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Small Caps Are a “Sell”

(February 5, 2006)

Dear Subscribers and Readers,

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 (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):

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

Over the last 67 years, small cap value stocks have outperformed the next best asset class – large cap value – by a factor of 7.7.  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 37.2 vs. small cap growth and a factor of 50.8 vs. large cap growth.  Moreover, small cap value has been the number one performer (on a cumulative basis) on this list since 1945, and has only been the worst performing asset class (among these four) on nine separate occasions since 1928 – with the latest year being 1998.  Small caps have also had a tremendous run since 1998 – with a cumulative return of 184.5% vs. 7.8% of large caps in general.

That being said, small cap value also tends to do very poorly in times of declining liquidity or in times of external economic shocks – and 2006 may turn out to be such a year, especially given the tremendous run we have seen since 1998.  While in the long-run small cap value may be a very sure bet, this author cannot say the same in the intermediate term.  Besides, even if small cap value stocks do not turn out to be the worst performer in 2006, it is by no means a guarantee that they will in general experience a positive return.  In fact, small cap value stocks in general have experienced a negative return in 22 out of the last 67 years – the last one being 2002.

Let's now end with a discussion of the most recent action in the stock market, including a discussion/update on the use of the Consumer Confidence Index (as compiled by the Conference Board) as a stock market contrarian indicator.  While things did start to look bleak for the bears early last week, the stock market came back down with a vengeance – on the heels of an earnings miss from Google and Amazon as well as a readjustment of rate hike expectations going forward.  Let's now take a look at the two popular Dow indices – with the following chart showing the most recent action of the Dow Industrials vs. the Dow Transports:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (July 1, 2003 to February 3, 2006) - Looking at this daily chart of the Dow Industrials vs. the Dow Transports, readers should focus on the big picture this week: That the Dow Industrials has been pretty much range-bound for the last two years. More importantly, the Dow Industrials has so far thus failed to confirm the all-time high on the Dow Transports - suggesting that this bull market is still in mortal danger. For the week ending February 3rd, the Dow Industrials declined 113 points while the Dow Transports declined 46 points. Whether the current downtrend is 'sustainble' we will find out in due time, but for now, we will continue to stay 50% short in our DJIA Timing System since the DJIA has been one of the weakest indices in this cyclical bull market.

In last weekend's commentary, I stated: “From a Dow Theory point of view, it should be noted here that the Dow Industrials still refuses to confirm the Dow Transports on the upside.  In fact, the Dow Industrials has been underperforming the Dow Transports since two years ago.  This is not a surprise, since we have been in a small and mid cap equity bull market since 1999 – but even in a small cap equity bull market, the large caps (and the Dow Industrials) should also be confirming on the upside by making all-time highs.  Moreover, it is interesting to note that the Dow Utilities made an all-time high in late October 2005 but have been struggling ever since.”

Again – at this point in the cyclical bull market – I would like our readers to focus on the big picture.  The big picture being that the Dow Industrials has been pretty much range-bound for the last two years, and that more importantly, the Dow Industrials has still so far failed to confirm the all-time high of the Dow Transports by bettering its January 14, 2000 closing high of 11,722.98.  Moreover, the Dow Utilities declined a further 2.6% in the latest week, even though bond prices enjoyed a nice reversal in Friday's trading action.  Given the fact the market is still not too oversold at this stage (the 10-day moving average of the NYSE ARMS Index is only at 1.08, while the 10-day moving average of the equity put/call ratio is still overbought with a reading of 0.57), my guess is that the major market indices (especially the small caps) will continue to decline in the weeks ahead.  Make no mistake: We are in dangerous territory.  And to top it all off, many analysts now have extremely divergent views on the market.  For example, Mr. John Mauldin of is now anticipating a new bear market to happen at any time now, while on the hand, TrimTabs believes that the S&P 500 will rise by 20% in the next six months.  For now, we are obviously bearish, but keep in mind that our models and indicators are always in flux.  That is, readers should just take it one day at a time.  Whatever happens in the next six months, the drama surrounding the action will definitely be very interesting.

As an aside, last week, I also stated the following regarding Google's then-upcoming earnings report on January 31st:  “This author's prediction: Google will disappoint no matter what earnings or guidance they give.  Historically, large cap growth stocks have nearly always under-performed – and it should be no different with Google, especially given that earnings estimates have been consistently revised upwards over the last few months and are now sitting at unprecedentedly high, unreachable levels.  Unless Google is added to the S&P 500, my guess is that Google will continue to underperform the general market over the next few months.”

This author does not mean to brag here.  Last week, we were able to get to make an 84-point profit on Google by short-selling the stock before earnings, covering in the after-hours market, and again short-selling the stock on Thursday right before the close.  When one of the best, leading stocks in this cyclical bull market starts acting so weak, it is definitely time to sit up and take notice.  Many analysts out there argue that we need to see a collapse in breadth before we can call for a significant top in this bull market – but given that both small and mid caps have been the leading performers in this cyclical bull market, this does not have to be the case. 

Let's now discuss our most popular sentiment indicators and start with the American Association of Individual Investors (AAII) Survey.  During the latest week, the Bulls-Bears% Differential in the AAII survey rose from a negative 2% reading back up to positive 12% – thus putting us once again back up to slightly oversold to neutral territory on a weekly basis.   However, it is more important to focus on the big picture, and thus the longer-term reading as exemplified by the ten-week moving average.  For the week, the ten-week moving average decreased from 19.9% to 17.0% - again suggesting that this survey (and thus, the stock market) is now solidly in a downtrend.  Following is the weekly chart showing the Bulls-Bears% Differential in the AAII Survey vs. the Dow Industrials from January 2003 to the present:

DJIA vs. Bulls-Bears% Differential in the AAII Survey (January 2003 to Present) - The Bulls-Bears% Differential in the AAII survey rose from negative 2% back to positive 12% in the latest week - which is a slightly oversold to neutral weekly reading. Meanwhile, the ten-week MA decreased from 19.9% to 17.0% in the latest week - suggesting that the AAII survey (and thus, the market) is now in a downtrend. For now, we will remain 50% in our DJIA Timing System until this survey gets to a more oversold area - which will most probably involve a ten-week moving average below 10%.

At this point, our longer-term indicator (the 10-week moving average) is still signaling for us to stay short – so for now, we will remain 50% short in our DJIA Timing System until the AAII survey “sells off” to an oversold area (which will most probably involve more weekly negative readings and a ten-week moving average at the 5% to 15% level).  If our sentiment or technical indicators sell off to a very oversold level in the short run (such as a daily NYSE ARMS Index level of over 2.5 or a NYSE McClellan Oscillator reading of below negative 200), then this author will not hesitate to cover half (25%) of our 50% short position in our DJIA Timing System – and reentering once the market gets back to a more neutral or overbought level.

The Bulls-Bears% Differential in the Investors Intelligence Survey has officially turned down last week, and this downtrend is further confirmed this week as the ten-week moving average again decreased from a reading of 34.0% to 33.6% in the latest week.  This reversal is doubly authoritative given that it is turning down from such an overbought level.  Meanwhile, the latest weekly reading declined slightly from 28.4% to 26.8%. Following is the weekly chart showing the Bulls-Bears% Differential in the Investors Intelligence Survey vs. the Dow Industrials:

DJIA vs. Bulls-Bears% Differential in the Investors Intelligence Survey (January 2003 to Present) - The Bulls-Bears% Differential in the Investors Intelligence Survey decreased slightly from 28.4% to 26.8% in the latest week. Meanwhile, the ten-week moving average decreased from 34.0% to 33.6% - suggesting that this survey (and thus the market) is now officially in a downtrend.  For now, we will remain 50% in our DJIA Timing System until this survey gets to a more oversold area - which will most probably involve a weekly reading at the 15% level (the readings of this survey should be interpreted different than those of the AAII survey.

Last week, I stated: “Coupled with the fact that the trend of the AAII survey has also turned down, there is a very good chance that the readings in the Investors Intelligence Survey will not reverse to the upside again until we start getting very oversold readings again.  For now, we remain comfortable with the 50% short position in our DJIA Timing System – especially given that the Dow Industrials has been one of the weakest indices since this cyclical bull market began in October 2002.”  As of Sunday evening, the position of this author remains the same – but like I have mentioned, this author will also not hesitate covering half of our short position in our DJIA Timing System should the market get very oversold in the short-run.  For now, we will again take it one day at a time.

Meanwhile, the Market Vane's Bullish Consensus again rose to a highly overbought level of 69% from 68% last week.  The ten-week moving average remained at 69.7% - the most overbought reading since August 1997.  At this point, this author believes that such an overbought reading in the Market Vane's Bullish Consensus is an indication that the market has or is making a significant top.  Following is the weekly chart showing the Market Vane's Bullish Consensus vs. the Dow Industrials:

DJIA vs. Market Vane's Bullish Consensus (January 2002 to Present) - Over the last week, the Market Vane's Bullish Consensus increased slightly from a 68% to another highly overbought reading of 69%. Our statement during the last few weeks remain the same: 'Such overbought readings cam only mean two things: That we are in the midst of a significant top or that the bull market will reassert itself in a powerful way. Again, the author is opting for the former.' This author still believes that we are in the midst of a significant top - readers should brace themselves for a possible correction in the next few months. Meanwhile, the ten-week MA remained steady at 69.7% - the most overbought reading since August 1997. For now, we will remain 50% short in our DJIA Timing System until our sentiment indicators decline to a sufficiently oversold level.

Given that all three of our popular sentiment indicators are now very overbought or have reversed from very overbought levels, we will remain 50% short in our DJIA Timing System until the readings of these surveys decline back to at least a moderately oversold level again. We will also switch back to a less aggressive 25% short position in our DJIA Timing System should the market get very oversold in the short-run (such as a daily NYSE ARMS Index reading of 2.5 or a NYSE McClellan Oscillator reading of less than negative 200).  At this point, the author still believes the market has yet to finish its downside correction and thus is very vulnerable to a multi-week decline.

The final sentiment indicator involves looking at the monthly Consumer Confidence Index as released by the Conference Board.  As we have noted in previous commentaries, the monthly readings of the Consumer Confidence Index has been a great contrarian indicator from a stock market standpoint, and my guess is that this time will be no different.  Interestingly, Consumer Confidence made a new cyclical bull market high at the end of last month – suggesting that consumers are still too optimistic about both the economy and the stock market at this point.  This does not bode well for the stock market in the weeks ahead.  Following is the monthly chart showing the historical relationship of the Consumer Confidence Index vs. the Dow Industrials:

Monthly Chart of Consumer Confidence vs. DJIA (January 1981 to January 2006) - After one of the biggest dips in history in October 2005 (which turned out to be a good buying opportunity), the Consumer Confidence Index bounced significantly during from November to January 2006 - bringing us again to the top of the range (actually a high not seen since May 2002) we have experienced in this cyclical bull market. While Consumer Confidence has had a better record in predicting bottoms, it has also had a pretty good track record in predicting tops. The current reading is screaming 'overbought' - this does not bode well for the stock market for the foreseeable future.

Conclusion: Given that small caps have significantly out-performed large caps since 1999 (135% from 1999 to 2004); given declining global liquidity; given that retail investors' sentiment on small caps are now at an extremely bullish level, and given the overbought condition and deteriorating technicals on small cap shares, my guess is that both the Russell 2000 and the S&P 600 have made a significant top.   Historically, small cap out-performance – just like stocks in general – have gone through phases of bull and bear markets, and this time should prove no different.  This author believes that the next buying opportunity will be in the large cap value, brand name stocks – which should occur sometime later this year or during 2007. 

For now, our most objective longer-term technical and sentiment indicators are still telling us that the downtrend is still in play– and so we will remain 50% short in our DJIA Timing System until we start getting more oversold readings in our technical and sentiment indicators.  Readers should continue to forgo or hesitate from buying “risky assets” going forward in 2006 – said risky assets including small and mid caps stocks, emerging market equities, and energy and metal commodities.

Signing off,

Henry K. To, CFA

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