• 253 days Will The ECB Continue To Hike Rates?
  • 253 days Forbes: Aramco Remains Largest Company In The Middle East
  • 255 days Caltech Scientists Succesfully Beam Back Solar Power From Space
  • 655 days Could Crypto Overtake Traditional Investment?
  • 660 days Americans Still Quitting Jobs At Record Pace
  • 662 days FinTech Startups Tapping VC Money for ‘Immigrant Banking’
  • 665 days Is The Dollar Too Strong?
  • 665 days Big Tech Disappoints Investors on Earnings Calls
  • 666 days Fear And Celebration On Twitter as Musk Takes The Reins
  • 668 days China Is Quietly Trying To Distance Itself From Russia
  • 668 days Tech and Internet Giants’ Earnings In Focus After Netflix’s Stinker
  • 672 days Crypto Investors Won Big In 2021
  • 672 days The ‘Metaverse’ Economy Could be Worth $13 Trillion By 2030
  • 673 days Food Prices Are Skyrocketing As Putin’s War Persists
  • 675 days Pentagon Resignations Illustrate Our ‘Commercial’ Defense Dilemma
  • 676 days US Banks Shrug off Nearly $15 Billion In Russian Write-Offs
  • 679 days Cannabis Stocks in Holding Pattern Despite Positive Momentum
  • 680 days Is Musk A Bastion Of Free Speech Or Will His Absolutist Stance Backfire?
  • 680 days Two ETFs That Could Hedge Against Extreme Market Volatility
  • 682 days Are NFTs About To Take Over Gaming?
Strong U.S. Dollar Weighs On Blue Chip Earnings

Strong U.S. Dollar Weighs On Blue Chip Earnings

Earnings season is well underway,…

Zombie Foreclosures On The Rise In The U.S.

Zombie Foreclosures On The Rise In The U.S.

During the quarter there were…

How Millennials Are Reshaping Real Estate

How Millennials Are Reshaping Real Estate

The real estate market is…

  1. Home
  2. Markets
  3. Other

Small Caps Are a "Sell"

Dear Subscribers,

I know, it is the Super Bowl today. But since many of our subscribers are from overseas and may not be interested in American football, there is no good reason to not write a full-fledged commentary for this weekend! On the contrary - given the current technicals of the stock market, the extreme complacency of Wall Street, and the many geopolitical events that are happening around us as we speak, it is even more important for us to keep track of these events while the rest of the U.S. population is focusing on the Super Bowl.

Here is an interesting thought that should be dear to the hearts of most of our readers: In our discussion of Capital vs. Labor in both our commentaries and in our discussion forum, we remarked that the tides may be changing in the age-old conflict of capital vs. labor. We also conjectured, ironically, that the bankruptcy of the airliners and Delphi - and the subsequent concessions given by unions such as the UAW may represent the high point of capital power - at least for this cycle.

However, such a conjecture may be too simplistic in its approach. No study of labor union history is complete without a study of the Homestead Strike of 1892. After the strike was crushed by Henry Clay Frick and Andrew Carnegie, steel workers' unions did not rise again until the 1930s. While the latest blow to the UAW did not result in any loss of lives, one can just as quickly make a case that unions are getting more irrelevant by the day and will cease to exist in the United States labor market sometime in the foreseeable future. Indeed, union membership declined from more than a third of the labor force in the 1950s to only 12.5% today. Interestingly, half of all the unionized labor force works for the government. Readers who know more about this subject than I do or who want to express their opinions can do so at our discussion forum.

We switched from a 25% short position in our DJIA Timing System on the morning of October 21st at DJIA 10,265 - giving us a gain of 351 points from our DJIA short on July 14th. On a 25% basis, this equates to a gain of 87.75 points. We switched to a 25% short position in our DJIA Timing System shortly after noon on Wednesday at DJIA 10,840. We then switched to a 50% short position (our maximum allowable short position in order to control for volatility in our DJIA Timing System) on Thursday afternoon at DJIA 10,900 - thus giving us an average entry of DJIA 10,870. As of the close on Friday (10,793.62), our position is 76.38 points in the black - and at this point, we believe that the correction in the stock market is not over yet.

Our mid-cycle slowdown scenario continues to remain in effect. In our January 8th commentary "Identifying Risks in the Upcoming Year," one of our chief concerns for 2006 is the extreme lack of complacency in the emerging markets - as characterized by the record low emerging market spreads we have witnessed since the beginning of January. Despite having a fanatic as a dictator and despite rampant corruption and purchase of firearms, S&P has just upgraded Venezuelan government bonds - primarily based on the assumption that both crude oil and foreign currency reserves will continue to remain at current elevated levels. Make no mistake: When Venezuelan bonds are trading at only a 230 basis point premium to U.S. Treasuries - with Russian bonds at a 100 basis point premium (which in 1998 famously defaulted on all their debt) and Iraqi 22-year bonds at a 400 basis point premium (this author highly doubts that Iraq will exist in its current form 22 years from now), there is really no other way to label emerging markets other than a "bubble" and there is no other way to label investment sentiment other than as "extreme complacency."

Of course, much of this money flows into emerging markets has also to do with the ever-continuing quest for "yield" or "alpha." Readers who have paid attention in the last few weeks should know by now that the hedge fund industry has just seen its first quarterly outflow in a decade. Make no mistake: Many hedge funds out there are getting desperate in the quest for yield - and many of these hedge fund players (especially the younger ones who have not experienced a downturn in emerging markets before) are willing to take on a lot more risk in order to get extra, incremental returns. Whatever the reason is, history has dictated that this extreme complacency and lack of respect for risk will always end in tears. While borrowing US$ at a Fed Funds rate of 4.5% in order to buy your Macedonian bonds denominated in US$ (which has a near-zero spread over U.S. Treasuries) still sounded profitable a month ago, that is no longer the case - given that we now officially have an inverted yield curve. Given that the ECB is also set to hike rates at least twice this year, readers should now be extremely careful with investing in emerging market assets. Of course, there is still potentially the "Yen carry trade" but given that the Yen is now hugely undervalued and given the historical upside volatility in the Yen (think Fall 1998 when the Yen appreciated over 10% in one day), managers must be crazy to borrow in Yen to invest in anything non-Yen denominated - period.

This "quest for alpha" is also no longer confined to hedge funds. In recent weeks, there has also been a historical surge into commodities and emerging market securities by pension and endowment funds alike. Quoting from a Bloomberg article:

Investment funds which track commodities are attracting more money after commodities outpaced gains in equities and bonds in 2005. Fund investments in commodities will soar almost 50 percent to $120 billion this year, Standard Bank in London said in a report yesterday. The increase is coming from pension and mutual funds, rather than hedge funds, analysts said.

"In recent months we have seen a whole different type of fund come in," said Angus MacMillan, an analyst at Bache Financial in London. "Myself and a number of my colleagues who have been in this business for years have never seen anything like this."

Given this extreme lack of respect for risk - as well as a mid-cycle slowdown in the U.S., our scenario for continuing disappointing economic growth in Western Europe in 2006, and a 90% chance of another rate hike by the U.S. Fed on March 28th, there is a good chance we will see some kind of emerging market crisis or a collapse in commodity prices sometime in 2006 (note that if copper is to decline by 50% from current levels, it will still be at where they were in the summer of 2004). Interestingly, the annualized growth rate of the ECRI Future Inflation Gauge for January popped back up to 3.9% - suggesting more rate hikes in the weeks ahead unless the housing market slows down significantly or unless the prices of precious and base metals collapse in the next couple of months.

This lack of respect for risk has also manifested itself in the performance of U.S. domestic small and mid caps. As we outlined in last weekend's commentary, small caps, in general, have outperformed large caps by 135% from 1999 to 2004 (2005 figures will be released in March per Ibbotson Associates). Moreover, valuations are nothing to write him about either - given that the 12-month trailing P/E ratio of the S&P 600 is now 20% greater than that of the S&P 500. To recap what I stated about small caps from last weekend's commentary:

Subscribers should note that small cap out-performance tend to end when one of two things (or both) occurs:

  1. Small cap out-performance tends to end after a sustained period where small caps outperformed large caps. Okay, this is rather obvious - but please note that from 1999 to 2004, the cumulative returns of small caps beat that of large caps by 135%. While this percentage is just slightly above the average of those during the last 70 years, it is definitely nothing to scoff at, and given that the duration of small cap out-performance is also slightly above the average of 5.13 years, small cap investors should be very careful here.

  2. Small caps also tend to significantly under-perform large caps during periods of liquidity squeezes or in the face of external economic shocks. Such memorable years include 1929, 1930, 1937, 1973, 1990, and 1998. This is not surprising - as the businesses and balance sheets of smaller companies tend to fare worse during liquidity squeezes.

Given the fact that small caps have out-performed large caps for a total period of six consecutive years from 1999 to 2004, and given that global liquidity is declining as we speak, this author is not exactly thrilled with investing in small cap funds over the next few years. Moreover, it should be noted here that small cap sentiment among retail investors is also extremely bullish - given that mutual fund inflows to small cap funds have been extraordinary over the last few years. In fact, not only have investors been pouring their cash into small cap funds, but they have also been liquidating their large cap holdings in order to purchase small cap funds!

The position of this author does not change from that of last week's. That is, this author is now very bearish on small caps in general - especially given that the series of rate hikes by the Federal Reserve is set to continue until late March or even mid May to late June. In fact, there is a good chance that the small cap bull market has now topped out. Let's now take a look at a couple of charts.

The first chart chronicles the daily action of the Russell 2000 from January 2003 to the present - as well as the daily percentage deviation from its 50-day and 200-day simple moving averages:

Daily Russell 2000 Closing Values vs. its % Deviation from its 50 and 200 DMAs (January 2003 to February 3, 2006) - The percentage deviation of the Russell 2000 from its 200 DMA got to as high as 12.24% on February 1st - comparable to the overbought level witnessed in late 2004 and 2% higher than the level we saw in early August 2005.

Note that the percentage deviation of the Russell 2000 from its 200-day moving average rose to as high as 12.24% two trading days ago - which is only comparable to the level we last witnessed in late December 2004 (and we all know what happened afterwards) and a full 2% higher than the overbought level we witnessed in August 2005. Given the deteriorating fundamental background for equities and in particular small cap equities (as we outlined above), there is now a good chance that small caps (as represented by the Russell 2000) have now made a significant top.

The deteriorating technicals of the small caps can also be witnessed in the McClellan Oscillator and Summation Index for the S&P 600. Following is a three-year chart showing the action of the S&P 600 vs. the McClellan Oscillator and Summation Index of the S&P 600 courtesy of Decisionpoint.com (unfortunately, the McClellan Oscillator for the Russell 2000 is not available):

Three-year chart showing the action of the S&P 600 vs. the McClellan Oscillator and Summation Index of the S&P 600

As mentioned on the above chart, the McClellan Summation Index for the S&P 600 has experienced a series of lower highs in the last 14 months. More importantly, the Summation Index is now at an overbought level and should be encountering stiff resistance - the more so given that the McClellan Oscillator itself has turned negative (-22.92) in the last two trading days. Most likely, the Summation Index has now reversed from an overbought level - and combined with deteriorating fundamentals for U.S. small caps, there is a good chance that the Russell 2000 and the S&P 600 may have made a significant top here.

That being said, subscribers who are good at stock selection should not be deterred from investing in small caps going forward - since, in the case of investing in small caps, stock selection is really the key. Precisely because of this, subscribers who are investing in individual small caps should at least have 10 to 15 stocks (and in different industries) in his portfolio in order to properly diversify his portfolio.

Speaking of stock selection within the realm of small caps, following is a chart that may be of use to most of our subscribers. 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 definitely 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 2004 (note that LG = large cap growth, SG = small cap growth, LV = large cap value, and SV = small cap value):

More follows for subscribers...

Back to homepage

Leave a comment

Leave a comment