances are we should now witness a significant bounce in the USD.

Please note that the second y-axis has been inverted. This is done in order to illustrate to our readers the significant negative correlation between the annual change in the dollar index and the annual change in the growth (second derivative) of foreign assets held at the Federal Reserve banks. Please note that aside from the decline in the growth of foreign reserves, the U.S. Dollar Index has also been declining - meaning that the divergence between the rate of growth in foreign reserves and the decline of the U.S. Dollar Index is now close to bouncing back. Assuming that foreign reserve growth continues to slow down in the weeks ahead (which it should given the current demand of U.S. dollars in the Euro Zone), I believe the U.S. Dollar Index should continue to strengthen in the next couple of months.

Another way to spot a good entry point on the U.S. Dollar Index is to keep track of its percentage deviation from its 200-day simple moving average. This is one of the major advantages of using an overbought/oversold indicator on a major currency - and especially the world's reserve currency - as major currencies usually do not gap up or down in a major way. That is, as along as there are no abnormal forces in the market place (such as Japanese housewives speculating on foreign currencies) - buying the dollar index when it is oversold (e.g. when it is trading at 5% below its 200-day moving average) has usually been a profitable endeavor, as long as one is not heavily leveraged. Following is a daily chart showing the U.S. Dollar index and its percentage deviation from it 200 DMA from December 1985 to the present:

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