During the final stages of a bull market, speculative stocks often gain the most. Investors get used to everything rising — a lot. They forget about “petty” things like earnings and put their money in the hottest lottery tickets…I mean…stocks.

It’s almost as if every five years or so investors lose their minds and go on a money-spending bender. How else can you explain why stocks like M-Wave, Inc. (MWAV:NASDAQ), GSE Systems, Inc. (GVP:AMEX) and AMDL, Inc. (ADL:AMEX) rose 143%, 177% and 142% between Jan. 1 and May 1?

M-Wave hasn’t made a dime in profits in five years. GSE Systems is a terrible company. Sales have fallen from $50 million to $22 million since 2001. And AMDL has not generated a dollar from operating activities as far back as I can see. Yet leading up to the recent Russell 2000 meltdown, these stocks were three of the best performers.

I wish I could tell you MWAV, GVP and ADL are statistical outliers — that the market isn’t full of these highflying, overvalued companies. I wish I could tell you that investors, for the most part, have been making sound investment decisions and have gone out of their way to avoid irrational speculation (like they swore they would do after the dot-com bubble). But unfortunately, that’s not the case.

Take a look at this chart John Hussman, a top-rated small-cap fund manager who has averaged a 16% annual return since June 2000, published in his April 3 weekly market commentary:

It shows the advance/decline ratios (leading up to the recent market meltdown) for:

*** S&P 500 stocks with the highest-quality rankings (in blue)

*** 60 largest S&P stocks (green)

*** Stocks on the NYSE (orange)

*** Lowest-quality stocks on market (red).

From April 2005-April 2006, the lowest-quality stocks on the market advanced at a higher rate than any other group of stocks — far outpacing their high-quality peers.

In fact, from the beginning of 2006 to early April, stocks with the weakest fundamentals (the most speculative stocks on Wall Street) gained 20.09%. Meanwhile, the stocks with the strongest fundamentals rose only 7.38%.

Irrational behavior like this cannot carry on forever. Hussman points out, “In general, bull markets have historically ended with investors showering their affection on speculative darlings that seemed to offer a ticket to sure money, fast money or preferably both.”

Certainly, small-cap “investors” have been smitten with their speculative darlings of late. But does that mean the bull run in the small-cap sector is over?

We don’t know.

Despite the Russell 2000’s recent 12% drop, it is possible that the irrational buying binge will pick up again and stocks like MWAV, GVP and ADL will continue to climb at a furious pace. Again, no one can know for sure what will happen.

What we do know is that the party must eventually end. Just as a child cannot grow into a healthy adult on a diet of candy bars and soda, the market cannot keep rising on weak fundamentals. It will have its day of reckoning. And when it does, the speculative stocks that have led the way in this bull market will come crashing down the hardest — just like they did during the last correction.

From March 15, 2000-March 15, 2003 (the three years after the last bull market), the most speculative stocks on the Russell 2000 and the S&P 500 fell an average of 71.05% and 63.96% each. Those kinds of losses are nearly impossible to recover from.

But you might be interested to know that the highest-ranked stocks (those with the strongest fundamentals) on the Russell 2000 and S&P 500 actually rose 6.88% and 16.08% during that same three-year stretch.

Makes you think, doesn’t it?

As we move into the second half of 2006, terms like “value,” “cash,” “earnings” and “sales growth” will start to re-enter investors’ vocabularies. Fundamentally sound stocks that have lagged the speculative darlings of the market will once again gain favor. And companies like MWAV, GVP and ADL will once again be left for dead.

I suggest you take some time this weekend and go through your own portfolio. If you are holding onto any speculative darlings that you can’t stomach to see fall 70% in the next three years, now is the time to get rid of them. Now may be your final chance.

Don’t say I didn’t warn you.

Regards,

James Boric
June 15, 2006

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.

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