James Boric reports from behind north Lovegrove Street in historic Baltimore…

*** It’s the question on every investor’s mind right now: Will the small-cap rally (that has lasted almost five years now) continue? Or are small-cap stocks about to go bust?

Those are the questions we will tackle in today’s Sleuth, dear reader. But before anyone can make predictions about which way the market is headed, you have to understand where we stand today. And let me tell you, it’s pretty darn impressive.

*** The Russell 2000, aka the small-cap index, hit a historic high yesterday – closing at 623.86. Who cares, you say? Well, consider this.

The Russell 2000 is the ONLY major index to reach its highs from the bull market of the 1990s. As I type this morning, the Dow Jones is still 1,358 points off its high of 11,908. The S&P 500 is off 369 points from its high of 1,552. And the once-mighty Nasdaq is off a breathtaking 2,094 points from its high – trading at just 40% of its 2000 level.

Meanwhile, the Russell 2000 is a full 9 points ahead of its peak in March 2000. And folks, there are no signs of a letdown.

*** “Since August, the index has risen 17.8%, the biggest gain of any major index,” Michael Flaherty reported for Reuters yesterday. And it’s no wonder why.

Small-cap companies are growing quicker than their large-cap counterparts. And that growth is expected to continue in 2005.

Matt Krantz reports in USA TODAY that, “Companies in the S&P 600 index are
expected to post 18.3% 2005 earnings growth. While that’s down from their expected 37.2% growth this year, it’s still well above the 10% earnings growth expected from the S&P 500 next year.”

Translation…

Smaller, nimbler companies grow their bottom lines quicker than the mature behemoths that dominate the S&P 500. And when earnings rise, stock prices do, too. Of course, it would be foolish to expect small-cap companies to keep rising at the pace they have been for the past five years. There are some pitfalls to be wary of as we move forward – namely inflation and valuations.

*** As the Fed continues to raise rates, it will become more and more expensive for smaller companies to borrow money. That means the companies that will continue to make you money will have low debt, plenty of cash in the bank and the ability to grow earnings quickly. And it is these kinds of companies you should have in your portfolio moving forward.

Eventually, there will be a correction in this market. It will be the stocks trading for ridiculous valuations that will come crashing down the hardest. I guarantee it. And although there are certainly dozens of overpriced small-cap stocks on the market right now, the majority of smaller companies are still attractive relative to their peers.

*** Richard Tortoriello, a stock analyst at S&P, said in USA TODAY on Nov. 11 that, “small-caps are valued about 30% less than large-company stocks when comparing their stock prices with their revenue. So even though small-caps have been leading for six years already, the rally can continue.”

Your small-cap editor agrees.

Even though the valuation gap between large- and small-cap companies has lessened in the last few years, it still exists. And as long as small-cap stocks are still a bargain, I expect the rally will continue.

Now is NOT the time to pull out of small-cap stocks.

Having said that, nothing rises forever. And as you know, no index…no stock…and no company rises straight up. There are rallies, and there are corrections.

And Irwin believes this market is ripe for a short-term correction. He’s identified a tool that gauges the most important factor for determining whether the market rises or falls. And you wouldn’t believe what it is saying right now.

Irwin, wow us with your market insight…

Melodramatic Profits

You’re sitting at your computer, ready to hit the buy button for a small-cap investment that you’re positive will shoot to the moon. After all, you’ve checked every possible ratio from P/E to PEG, and they’ve all pointed in one direction – up. But chances are you didn’t consider the single most important characteristic of the stock market itself – and that’s called investor sentiment.

Investor sentiment measures the mood of the market. It tells you whether investors are stampeding into the market because everyone else is (inflating stock prices) or fleeing the market in fear (creating great buying opportunities). Either way, greed or fear, you need to anticipate the emotions (sentiment) of the market – or risk losing a bundle.

And when it comes to small-cap stocks, investor sentiment is crucial. When the Wall Street herd is buying at the same time, small-cap prices soar. That’s when you stand to make a fortune in the up-and-coming companies of tomorrow. But when the herd starts selling, you better get out quick – as small-cap stocks can plunge in a short period of time.

As an investor, it’s important to understand what investor sentiment is. It can be the difference between making and losing a fortune.

In fact, investor sentiment has been the secret weapon of some of the best investors of all time. It lets them figure out how to read the market – to know what everyone is going to do even before they do it. And you wouldn’t believe what investor sentiment readings are saying right now! I’ll show you in a second. But first, let me explain how this secret weapon works…

To measure investor sentiment, researchers constantly survey financial newsletter writers and analysts to measure whether they are bullish or bearish on the market. The results are assigned numerical values. For example, Chartcraft’s Investors Intelligence Sentiment Index assigns a point value ranging between 10 and negative 10. A reading of 10 indicates ultimate bearishness. And a reading of negative 10 indicates extreme bullishness.

In the case of Chartcraft’s index, when fewer than 25% of the survey’s 135 newsletter writers are bullish, a buying opportunity is just around the corner. By contrast, when the bullish sentiment climbs to 60%, then the market is overheated and it’s time to sell.

Any proof to back this up? How often is it right? Has it predicted any major swings in the market?

Chartcraft’s Investors Intelligence Sentiment Index is the granddaddy of sentiment measurement…having been around since 1963. It’s now cited in the media, especially on Wednesdays, when the survey’s results are published for subscribers at chartcraft.com.

So what is Chartcraft’s market sentiment reading right now?

In its mid-November report, Chartcraft said that bullish sentiment rose 55.1% as of Aug. 20 – up from 52% for the period beginning Aug. 13. Likewise, bearish sentiment fell to 18.4%, from 19%. And 26.5% of the experts felt that a mere correction was in store, down from 29% during the same one-week period in August.

Analyzing those numbers tells us that the market is on the verge of being overpriced and that maybe sitting on the sidelines is the best thing to do…until the bears reclaim more territory.

If you think investor sentiment is hocus-pocus, then listen to a couple of scholars from Harvard and NYU.

In a paper published in December 2003, Malcolm Baker of the Harvard Business School and Jeffrey Wurgler of NYU’s Stern School of Business have correlated the true relationship between investor sentiment and moneymaking small-cap investments. Baker and Wurgler write that investor sentiment serves as a valid substitute in the absence of hard analytical data (a chronic condition of small-cap companies). The lack of a long earnings history or accurate market size can be replaced with the valuations that the market itself places on the stock. But here’s the rub…

These same small-cap stocks are the most vulnerable to sentiment swings. The feverish pitches of chat rooms and bullet boards can drive a low-volume small-cap stock price up or down – simply because a few people are having a bad day. Instead of trading with their heads, they get extremely emotional and trade with their hearts – and that’s a death spiral for any small-cap investor.

Let the herd traders buy, sell and hold based on desperation, fear and greed. But you’ll be amazed how your profits will soar once you anticipate their moves…and leave them in the dust. Keep reading Penny Sleuth to find out what the market sentiment is. We’ll let you
know.

Happy investing,

Irwin Greenstein

November 16, 2004

James Boric

James Boric began his finance career by successfully picking winning stocks. With time and experience, James realized his goal- to figure out how an average, everyday investor with little capital could become wealthy. The trick, he discovered, was to look to the quickest moving, most exciting and lucrative group of stocks in Wall Street history -- small-caps. Special Report: HOW YOU COULD TURN $200 INTO $1.2 MILLION!

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