Irwin Greenstein reports from Baltimore, where the crocuses are finally popping up through the mulch…

*** At the ValueRich Small-Cap Financial Expo held in West Palm Beach, Fla., March 9-12, the collective sense was that an investment milestone had been reached. In his opening remarks, ValueRich CEO Joseph Visconti said that this first-of-its-kind small-cap conference attracted 2,000 attendees and 120 presenting companies from around the world. Personally, I was chatting up investors and entrepreneurs from Sweden, China, the UK and elsewhere. In the next few issues, I’ll be reporting more about it…

But in the meantime, one hot potato at the conference deserves immediate attention — the Sarbanes-Oxley Act. For those of you unfamiliar with Sarbanes-Oxley, it’s a divisive piece of legislation passed in 2002 that, among other things, holds public-company executives and directors personally liable for a company’s financial reporting. We can thank the likes of Kenneth Lay, Bernie Ebbers and Gary Winnick for its passage. Sarbanes-Oxley compliance involves the adoption of rigid, anti-fraud financial controls that are extremely pricey to develop and maintain — especially for small caps. Sarbanes-Oxley is so onerous that some promising small-cap stars prefer to remain private.

As the keynote speaker, Charles Payne — CEO of Wall Street Strategies and a prominent media pundit — appealed to lawmakers to “take Sarbanes-Oxley off our backs now.” Bruce Foerster, a 25-year veteran of investment banking and now CFO of Aurora Capital, said that his company is concerned about incurring the massive annual expense of Sarbanes-Oxley compliance when or if it goes public. While the law was originally enacted because of large-cap fraud, “one size doesn’t fit all,” Foerster observed about Sarbanes-Oxley’s financial burden on small-cap companies.

I’d love to go on about the wonderful ValueRich conference, but before I run out of space today, just let me say that I’ll be telling you why some experts there believe that earnings are manipulated, the media can’t be trusted when it comes to reporting on the stock market, and why the young punk analysts on Wall Street who don’t know squat about the day-to-day challenges of running a business could sucker punch a solid investment opportunity — giving it a painful black eye.

*** Speaking of the media, it’s been trained lately on the hedge funds that have been mushrooming everywhere since the dot-com bubble popped. These hedge funds are run by brilliant and experienced managers who charge hefty fees. You’d be surprised to know that most hedge funds only invest in large-cap stocks, according to our own Sala Kannan.

The more nimble, highly profitable small-cap stocks are largely ignored. Sala discovered that only 2% of all hedge fund assets were invested in small caps last year. Frankly, it’s shocking that hedge funds, which claim to give you monstrous returns, don’t even invest in the historically best-performing group of stocks, small caps.

Sala was telling me about Jeffrey James of Driehaus Capital Management, Inc. She had read that James said about small caps, “It is precisely this part of the market that, in our opinion, offers the structural inefficiencies that create the potential for significantly greater price appreciation and that, therefore, constitutes an optimal area for hedge fund investing, especially in the current environment.”

In other words…

James was as surprised as we were that hedge funds are not investing in small caps and felt they should. And Sala has the numbers to prove it. If you had invested just $1 in small-cap stocks in 1926, that would have grown to $7,347 by 2001. With returns like that, why wouldn’t hedge funds invest in them?

Sala said it’s because it takes time, talent and a lot of sleuthing to find small-cap stocks with growth potential. The hedge funds would rather charge you exorbitant fees and give you mediocre returns. Some hedge funds charge up to 2% in fees and 40% of your profits. In the meantime, 10-20% of hedge funds fail each year.

According to financial-planning.com, the average hedge fund return was a pathetic 9.64%. The Russell 2000 small-cap index, on the other hand, returned an amazing 17% during the same period. If only hedge funds invested in small caps…

*** On to the meat and potatoes of this issue. In his essay, Chris Mayer, editor of Fleet Street Letter, provides us with a brief history of a century-old trading system. In fact, Chris perfected this world-famous system, which has actually predicted every major market event from the Great Crash to the massive bull market in the ’90s. Still, Chris has found room for improvement…to the tune of scoring gains of 121.4%, 42.2% and 40.3%.

Through his new CrisisPoint Trader, Chris makes aggressive recommendations by identifying the exact points where a stock is poised for a massive move. Find out how you can profit from CrisisPoint Trader: http://www.agora-inc.com/reports/CPT/WCPTF317

How Now Dow?

The market can be a nasty waterway, especially for the traders trying to navigate through the squalls. Through the years, all sorts of market-timing devices have been created with the idea of improving the odds of success. What investors and traders have been looking for is, in essence, a compass. A favorite Dickinson epigram reads, “The Sailor cannot see the North, but knows the Needle can.”

That is the holy grail of market forecasting, to be able to trust an objective measure that will deliver reliable signals about the future course of the market. Though there is no perfect system, one system has stood out over the years and survived and prospered in all sorts of markets. Nearly everyone has heard of Dow, but few know his story, which is interesting on its own terms. But it also reveals what he thought about the market, which is contrary to what most people assume he thought. These insights are still valuable today.

Charles Dow was born in the coolness of a New England autumn, in November 1851, in the town of Sterling, Conn. The son of a farmer, little is known of his early years or education. He began as an investigative reporter on the world of business and finance for the Springfield Daily Republican, edited by Samuel Bowles, a famous journalist of the period. He would also work for another respected newspaperman of his day, George Danielson, at The Providence Journal.

It is probably safe to say that Dow had the good fortune to work for such outstanding editors, and presumably, they influenced his own work, which would shortly earn him a reputation as an outstanding reporter and keen observer of the market scene.

By 1882, the now-accomplished and successful Charles Dow ventured out on his own and, with the help of Edward Jones and Charles Bergstresser, established Dow Jones & Co. There, he wrote The Customers’ Afternoon Letter, later becoming The Wall Street Journal.

The Journal was popular among businessmen, as it filled a hole in Wall Street market statistics. It contained more complete information on stock and bond prices and other financial miscellany than was available in any other single source. And it could be had for the bargain price of 2 cents per issue.

Looking to further enhance his coverage of markets and to provide some snapshot that would capture in summary fashion the most active stocks of his day, Dow devised the idea of his averages. In the summer of 1884, the Dow Jones Industrial Average made its debut. It wasn’t until 1896 that the Dow Jones Transportation Average was published, consisting of a list of 20 railroad stocks.

These averages were important in Dow’s assessment of the stock market and economy, as we will see. A basic tenet of his theory was that these averages discounted all the hopes, dreams and fears of investors.

I should also note that Dow became a member of the New York Stock Exchange in 1885, giving him up-close and intimate knowledge of the workings of the stock market.

All of Dow’s work on the market appeared in editorials published in his beloved Wall Street Journal during 1899-1902. He never wrote any books or offered any formal full-length treatment of his ideas. As William Hamilton would observe, “His theory must be disinterred from those editorials, where it is illustrative and incidental and never the main line of discussion.”

That we have them in any organized fashion at all is due to the diligent work of his friend S.A. Nelson. Nelson pushed Dow to write a book about his observations, to no avail. The reticent New Englander was stubborn on this point. Hamilton gives us some insight into Dow’s personality, calling him, “intelligent, self-repressed, ultra-conservative…judicially cold in his consideration of any subject, whatever the fervor of discussion. It would be less than just to say that I never saw him angry.” Like Nelson, Hamilton tried unsuccessfully to get Dow to expound on his theories. (Hamilton would go on to what Dow refused to do: build out the tenets of Dow Theory in over 252 editorials, culminating in the market classic The Stock Market Barometer.)

Little is known about S.A. Nelson today, but he plays a critical role in the dissemination of Dow’s ideas. Nelson would cobble together Dow’s editorials between the covers of a little book titled The ABC of Stock Speculation, which was published in 1903, the year after Dow’s death. The book includes some 35 chapters, of which 15 represent Dow’s original works. Each of these is marked with a small footnote on its first page that says, simply, “Dow’s theory.”

So what about those treasured Dow editorials? What did they say that stirred the minds of his fellow market watchers? The collection of Dow’s editorials are interesting on several levels, not the least of which is the fact that they are so contrary to what people assume Dow wrote.

First, Dow’s primary focus was on values. “Value is the imperative word in Dow Theory,” writes Richard Russell. “All other Dow Theory considerations are secondary to the value thesis…critics of the theory seem totally unaware of that fact.”

For Dow, this meant price-earnings ratios and dividend yields, the two common statistics available in his time, at a time during which market statistics of any kind were scarce and often unreliable. But in today’s market, we can assess values using a lot more data, although one may question whether the increase in information leads to wiser conclusions. It is important to note that Dow did not blindly follow his averages, but also reasoned using value considerations.

The second component of Dow Theory is understanding market psychology. “As a student of market psychology, Dow had few peers,” Russell writes. “His observations concerning the emotions of the crowd and the movements of stocks form an intricate part of the theory.”

Markets are cauldrons filled with the swirling emotions of its human participants, and they can go to extremes of optimism and pessimism. As Hamilton eloquently summed up in his book, “The pragmatic basis for the theory, a working hypothesis if nothing more, lies in human nature itself. Prosperity will drive men to excess, and repentance for the consequences of those excesses will produce a corresponding depression.”

Today, there is a whole flourishing branch of finance, called behavioral finance, which seeks to catalog and explain these human tendencies. Concepts from psychology are applied to investors to explain recurring “errors.”

Again, Dow finds himself ahead of mainstream finance, which took decades before accepting the teachings of behavioral finance, a discipline that only emerged in the 1970s (and it is open to debate whether the implications are fully accepted today or not).

Dow’s reading of the averages was an attempt to illustrate his reasoning on market values and the psychology at work among the market’s participants.

Finally, Dow crafted a view based on the action of the market itself — the price action, trend and volume. Dow thought that the market had three main movements all going on simultaneously. As he described it, “The first is the narrow movement from day to day. The second is the short swing, running from two weeks to a month or more. The third is the main movement, covering at least four years in its duration.”

For the day-to-day movements, Dow recommended disregarding them, unless you were a trader who paid no commissions. It is the latter two movements that Dow thought could support profitable investment operations.

Dow’s observations contain many nuggets of useful information and practical advice for trading. But they were only loosely held together in his editorials and required additional development.

Fortunately for Dow and future traders and investors, a procession of able and talented Dow Theorists emerged to take his assorted observations and mold a more systematic working theory that has stood the test of time.

Sincerely,

Chris Mayer

March 15, 2005

Editor’s Note From James Boric:

Followers of the Dow Theory have beaten buy-and-hold investors by a margin of 7-to-1…averaged 22.6% gains for 50 years straight…and slashed exposure to risk by as much as 30%. In fact, following the Dow Theory, you could have turned $1,000 into $476,470! And Chris’s new system could multiply those gains by as much as 4-5 times over. Find out why his CrisisPoint Trader System is the talk of the town.

Chris Mayer

Chris Mayer studied finance at the University of Maryland, graduating magna cum laude. He went on to earn his MBA while embarking on a decade-long career in corporate banking. Chris is the editor of Capital and Crisis and Mayer’s Special Situations, a monthly report that unearths unique and unconventional opportunities in smaller-cap stocks. In 2008, Chris authored Invest Like a Dealmaker: Secrets From a Former Banking Insider.

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