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Small Cap Value Stocks and the U.S. Dollar

(May 4, 2008)

Dear Subscribers and Readers,

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:

USD Index vs. Percentage Deviation from its 200 DMA (December 1985 to Present) - The percentage deviation of the USD Index from its 200 DMA hit a level of negative 9.28% on November 30, 2007, the most oversold level since January 2004. It then followed up with another oversold readng of negative 8.35% on March 17, 2008. Collectively, these two readings were as oversold as significantly oversold redings of years part, such as the -9.50% reading in January 2004 and the -8.57% reading during the depths of the Russian and LTCM crises in October 1998. Given that the amount of foreign reserves in the custody of the Fed is no longer rising at a record high pace, this author now believes that the USD should continue to strengthen in the upcoming weeks.

Even though the U.S. Dollar Index closed at 3.75% below its 200 DMA last Friday, it is still relatively oversold.  More importantly, as mentioned in the above chart, the U.S. Dollar Index twice hit a severely oversold level over the last five months, hitting a level of -9.28% and -8.35% on November 30th and March 17th, respectively, and equaling or surpassing oversold readings such as those during October 1998, July 2002, May 2003, January 2004 and December 2004.  Furthermore, as demonstrated by the diminishing growth in foreign reserves held at the custody of the Federal Reserve, as well as the fact that many European banks have still yet to disclose their subprime losses, chances are that the U.S. Dollar Index is now in an uptrend for at least the next couple of months.  Finally, as far as the UK is concerned, it is definitely still way behind the curve in terms of its easing campaign – by the time this is all over, we may actually see the Bank of England easing more aggressively than the Fed, given that its economy is way more leveraged to the financial and housing sector, versus the US economy.  Subscribers please stay tuned.

Let us now discuss the most recent action in the U.S. stock market via the Dow Theory.  Following is the most recent action of the Dow Industrials vs. the Dow Transports, as shown by the following chart from January 2006 to the present:

Daily Closes of the Dow Jones Industrials vs. the Dow Jones Transports (January 1, 2006 to May 2, 2008) - For the week ending May 2, 2008, the Dow Industrials rose 166.34 points while the Dow Transports rose 191.21 points. While the Dow Industrials is still 8% away from its all-time closing high, the Dow Transports is now only 2.5% away from its all-time closing high and could stage a break out as soon as this week . In light of the record amount of capital on the sidelines, the latest weekly rise in both Dow indices is unequivocally bullish. Moreover, given the Dow Transports' role as a leading indicator since October 2002, the continuing strength (especially in light of resilient oil prices) in the Dow Transports is doubly bullish for the market for the foreseeable future. This author continues to be bullish, based on three overriding ideas: 1) The fact that we have seen a capitulation low with the demise of Bear Stearns, backed-up by the once-in-a-cycle lows in our sentiment and technical indicators during late January and mid-March, 2) Our view that the Fed, Congress, and now the G-7 countries will continue to work together to resolve the liquidity crisis (e.g. the arrangement of the new swap lines with the ECB and Swiss Central Bank last week), and 3) The tremendous amount of capital sitting on the sidelines that will shift back to equities in due time. Bottom line: I believe we have made an important intermediate-term bottom as of January 22, 2008 - and that we should the line of least resistance for the U.S. stock market is still up.

For the week ending May 2, 2008, the Dow Industrials rose 166.34 points while the Dow Transports rose 191.21 points.  With the latest rise in the two popular indices last week, the Dow Transports is now a mere 2.5% away from its all-time closing high (rising over 27% from its January low) – setting up for a breakout potentially as early as this week.  Given the Dow Transports' role as a leading indicator of the broad market since October 2002, the strength in the Dow Transports is very encouraging, especially given the resiliency in crude oil prices last week.  Moreover, with the latest decline in credit spreads across the world, and with further capital-raising within the global financial sector, it remains a dangerous time to stay short, especially given the unprecedented amount of global investment-ready capital sitting on the sidelines.  We will stay 100% long in our DJIA Timing System.

I will now continue our commentary with a quick discussion of our popular sentiment indicators – those being the bulls-bears percentages of the American Association of Individual Investors (AAII), the Investors Intelligence, and the Market Vane's Bullish Consensus Surveys.  The latest four-week moving average of these sentiment indicators increased from last week's reading of 0.1% to 3.7% for the week ending May 2, 2008.   Following is a weekly chart showing the four-week moving average of the Market Vane, AAII, and the Investors Intelligence Survey Bulls-Bears% Differentials from January 1997 to the present week:

Average (Four-Week Smoothed) of Market Vane, AAII, and Investors Intelligence Bulls-Bears% Differentials (January 1997 to Present) - For the week ending May 2, 2008, the four-week MA of the combined Bulls-Bears% Differential ratios rose from 0.1% to 3.7% - the 6th consecutive weekly rise from an extremely oversold reading of -13.9% (which represented the most oversold level since late March 2003 and comparable with the late Sept/early October 2001 readings). This reading is now also at its highest since early January 2008. With this turnaround, there is virtually no doubt that the market made a sustainable bottom on January 22nd, with a successful retest on March 17th. I continue to believe that the line of least resistance for the stock market is still up for the next several months. We will stay 100% long in our DJIA Timing System.

Given the latest continued rise in this sentiment indicator from a historically oversold condition (by far the most important reversal signal in the stock market is when this indicator reverses from a very oversold situation), there is no question that the broader market has already bottomed and that the line of least resistance continues to be up.  Given the readings of this sentiment indicator, the positive divergences we previously mentioned at the time of the Bear Stearns collapse, the relative strength in the Dow Transports, the latest decline in credit spreads, the implementation of the fiscal stimulus plan early last week, as well as an essential guarantee by the Fed for most of the U.S. financial system, I continue to be comfortable with a 100% long position in our DJIA Timing System, and will most likely not par back until/unless we see the stock market or these sentiment indicators get overbought again, or should the Fed or Congress fail to find more solutions to cushion the decline in U.S. housing prices going forward.

I will now close out our commentary by discussing the latest readings of the ISE Sentiment Index.  For newer subscribers, I want to again provide an explanation of ISE Sentiment Index and why it has turned out to be (and should continue to be) a useful sentiment indicator going forward.  Quoting the International Securities Exchange website: The ISE Sentiment Index (ISEE) is designed to show how investors view stock prices. The ISEE only measures opening long customer transactions on ISE. Transactions made by market makers and firms are not included in ISEE because they are not considered representative of market sentiment due to the often specialized nature of those transactions. Customer transactions, meanwhile, are often thought to best represent market sentiment because customers, which include individual investors, often buy call and put options to express their sentiment toward a particular stock.

When the daily reading is above 100, it means that more customers have been buying call options than put options, while a reading below 100 means more customers have been buying puts than calls.  As noted in the above paragraph, the ISEE only measures transactions initiated by retail investors – and not transactions initiated by market makers or firms.  This makes the indicator a perfect contrarian indicator for the stock market.  Since the inception of this index during early 2002, its track record has been one of the best relative to that of other sentiment indicators.  Following is the 20-day and 50-day moving average of the ISE Sentiment Index vs. the daily S&P 500 from May 1, 2002 to the present:

ISE Sentiment vs. S&P 500 (May 1, 2002 to Present) - After the historical four-week plunge of the 20 DMA ending mid March, the ISE Sentiment Index staged a tremendous bounce over the last six weeks. With the 20 DMA rising above the 50 DMA four weeks ago (the first time it has done so since December 31, 2007) and again with the latest rise, both the 20 DMA and 50 DMAs are now in established uptrends. Given this and given that this indicator has just reversed from historically oversold levels and given the amount of capital that is stilling on the sidelines, the line of least resistance for the stock market continues to be up. Bottom line: The 20 DMA and the 50 DMA have reversed from historically oversold levels - levels that were even more oversold than mid October 2002 lows. We will stay 100% long in our DJIA TIming System.

With both the 20-day and 50-day moving averages of the ISE Sentiment Index reversing from their historically oversold readings – and given that both the 20 DMA and the 50 DMA are now firmly in established uptrends – probability suggests that the stock market has already bottomed and should continue to rally for the foreseeable future.  Given this reversal from a historically oversold condition of the stock market, the Fed “backstopping” the majority of the U.S. financial sector, the mailing out of the “fiscal stimulus” early last week, and the unprecedented amount of capital sitting on the sidelines, I continue to believe we have already witnessed a bottom in both the Dow Industrials and the S&P 500.  For now, we will stay with our 100% position in our DJIA Timing System, and will only scale back once the market becomes significantly overbought or if sentiment turns rampantly bullish again.

Conclusion: While small cap value stocks should continue to outperform large cap growth, value, and small cap growth stocks in the long run, the combination of institutional interest in small cap value stocks over the last five years, as well as the general deleveraging trend in the U.S. economy, should serve to “put a lid” on small cap value outperformance over the next 12 to 18 months.  Once the general deleveraging trend is close to being over, I expect another tremendous run in small cap value stocks (homebuilders and other turnaround situations come to mind).  In the meantime, subscribers should continue to be careful when buying small cap value stocks, as many of these tend to be “value trips” in an economy that is in the midst of deleveraging.

I also expect the U.S. Dollar Index to mount a strong counter-trend over the next couple of months.  At this point, I do not believe the bear market in the U.S. Dollar Index is over yet – but as indicated in our above charts, and given that many European banks have still yet to disclose their subprime losses – there is a good chance that many investors in the Euro Zone are now short of U.S. dollars as they struggle to cover their subprime losses in the weeks ahead.  Moreover, the U.S. Dollar Index still remains highly oversold relative to its 200-day moving average.  My sense is that the counter-trend in the U.S. Dollar Index could take it back to 80 or above.  Finally, we are also still bullish on the U.S. stock market, at least until the majority of our sentiment indicators start to become overbought.  In the meantime, I will continue to be vigilant and inform our subscribers should we see a gathering storm that would impact the global equity markets, such as growing global discontent among the world's poor, or the threat of a more vicious corporate or capital gains tax policy leading up to the U.S. Presidential election later this year.

Signing off,

Henry To, CFA

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