*** I went to the podiatrist yesterday and got a dose of bad news. It looks like I have arthritis in my right big toe and will require surgery. The doctor said it probably came from a combination of treadmill and cross trainer power workouts. It would be an outpatient procedure, about 2½ hours long, but I’d be on crutches for months. As I was leaving his office and feeling really sorry for myself, he broke some crushing news to me.

The good doctor has lost a bundle on small-cap stocks. Knowing that I cover the beat, he asked my opinion about what to do. I asked him about his trading practices, and I was absolutely floored when he told me that he traded on chat room gossip. Suddenly, it all became painfully clear…

He might as well be stopping strangers in the mall and asking them what they think about the market. In fact, he’d probably be better off, because at least he could look them straight in the eye. OK, fellow Sleuthers, a word of caution…

NEVER TRADE ON CHAT ROOM CHITCHAT. If you read about the world’s best traders, they always stick to their own counsel. In fact, Jesse Livermore, considered by many to be the best trader who ever lived, followed a sacred rule to ignore tips from chumps. Every time he broke that rule, he lost a bundle.

Chat rooms are just that…chat. And for all you know, it could be chat from a slobbering psychopath, an irate employee or a 9-year-old who broke into his parents’ liquor cabinet.

The only way to make big bucks on small-cap stocks is to conduct thorough due diligence, be patient and follow your stop losses (and, of course, read Penny Sleuth every Tuesday and Friday).

And talk about losing money…

*** Buy.com is planning a comeback IPO. Get this madness…

Buy.com, a self-proclaimed Internet superstore, had gone public in 2000 at $13 per share. The stock peaked at $25.13, but when it tanked to 17 cents in 2001, founder and CEO Scott Blum took it private. Now Blum is looking is to take it public again… EVEN THOUGH THE COMPANY HAS NEVER TURNED A PROFIT.

While this could be a sour deal for investors getting in after the IPO, it’s a sweet one for Blum. Since Blum paid $23.6 million for Buy.com and holds 98% of the company, a proposed IPO at $13 per share puts the company’s valuation at some $86 million. With the IPO, Buy.com will repay Blum $25.8 million that he loaned the company while it was private. And you thought sailing was an expensive hobby.

How has Blum done so far?

The S-1 filing submitted to the SEC reports that in the year ended Dec. 31, 2004, Buy.com incurred a loss of $15.4 million, down from its loss of $25.6 million in 2003. Meanwhile, operating expenses declined to $43 million last year from $166.8 million in 2000. So it looks like Blum cut losses by cutting overhead. Blum has been experimenting with various pricing formulas, but still hasn’t cracked the code…because Buy.com is losing 5 cents on every dollar of revenue.

While Buy.com may be a long-term small-cap play that capitalizes on the strength of the e-commerce wave, forget about the IPO. Instead, think crude…

*** Standard & Poor’s just issued a report under its “Small-Cap Dynamics” banner, which includes an analysis of small-cap energy stocks. When it comes to both commodities and equities, S&P believes that the segment is undervalued. Core assumptions include supply constraints, fewer existing wells primarily from a lack of investment and political instability. The shortage is expected to worsen due to greater consumption by emerging economies such as China and India.

After reading the information, I checked in with Kevin Kerr, editor of Resource Trader Alert. For those of you who haven’t heard of Kevin, he’s a regular on MSNBC.

Kevin’s take on small-cap energy stocks is that they’re offering stellar opportunities for investors to jump on the energy profits bandwagon in an affordable way.

Kevin pointed out that small-cap domestic energy stocks sold like hotcakes when crude oil backed off its highs initially Monday. It didn’t matter whether a company was focused on the Permian Basin, the Gulf of Mexico, oil, coal, gas or drilling services. If it was small, up a bunch this year and reeked of fumes, it was a candidate for indiscriminate selling.

“This sell-off really just goes to show the volatile mix of insanity and capitalism that trading is sometimes, especially since many of the names that sold off don’t normally trade on the basis of crude oil prices,” Kevin said. “Some actually explore for natural gas, for instance, which is as different from crude oil as an orange is from a potato.

“The move was largely emotion driven, as many late-coming shareholders hit the panic button when the International Energy Agency recently suggested that high crude prices would erode demand. Uh, absolutely wrong!”

I know that Kevin has a lot more on his mind….that’s why you should click here: http://www.agora-inc.com/reports/RTA/WRTAF111

*** Small-cap exchange-traded funds (ETFs) recovered from a January thrashing as institutional investors and hedge fund managers pumped $593 million into them during the last three days of the month, according to research firm TrimTabs. This begs the question, are we seeing the so-called January effect?

The January effect posits that stocks (especially small caps) have historically risen during the period starting the last day of December and ending on the fourth trading day of January. The ensuing sell-off is for tax write-offs, capital gains and Christmas present bills (after all, sweetie, the new Aston Martin V12 Vanquish S does cost $255,000).

Anyway, two research firms found there is something to the January effect. Ibbotson Associates concluded that small cap stocks performed better in January in 56 of the 69 years between 1926 and 1995. Instinet cites academic studies that show smaller stocks on the New York Stock Exchange outperformed larger ones in January by almost 11 percent from 1926 to 1981. From 1982 to 1995, the gap narrowed to 4.48 percent. Citing its own research, Instinet concluded that between 1996 and 1999, the performance difference was only 1.98 percent.

As the gap narrows, there’s a growing consensus that the January effect may become as outdated as the Druid calendar. We’ll see…

In the mean time, just before the month closed bargain hunters swooped down to drive small caps back up. For example, the Russell 2000 small-cap index received an infusion of $286 million on Jan. 31, although the index still had a negative cash flow of $773 million for the month. Obviously, the smart money is warming to small caps again. Does the January effect mean plenty of new opportunities for us in February and beyond? At this point, we’re remaining cautiously optimistic about the upswing. Stay tuned…

*** He’s back! Carl “The GRIPPER” Waynberg writes about technicals, tea leaves and rugged individualism. Let’s say that Carl has a sixth sense about these things. CUT TO:

Bulls and Bears and Pigs, Wolves and Sheep and Eagles, and One Dead Frenchman

Gustave Flaubert, the French novelist best known for his scandalous portrayal of an adulteress (published 20 years before Tolstoy’s scandalous portrayal of an adulteress), despised stupidity and cliche. His Dictionary of Received Ideas pokes merciless satirical fun at bourgeois banality. It’s a testament to overused catchphrases and a kind of anthology of the stupidity of French society during the Second Empire.

Since there was then, as now, no shortage of stupidity, it was an ever-expanding work that likely would have worn its own dust jacket – had Gus not succumbed to cliche by doing just what we all do at the end of our lives: dying. It seems his hypocrisy knew no bounds.

Human nature being what it is – and not being what it could be – Flaubert could have kept himself very busy with just this one work, and I can imagine he would have devoted at least a chapter to our friends on Wall Street. Let us pick up where Gus shuffled off.

A STOCK PICKER’S MARKET: Often preceded by “the market is at a crossroads,” “time will tell” or a fluffy, exasperated “well,” it indicates its utterer is completely stumped and has, like Gus himself, thrown in the towel.

It’s not that it’s wrong – it’s just not very helpful and there’s a troublesome implicit admission behind the cliche. Most markets are a stock picker’s market, so why make a special note of this one? The only reason would be to lower expectations. It’s a way for money managers to confess to clients, “Look, I learned how to make money in a bull market, but not in a stock picker’s market. I suppose I could work harder, but frankly, it won’t help, ’cause I’m just not that smart, so don’t expect much.” It’s kind of a welcome, even if only implied, warning coming from a crowd that hoodwinked us into believing in buying a stock when it’s rising and selling when it’s falling – a strategy Ben Graham
described as “the exact opposite of sound business sense everywhere else.”

Certainly, there are plenty of reasons to be bearish – that’s true. But the evidence is so clear – the evidence supporting a bearish view on the one hand, and the evidence telling us how to deal with it on the other – that there’s no reason to be stymied.

First, evidence of the bear…

We can start with an economy that’s beginning to look just a little winded. The yield curve has been flattening – meaning the gap between short- and long-term interest rates is narrowing – and bonds, which typically weaken when the Fed tightens short-term rates, are instead showing atypical strength. If short-term rates overtake long-term rates, you have at least part of the recipe for a recession.

If it’s true that earnings drive growth, the market’s fortunes still don’t look good. Because corporations have managed better-than-average earnings growth during the current expansion, it’s going to become increasingly difficult for them to expand their earnings moving forward, a difficulty that’s compounded by the relative dearth of technological innovation. In other words, quarterly comparisons will be much tougher this year than last.

The technical picture is crystal clear, too, with the trend having turned definitively short-term bearish just a few weeks ago. Between November and December, the Dow, S&P 500, Nasdaq and Russell 2000 all had bullish crossovers of their 50-day moving averages through their 200-day moving averages, beginning with the Russell 2000 on Nov. 1 and followed by the S&P 500 a few days later, the Nasdaq a week later and the Dow at the beginning of December. These crossovers produced the anticipated strong performances that followed. But a few weeks ago, all the indexes breached their 50-day moving averages. This looks like a classic rotation, with what was once support now offering resistance. In addition, each market rally – most recently, the three-day rally between the 13th and the 18th of January and the four-day rally from the 24th through the 27th – has been summarily sold off, indicating a top has been put in place.

Speaking of rotation, the Amex Drug Index is trading below its 50-day as well, but over the past two months, it has outperformed both the S&P 500 and the Nasdaq. This rotation in favor of drug stocks, a group that’s considered defensive, is, then, considered bearish for the broader market. Investors’ preference for drug stocks over tech stocks is an indication they’ve grown more averse to risk, an interpretation supported by the lack of new money being put to work. (Mutual fund inflows have been uncharacteristically low for a January.)

Despite all the blather you’ve probably been hearing, the one recent bright spot has been small caps. The Russell 2000 is off 6% for the month, but the ratio of the Russell 2000 (RUT) to the S&P 500 (SPX) has been in a gentle uptrend since Dec. 12. Small caps ceded market leadership to big caps in the first week of January and are now struggling to wrestle it back. If they are unsuccessful, this would be bearish – another indication of increasing aversion to risk. Indeed, big caps tend to fare best when they are being outperformed by small caps. The more likely scenario, however, is that neither will lead for the short term. The RUT/SPX ratio got a boost in November, thanks to one of those bullish 50-day crossovers. But there’s no such bullish technical indicator at work today, and the 50- and 200-day moving averages look to be leveling out into a horizontal channel that signals performance parity between small caps and big caps.

Technicals not your bag? How ’bout tea leaves?

AS JANUARY GOES, SO GOES THE YEAR: A perennial favorite among cliches. Every year – almost like clockwork – the Street breaks out into impromptu choruses of, “As January goes, so goes the year.” And to be fair, there is some statistical evidence that January does possess some unique predictive power (it’s been particularly accurate since the ’40s). But the reason for this power has escaped explanation, and more rational people think it’s a lot of hooey – “robust to data snooping,” as researchers might describe it, which means that if you set out with the idea of finding a pattern, you’ll probably find one. In investing, data snooping has given rise to all sorts of “trends” – like the January Effect – that are really just a matter of coincidence, but that doesn’t stop investors from trying to exploit them. The comforting (and kind of unnerving) thing about a trend, like the January Effect, is that it need not be real to exist. Yes, it may be a figment of the Street’s imagination, but if enough investors come to believe in it, it becomes a self-fulfilling prophecy.

Anyway, if this one holds up, we’re in for a rough ride. January’s lowlights: The Dow – lower in the first three weeks for the first time since 1982, a recession year – and the S&P 500 both down 3.5%, the Nasdaq lower by 6.8%.

One other “trend” does offer a few photons of hope, however, but it requires the Eagles of Philly to soar on Sunday. According to the Super Bowl Indicator, a win by a team from the old NFL is bullish, while a win by a team from the old AFL is bearish. Hey – it’s been accurate 30 of 38 Super Bowls! It was notably wrong last year, though, thanks to that November-to-December surge, which saved the Pats from being the market’s patsies. Perhaps another Pats victory portends not pecuniary peril, but profits.

Still, that’s not much to hang your helmet on. Another cliche comes to the rescue…

BULLS CAN MAKE MONEY, AND BEARS CAN MAKE MONEY, BUT PIGS GET SLAUGHTERED: The contrarian response to the kind of massive weakness we’re seeing is (a) to protect the downside by setting up specific exit strategies for your stocks and (b) to become more active in the search for investment candidates – not less. Contrarians look on such a decisively bearish market as not an obstacle, but an opportunity – an opportunity to search every outhouse, doghouse, cathouse, henhouse and no-tell motel for any stocks that have been unfairly punished by the bear. If you’re a contrarian, this kind of weakness is to be exploited, not feared.

And by combining a contrarian search for the undeservedly downtrodden with a search for momentum stocks that are bullishly bucking the downtrend (especially those with current or imminent bullish 50-day crossovers), a player in today’s market can be both investor and trader, setting up market-beating long- and short-term positions.

IF YOU CAN’T GRAB THE BULL BY THE HORNS, GRAB THE BEAR BY ITS CLAWS: I’m not sure what that means, either, but I do know that you can start exploiting the bear by employing some of the strategies James outlined in Sleuth just a few days ago – all value strategies and all, therefore, manifestations of a contrarian ideology. For most investors, despite all the evidence favoring it, contrarianism is still not easy to embrace. It can be unnerving to be the lone wolf, to act alone against the herd of investors. You may find comfort in the fact that those who can muster the courage tend to benefit in the long run.

WHILE THE CHICKEN AND SHEEP ARE SLAUGHTERED, THE FOX FEASTS: Now that’s a trend worth playing.

This has been…

Carl Waynberg
The GRIPPER

February 01, 2008

Carl Waynberg is editor of The GRIP, a unique contrarian investment strategy for investors who prefer the road less traveled. The GRIP targets young companies that trade on the OTC Bulletin Board. Over the past two years, his portfolios of just such stocks identified 18 companies that went on to the fame and fortune of the NASDAQ and AMEX.

Bulls and Bears and Pigs, Wolves and Sheep and Eagles, and One Dead Frenchman was originally featured in the Penny Sleuth.