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When Will Small Cap Turnaround Situations be a Buy?

(May 11, 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 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:

Relative performance of the S&P 600 vs. the S&P 500

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:

U.S. Companies with Overseas Revenue

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.

Asset-backed commercial paper

  1. 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, 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.

Worldwide ABS issuance

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.

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 9, 2008) - For the week ending May 9, 2008, the Dow Industrials declined 312.32 points while the Dow Transports rose 114.60 points. While the Dow Industrials is still 10% away from its all-time closing high, the Dow Transports is only 4.6% away from its all-time closing high and could stage a break out once crude oil prices correct. Given the Dow Transports' role as a leading indicator since October 2002, the continuing relative strength in the Dow Transports is bullish for the market for the foreseeable future. While rising energy and commodity prices may put a lid on the stock market in the short-run, this author is still bullish over the next 3 to 6 months, 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 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 two weeks ago), 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 9, 2008, the Dow Industrials declined 312.32 points while the Dow Transports declined 114.60 points.  While the Dow Industrials gave back all of its gains from the week prior, the Dow Transports still closed the week higher than two Fridays ago.  Moreover, the Dow Transports is still only 4.6% away from its all-time high closing – thus again confirming it as the stronger index over the Dow Industrials.  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 record high 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 (unless one is selectively shorting small cap stocks), 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 3.7% to 7.2% for the week ending May 9, 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 9, 2008, the four-week MA of the combined Bulls-Bears% Differential ratios rose from 3.7% to 7.2% - the 7th 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 the first week of 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.

While the above sentiment indicator is now starting to get overbought, it is still far from overbought conditions that we have experienced over the last four years.  In other words, we are still not near “danger territory” just yet.  However, should this sentiment indicator (and others that we track, such as the equity put/call ratio, the ISE Sentiment Index, etc.) get more overbought over the next few weeks, and should this be accompanied by weak breadth or weak volume in the financial markets, then we will start to become more concerned.  In the meantime, given the 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 line of least resistance remains 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 in the last week of April, 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) - Since the historical four-week plunge of the 20 DMA ending mid March, the ISE Sentiment Index has staged a tremendous *rally* over the last seven 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. Coupled with the fact 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 is still 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 should continue to rally for the foreseeable future.  Despite this uptrend, we will continue to monitor this and other sentiment indicators for signs of an “over optimistic” market that may not be justifiable from a technical basis (weak volume, weak breadth, etc.).  In the meantime, 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.

Conclusion: As of Sunday evening, I am still very wary of buying small cap turnaround situations or small cap value stocks in general, given that the general deleveraging trend in the U.S. economy should adversely impact small cap value companies the most.  Despite this, I still expect small cap value stocks to outperform small cap growth, large cap growth, and large cap value stocks over the long-run.  Once the general deleveraging trend is close to being over, I expect another tremendous run in small cap value stocks (homebuilders, small cap consumer finance companies, and other turnaround situations come to mind).  My initial timeline of 12 to 18 months still stands.  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.

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.  Given that nearly 50% of all revenues within the S&P 500 components are derived from overseas markets, I continue to be comfortable with a long position our DJIA Timing System despite the fact that the U.S. economy is still in the midst of deleveraging.  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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