In whatever direction the market chooses, there will inevitably be money making opportunities. However, patience will be key in the following days and weeks as the market attempts to sort itself out. You’ll need to be prepared — and be aware of the possible pitfalls — if you are going to be putting your trading dollars on the line.

First, avoid going all-in on the short side. It has been very tempting to sell short momentum stocks in this environment. Many of these names became overextended during the summer months and became attractive short opportunities during the August correction.

However, shorts have been absolutely decimated twice in October as equities have fought for higher ground:

At the very beginning of the month, stocks staged a spectacular 3 p.m rally, igniting a short-covering frenzy that pulled the market from the drink of disaster (red circle). Yesterday’s action was very similar — a sharp drop at the open that eventually led to a significant rally during the last hour of trading (blue circle).

Even with stop orders in place, it is doubtful that a trader would have been able to cover at his desired price. All in all, it appears that way too much money is headed to the short side as the market approaches major areas of support and resistance. It would be wise to seek additional confirmation at these important levels before betting too heavily on the long or short side.

Next, it’s becoming obvious that when it comes to market sentiment, Europe is in the driver’s seat. Yesterday’s price action is proof enough of this. Just the whiff of European bailout rumors was all it took to march stocks back toward resistance in just 12 minutes of non-stop buying. Unfortunately, this tells us that continued negative Eurozone news could have the opposite effect.

As I’ve written a few times before, I want to see this market shrug off bad news out of Europe and move higher. An event like this would be a true mark of a change in sentiment for the better. For now, I believe many traders are still waiting for the other shoe to drop.

Until this mentality is squashed, an honest attempt at a recovery in equity prices might have to wait…

Sincerely,

Greg Guenthner
for The Penny Sleuth

Be Prepared: Don’t Get Caught Short… was originally featured in the Penny Sleuth.

The rally began more than a week ago as stocks surged from the brink of new lows to impressive gains just before the closing bell. Since that day, stocks have barely paused, recording gains in five of the past six trading sessions.

However, I will be the first to admit that I remain skeptical of this rally. As much as it has been exciting (and relieving) to see stocks recover some of their losses so quickly, my mind remains in bear-market mode. Anyone looking to go “all-in” right now — while the market is overextended in the short-term and the primary trend is in flux — does so at his own risk.

Here are three things I’ll need to see over the next several days…

Small stocks need to break downtrends — If you were perusing microcap charts recently, you probably noticed a lot of V-shaped bottoms. Many of the stocks in the small-cap and microcap trading universe have established sharp downtrends since the beginning of the market correction two months ago. Obviously, this makes for dangerous trading ground for those of us looking to go long. A sharp break to the downside could easily wipe out any gains most of these stocks have posted over the past week. I want to see clear, convincing breakouts from downtrends before going long here.

Also, keep in mind that most of the small stocks posting double-digit gains during the most recent rally have been benefiting from being scooped up off extremely oversold levels. This type of buying rarely lasts unless the stock clears significant resistance levels, and I don’t recommend latching on to these names in an attempt to play them as a momentum trade. The timing has to be perfect if you want to bank significant gains, and most of the plays are far too risky to warrant consideration for a swing trade.

The market needs to move higher on bad news — In particular, I would love to see stocks shrug off universally bad news out of Europe. If stocks can move higher when the headlines are negative, you can be close to certain that there has been a drastic change in market sentiment. After all, it’s easy to expect a rally when bullish news is flying across the wire. When market participants begin to “believe” that prices will move higher, there’s little that can stand in the way of the bulls.

The Russell 2000 has to hold its ground —

I like how the Russell has popped above its 50-day moving average. The small-cap index will need to either consolidate or move higher from here to convince us that the downward momentum has stalled.

Sincerely,

Greg Guenthner
for The Penny Sleuth

Back From The Brink? was originally featured in the Penny Sleuth.

How quickly the atmosphere can change…

It would be easy to look back at Monday and proclaim that the market’s troubles are running deeper than an overblown political quarrel. I certainly wanted the bulls assert themselves Monday as much as anyone. After all, earnings have proven strong again this quarter. And aside from lumpy guidance coming from companies that have already reported, the idea that the economy was suddenly on the brink of ruin appeared to be pegged on the specter of debt default alone.

Ultimately, it comes down to this: The ball was in the bulls’ court this week– but they showed us they weren’t ready to play.

Instead, a huge miss in manufacturing numbers pounded stocks. Now market has indicated an underlying fear in the economy’s ability to sustain its current pace— and it feels as if those fears are becoming more justified with every bit of data hitting the wires.

Turning to the indexes, Bloomberg notes that the S&P 500 gave back a gain of 1% and more during the first hour of trading Monday for just the 10th time since 1985. Even more interesting, all but two of these sharp reversals have occurred since the beginning of the 2008 financial crisis, proving once again how schizophrenic the markets have become over the past three years.

Even after the big afternoon sell off yesterday, the Russell remains in even worse shape. Here’s an updated version of the long-term chart of the Russell 2000— the same chart I’ve been pulling out every time the market has been in a tough spot this year:

As any technician will tell you, the index has broken through horizontal resistance, meaning we should look for additional downside action.

At this juncture, preparation is key. You will want to remain nimble while the market is in flux— anything and everything could happen.

At what could be a potential turning point, it’s important to remain nimble. Don’t feel that you need to trade this downside action right away— an edge won’t be readily found. Early shorts could easily be squeezed in this environment.

Instead, it would be wise to use this week to seek out new trading ideas on both the long and the short side.

For longs, concentrate on relative strength. Even on days when the markets are down more than 2%, there is a basket of stocks in the green. Yesterday, more than a handful of small-cap names posted gains of more than 5%. Seek these strong performers out and watch them closely.

For the short side, concentrate on overextended names that lack the earnings performance and fundamentals to prop up an inflated share price. These will be the stocks investors abandon first.

Sincerely,

Greg Guenthner
for Penny Sleuth

Preparing For A Correction was originally featured in the Penny Sleuth.

The old days of trading stocks was a wild-west show. Finding out how a stock has done over the past few years was one of the hardest things about it. There was virtually no record keeping. Even worse than that, no one had any clue what the market, itself, was doing.

That’s exactly what Charles Dow came to Wall Street to fix. Dow was a journalist with hardly any investing background. As an outsider himself, Dow came up with a system to let anyone understand what was actually happening on Wall Street. As you can guess, that system became what we now know as the Dow Jones Industrial Average.

Starting in 1896, the Dow became the first index to let outsiders understand what was happening in the stock market. You could pick up your newspaper and see whether the Dow was up or down. That may not sound like a lot. But, this index brought a lot of people into the market.

A century later, we find ourselves with hundreds of indexes that cover everything from Australian stocks to U.S. gold mining companies. But there is one that is more important to us small-cap investors than any other…the Russell 2000.

Back in 1984, Russell Investments launched the very first float-adjusted indexes: the Russell 1000, which includes the largest 1,000 companies in the U.S. and the Russell 2000, which encompasses the next 2,000 smaller ones. It’s impossible to be a true small-cap investor without religiously following what the Russell 2000 is up to.

The next logical question would be, “why would a small-cap investor need an index in the first place?” The answer is simple; the small-cap market is the most cyclical of any sector on Wall Street. Let me explain…

For years, small-caps were thought to be quite independent of economic conditions, investor sentiment, and any other macroeconomic element of investing. But with the introduction of the Russell 2000, it became clear that that’s not the case.

As you can tell from this chart, the Russell moves similar, but not directly in-line with the Dow:

Check out the market recovery in 2003. The Russell spiked up much faster and much higher than the Dow. That’s what small-caps do. If you can time when those spikes are about to occur, you can make big money. That’s the real point of staring at indexes day in and day out.

Why tell you about this today? Because we are on the verge of the next spike, and Wall Street doesn’t even see it yet.

You see, when we go through a severe correction like we have been going through the past nine months, the Russell is hit the hardest. But, by the time the Dow bottoms out, the Russell is ready to make a huge rally. You can see it post-correction 2002 above. And you will see it very soon in the post-correction 2008:

This chart shows the Russell leveling out ready for a rally. When the Dow finally finds its support, the Russell and almost every small-cap out there will surely lead the comeback rally.

Simply put… Now is the best time in years to buy small-caps. So go out there and do it…

Sincerely,
Jim Nelson
August 15, 2008

Russell 2000 Is Destroying the Dow was originally featured in the Penny Sleuth.

That’s the whole story as far as most investors are concerned. There has been a lot of chatter in the media lately about the return of blue-chip dominance, even though the Russell 2000 still posted a gain of more than 18% in 2006.

One particular Associated Press headline caught my eye a few weeks ago. It read: “Signs Point to Good Year for Investing in Large-Cap Stocks.”

The article says it might be time for small-cap investors to rethink their stock picking strategy. The author thinks this year, the best bet for anyone with a dime in his pocket will be the big-name stocks. The logic is that eventually, large-cap, blue chip returns must have a special year where they whip the Russell 2000—a benchmark group of 2000 stable small-cap stocks with proven, long-term performance.

This could be true. After all, the Russell 2000 posted a gain of more than 18% for 2006, officially beating the Russell 1000 Large-Cap Index for seven of the last eight years. However, the Russell 1000 caught a second wind and slammed the Russell 2000 for the second half of 2006.

The blue chips could slap around the Russell 2000 any given year. Whether or not this happens is none of our concern…

Our attention should not be fixed on the index as a whole, but rather on the individual companies we look to for profit potential.

For the first two months of 2007, some big-name stocks have performed quite well. Three members of the Dow Jones Industrials are showing double-digit gains so far in 2007: General Motors, Alcoa and Caterpillar (up 18%, 16% and 10%, respectively).

And while these early returns are nothing to scoff at, they hardly compare to the best performing smaller stocks. Take a look at some of the best performers of the Russell 2000:

Molecular Devices Corp (MDDC): This medical instruments maker received a huge boost in its share price in late January when drug developer MDS Inc. announced it was buying the company for $615 million.

MDS agreed to pay $35.50 per share for Molecular Devices, approximately 50% more than its then-current price of about $23.80 a share.

Hansen Medical Inc. (HNSN): Here’s another medical device company for you. This one develops robotics designed to position catheters. Just this month, Hansen submitted data to the FDA from a successful patient trial of its new products.

January 3 was the last time this stock closed under $12. As of this morning, shares of Hansen Medical were trading around $17.65—that’s more than a 60% gain in less than two months.

Zoltek Companies Inc. (ZOLT): Zoltek manufactures a new, futuristic carbon fiber that is 100 times stronger than steel. It beat estimates earlier this month, and continues to post solid gains. As reported on Forbes.com, Zoltek controls 85% of the market for aircraft brakes, and BMW is experimenting with car parts made of the company’s carbon fiber.

Zoltek was trading for less than $20 a share at the beginning of January. As I type, it is up more than 1.3% this morning to $31.50.

As you can see, if you’re choosy, you’ll still find the biggest gains in the small-cap universe…no matter what.

Best,
Gunner
February 26, 2007

P.S.: You can read all about the fastest-moving penny stocks on the market in the new Penny Stock Fortunes. In fact, one of our picks is already up 25% as I type.

Investing with the Russell 2000 was originally featured in the Penny Sleuth.

I couldn’t help but wonder what signs these people are reading…

The gist of the article is that it might be time for small-cap investors to rethink their investment strategy. The author thinks that this year, the best bet for anyone with a dime in his pocket will be the big-name stocks that can ride out any bumps in the economy.

You see, his logic is that eventually, large-cap, blue chip returns must have a special year where they whip the Russell 2000′s returns. I’m sure some are eagerly anticipating this event as if it will somehow restore order to the stock market and promote world peace.

But as much as we humans enjoy synchronizing our watches and measuring significant events by calendar year, we tend to miss out on the bigger picture attempting to predict the unpredictable. Take, for instance, the AP article. The initial question posed is whether an investor should alter his strategy to focus on larger stocks since they are “poised to outperform” smaller ones.

The article states that the Russell 2000 posted a gain of more than 18% for 2006, officially beating the Russell 1000 Large-Cap Index for seven of the last eight years. However, the Russell 1000 caught a second wind and romped the 2000 for the second half of 2006.

So all of those investors who have been biding their time and are now claiming this is the year of the large-cap might have missed the boat. Ever since the Russell 2000 took a hit in May 2006, a lot of money has been flowing into large-cap stocks. The Dow Jones Industrial has soared while the Russell 2000 and the NASDAQ have lagged behind. Just look at the chart below:

Now we have the Dow squeaking out record highs seemingly every week. The Wall Street Journal reports that the Dow has posted 25 record closes since October 3.

So what are investors to do?

Well, there is a group of small-caps that are very attractive, but you must be selective…

A few months ago, our former value guru James Boric wrote that average investors are, in fact, buying garbage stocks, even in the small-cap arena. He determined this two ways:

The first, he searched for all small-cap companies traded on the NYSE at the 15 times earnings level or less, 1.5 times book value or less, 1.5 times sales or less, with positive free cash flow, revenue growth, and net income growth. This group would represent attractive small-cap value stocks. James watched as this group only appreciated 6.1% over the prior year — not much at all…

These stocks with good fundamentals are what investors should be clamoring for.

But it was another group of stocks that got all the attention…

The second group James followed were small caps on the NYSE that had negligible sales growth, no free cash flow, were trading at two times book value or more and had no earnings to speak of. The 19 stocks that made this list climbed 51% over the previous year as James watched…

Do you think that these stocks with rotten fundamentals will continue to rise? Well, we can’t tell you when they will stop, but we can tell you where we’d put our money.

Don’t get caught chasing the big returns, even if you are a devoted small-cap investor. We’ll be bringing you some of best plays on the small-cap market in upcoming issues of The Sleuth.

Best,
Greg Guenthner
January 22, 2007

Small-Cap vs. Large-Cap Returns in 2007 was originally featured in the Penny Sleuth.

Back on July 25, I wrote a column on the concept of “relative strength.” I examined the nine American Stock Exchange Select Sector SPDRs to compare the performance of nine different market sectors and illustrate how one can use relative strength analysis to determine which areas of the market were the most appealing.

My underlying thesis in focusing on a sector’s relative strength was that strength begets strength. In other words, so long as the general market remains constant, the best performing sectors should continue to do better than others. Therefore, when you are considering what areas of the market to trade or invest in, you’re better off buying the leading sectors rather than the laggards.

This same concept of relative strength can also be applied to individual stocks within a particular sector or industry. When you have targeted a few areas of the market to invest or trade in, it’s usually wise to focus your attention — and your capital — on the issues within the sectors that have performed the best. More often than not, so long as there is not a fundamental change to alter the underlying character of the market, those same leading stocks are likely to continue to outshine the shares of other companies in the same industry.

That same concept of sticking with the strongest stocks also applies to stocks from different sectors within the same broad-based market average. Even when examining a diversified market index, you pick up some clues about where best to deploy some of your trading or investing capital.

To illustrate the concept of relative strength applied to a broad-based market index, I put the Dow Jones Industrial Average under the microscope. In contrast to other closely scrutinized large-cap indexes such as the S&P 500 and Nasdaq Composite, the Dow Jones Industrial Average has been able to use the rally of the past few months to recoup all of its losses from the market meltdown that commenced in 2000. In fact, dropping as low as 10,698.85 on June 14, the venerable Dow 30 index has notched profits of 12% through the end of trading on Monday,
October 16.

My goal in applying the relative strength concept to the Dow Jones Industrials was to find out which of the 30 stocks that comprise this heavily monitored stock gauge performed the best in order to get a heads up on where the superior performances in the average are likely to come from in the next few weeks and months. I also figured that since the 30 stocks in the Dow Industrials cover a number of diverse market areas, examining the relative strength of these large-cap industry leaders could provide clues as to which sectors were likely to do well over the near-term.

Now, a variety of fundamental and economic reasons have been suggested as the catalyst for the strength behind the major equities averages over the past few months — plunging oil prices, lower long-term interest rates, decelerating economic numbers and declining commodity prices to name a few. I’m not dismissing the effect of any of these influences on the market’s overall performance. But it’s my belief the actual price changes in a stock or index often precedes knowledge of the underlying factors that caused those price changes.

Let me issue a caveat here. There is no guarantee the stocks that have acted well will continue to outperform all the others. Markets are dynamic and change based upon differing macroeconomic, political, and fundamental factors. Still, barring a significant change in the market’s character, odds favor the Dow stocks that captured the greatest portion of the Index’s gains since the summer run-up and will continue to lead the way during the next move up — if in fact there is one.

With that in mind, I went back and calculated the respective performances all 30 Dow Jones Industrial components since the close of trading on July 14. The Dow Jones Industrial Average technically bottomed on June 14. However, with the benefit of 20/20 hindsight we can see the index formed a bullish double-bottom on July 14 when it successfully retested that June 13 low.

Here is each Dow component listed in descending order by absolute percentage return, including dividends, from the close of trading on July 14 through the end of trading on Monday, October 16:

Microsoft Corp. (MSFT:NASDAQ)                                         28.1%
McDonald’s Corp. (MCD:NYSE)                                            27.5%
Hewlett-Packard Co. (HPQ:NYSE)                                        26.3%
AT&T  (T:NYSE)                                                                  25.4%
Pfizer, Inc. (PFE:NYSE)                                                       24.5%
Merck & Co., Inc. (MRK:NYSE)                                            22.2%
Intel Corp. (INTC:NASDAQ)                                                  21.5%
General Motors Corporation (GM:NYSE)                                19.5%
Verizon Communications (VZ:NYSE)                                     18.4%
International Business Machines Corp. (IBM:NYSE)               18.3%
JP Morgan Chase and Co. (JPM:NYSE)                                 17.6%
American International Group, Inc. (AIG:NYSE)                       17.0%
Honeywell International, Inc. (HON:NYSE)                              16.9%
E.I. DuPont de Nemours & Co. (DD:NYSE)                             15.4%
Verizon Communications (VZ:NYSE)                                      14.5%
United Technologies Corp. (UTX:NYSE)                                  14.1%
American Express Co. (AXP:NYSE)                                       12.7%
Wal-Mart Stores, Inc. (WMT:NYSE)                                       12.7%
Proctor & Gamble (PG:NYSE)                                               12.1%
General Electric Co. (GE:NYSE)                                            11.5%
Walt Disney Co. (DIS:NYSE)                                                 8.9%
Exxon Mobil Corp. (XOM:NYSE)                                            8.1%
Johnson & Johnson Inc. (JNJ:NYSE)                                      8.0%
Home Depot, Inc. (HD:NYSE)                                                7.9%
The Boeing Co. (BA:NYSE)                                                   7.4%
3M Co. (MMM:NYSE)                                                           7.1%
Citigroup, Inc. (C:NYSE)                                                        6.5%
Coca-Cola Co. (KO:NYSE)                                                    4.5%
Altria Group Inc. (MO:NYSE)                                                 3.3%
Caterpillar, Inc. (CAT:NYSE)                                                  1.5%
ALCOA Inc. (AA:NYSE)                                                        -10.8%

You can see that the top five Dow performers since July 14 have all achieved returns in excess of 24%. And if you look at those five stocks — Microsoft, McDonald’s, Hewlett-Packard, AT&T and Pfizer — you will notice that all of them fall into one of two broad categories. They are either defensive, non-cyclical issues (McDonald’s, AT&T and Pfizer) or technology-related shares (Microsoft and Hewlett-Packard).

If you expand your search to the top 10 above, you will have covered all of the components that returned at least 18% over the last three months. With the exception of a rebound by beaten up General Motors, the remaining companies in stocks six through 10 in the above list are either drug giant Merck and telecommunications leader Verizon (both defensive issues) or technology mainstays IBM and Intel.

I’m not suggesting you jump in and scoop up shares of any or all of the top 10 companies above. Many are far too extended from logical buy points and vulnerable to short-term retracements or consolidations.

Instead, I suggest you keep a close eye on these relative out-performers and watch how they act when the Dow Industrials pulls back to areas of support, based on trend line analysis or the location of key moving averages. Observe how these leading stocks act.  The ones that hold their ground, or relinquish just a modest portion of their recent gains, are the stocks likely to continue to lead the way if the Dow decisively busts through the 12,000 level. And if one of those leaders holds up well, it’s likely the sector that stock represents will also contain shares of other companies poised to do well.

So, remember to follow the leaders. Those are the stocks most likely to power the Dow higher and fatten your financial capital in the process. And you can find out who they are by simply employing the concept of relative strength.

Trade well,
Mark Bail
October 17, 2006

Relative Strength of Stocks was originally featured in the Penny Sleuth.

*** 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.