This August, individual investors have been grossly underestimating the amount of volatility that still remains in stocks. Today, I want to introduce you to a much better tool to gauge market volatility…

Normally, in trending markets, volatility is a good thing for traders. It means that the market’s making bigger moves, and our average gains increase as a result. In ranging markets, like the one we’re in now, volatility is significantly less appealing — it means that risk is being applied much more haphazardly.

It pays to understand what the market’s volatility levels look like before you take any trade…

Not surprisingly, plenty of people have been trying to predict when the volatility will decrease to more normal levels. Usually, people refer to the VIX volatility index when they’re trying to measure the level of volatility in the market. But that’s a big mistake…

The VIX measures the implied volatility of the S&P 500 — in other words, it measures how much risk people are pricing into “the market” as a whole, not how much risk there really is. It became popular during the crash of 2008, when stocks were in free fall, and volatility was soaring.

But the VIX isn’t a very good volatility indicator at all. When traders aren’t pricing in adequate risk, the VIX doesn’t tell us the true amount of volatility in the market.

And that’s not all…

The VIX is, seriously, negatively correlated with the S&P 500. As a result, it increases primarily when stocks are quickly moving lower. If stocks are moving higher just as quickly, it doesn’t register. That’s a crucial shortcoming to keep in mind when gauging volatility in this market. The VIX is a great way to measure “fear” in the market, but it’s a pretty poor way to measure how volatile things are right now.

Instead of the VIX, I’ve got a better volatility indicator to show you. It’s called a Bollinger Band.

Developed by analyst and money manager John Bollinger in the early 1980s, Bollinger Bands measure a stock’s volatility by charting a band that’s a specific standard deviation away from its moving average. As a result, Bollinger Bands are adaptive to the market, and they’re based on what’s actually going on in the market — instead of relying on how investors are pricing risk.

The space in between the two bands is known as the bandwidth; it’s an excellent measure of volatility in the market. The wider those bands get, the more volatile a stock is.

The chart below of the S&P 500 shows just how volatile stocks still remain right now:

Above: Bollinger Bands set around the S&P 500 index. Subchart shows bandwidth.

As you can see, the market’s bandwidth is currently 25.1 — from a daily time frame, that’s the highest we’ve seen volatility since back in March 2009, when the market set its secular bottom. For comparison, the VIX didn’t even set as much as a new quarterly high in August.

There’s a considerable amount of hidden volatility in the market right now.

The key to wrangling this market is going to be harnessing that volatility when it becomes directional — and sitting aside while haphazard trading continues. Don’t underestimate the risk in stocks this month…

Cheers,

Jonas Elmerraji
Penny Sleuth

A Better Way to Gauge Market Volatility was originally featured in the Penny Sleuth.

Just turn on the TV or flip open the paper, and it’ll be clear as day: The economy is still struggling. Governments are unable to pay their bills. Stocks are stuck in a rut.

But while the message isn’t complicated, it’s not exactly correct, either. You see, while the media commiserate about an economy that’s unable to bear its own weight, the truth is that corporate earnings are better than they’ve been in years.

It all boils down to the fact that stocks are out of synch with fundamentals right now.

I know it’s hard to believe that the economy isn’t teetering on the edge of oblivion this summer, but take a quick look at the data and it becomes apparent that the sentiment on Wall Street is wrong. It all starts with earnings…

More than 70% of stocks in the S&P 500 beat their earnings estimates last quarter. A full 83% of the Dow Jones industrial average did the same. All told, the largest corporations took home the biggest profits they’d seen in years – and the stock market reacted by dropping around 5% last earnings season, erasing all of 2011’s gains.

Second-quarter earnings season is just kicking off as I write. How are another quarter’s numbers impacting stocks?

With the exception of a couple of months in 2007, the S&P 500 is sitting on higher earnings right now than at any time in history. The Dow’s profits are at an all-time high this month…and still, stocks are falling.

It gets worse.

Adjusting for current share prices, stocks are actually valued at crisis levels right now.

The Dow’s price-to-earnings ratio is currently 13.67 – that means that stocks are currently valued cheaper than they were at their lowest point in October 2008. Assets are cheap too – with a price-to-book ratio of 2.2, for instance, the S&P 500 trades for the same small premium that shares fetched in the latter half of 2008.

Warren Buffett is known for saying that “If a business does well, the stock eventually follows.” While that’s an idea that I generally agree with, it’s a question of timing. How many months – or even years – could go by before stocks start trading at rational prices again?

The fact remains that market conditions dictate prices. Until Main Street becomes willing to take on risky assets once again, investors are going to be slaves to a volatile stock market.

How to Profit in Spite of Slumping Stocks

I’m not particularly pleased with the idea of waiting for the market to come around on us. It’s incredibly frustrating to see companies raking in cash hand over fist – only to watch their share prices die a slow death each trading session.

That’s why my colleague Greg Guenthner and I have already recommended that our Penny Stock Fortunes readers pick up shares of two companies willing to cut you in on their profits…

Our logic is simple. By buying mispriced companies paying out substantial cash dividends right now, we’re able to generate a real-world return even if market conditions continue to be soft. And since prices are depressed right now, we’ll also be first in line to benefit from a recovery in the stock market.

Don’t think that dividends are only for blue-chip investors. There are scores of small-cap companies out there that are doling out impressive dividends right now. We’re betting on them this month – I’d suggest you give penny stock dividend payers a second look in 2011…

Sincerely,

Jonas Elmerraji
Penny Sleuth

Why Investors Are Wrong About Stocks Right Now was originally featured in the Penny Sleuth.

Don’t think that anyone – present company included – is immune from the frustrations of seeing portfolio positions dip or watching as the S&P 500 sells off for yet another consecutive day. But stock market frustration only becomes a real problem when it starts to interfere with your decision-making process. Now more than ever, it’s crucial to follow your preset trading rules, and stick to the system.

Whenever you enter a trade, you should go in thinking about your exit plan from the start, whether the stock performs as expected or it doesn’t. Those two price levels need to be dictated by predetermined analysis, not by how we feel about the market; when used to guide your trading, they can spare you from premature selling.

It’s all about having perspective. With the right context for a stock’s move, suddenly sell-offs aren’t panic inducing. Today, I want to share some of the market context that my Penny Momentum Trader readers have been benefiting from:

I’ve been putting a lot of emphasis on the technical significance of the 1,300 level in the S&P 500 since late 2010. So, can you guess where last week’s sell-off stopped?

That’s right. Despite some flirtations in the mid-1,290s for around 20 minutes on Thursday, the S&P held up above our technical support level nearly perfectly. Remember, it’s important that the market is following our technical cues – it means that last week’s price action is probably just a healthy correction, and that our cautiously bullish outlook for the near-term continues to hold. Even though we were able to pin the market’s “floor” within a few points, I want to stress for newer members that we’re not in the business of making predictions here. As technical traders, we’re focused on contingent expectations – a framework for trading that’s based on if/then rules.

If the market stays above 1,300, we’ll continue to be cautiously bullish…

So that said, what would we like to see as we enter the first week of March? Ideally, we’ll get a bit of sideways consolidation in the S&P 500 this week as the market cools off from the rollercoaster ride we’ve just endured.

Cheers,
Jonas Elmerraji
Managing Editor, Penny Sleuth

March 1, 2011

Avoid Serious Losses By Following the Rules was originally featured in the Penny Sleuth.

Don’t let that investor anxiety get to you, however. The market technicals are pointing toward continued bullishness in stocks, and 1,400 looks like the next stop for the S&P. Here’s everything you need to know to keep a cool head in 2011’s hot market…

As you know, as traders, predictions aren’t our game. That said, contingent expectations are our game – and one of those contingencies triggered last week, clearing the path for a straight shot to 1,400 for the S&P 500 and 13,000 for the Dow.

Take a look at the chart below – the annotations on which I haven’t changed for weeks (that’s crucial because it shows that the market is being obedient to our expectations). It shouldn’t come as a surprise that the S&P found support right on the top horizontal line we’ve been watching; it’s just another example of the market following our cues:

Last week, I told my Penny Momentum Trader readers that “If stocks sustain a break above 1300, expect rally mode; if the S&P falls below 1275, brace for selling.” And despite some flirtations around support at 1275 on Friday, the S&P 500 pushed definitively above 1300 on Wednesday, clearing the last overhead barrier between the major index and its next important resistance level at 1400.

So, now that stocks are in “rally mode,” what should you expect? For PMT’s small-cap trades, we watch the broad market purely for direction – when the S&P looks to rally, we’re long, and when it’s pulling back, we’re short. Simply put, we’re using power-packed small-cap stocks to trade the S&P’s broad trends (it’s a bit more complicated than that, but you can get the full story here…)

That means you can expect us to keep betting on stocks set to rise as we move deeper into February.

The Reluctant Bulls…

Meanwhile, some of the market’s most anxious investors are seeing the writing on the wall, and turning bullish. My colleague Greg Guenthner pointed me to news that noted hedge fund T2 Partners is reducing their short exposure and focusing instead on buying value stocks.

“Over time we’ve been quite successful shorting fads, frauds, promotions, declining businesses, and bad balance sheets. Where have had much less success, however, especially in recent months, is shorting good businesses that are growing rapidly, even when their valuations appear extreme…”

“Such open-ended situations, regardless of valuation, are very dangerous, so going forward we will avoid them…” said Managing Partners Whitney Tilson and Glenn Tongue in their February letter to shareholders.

Added institutional buying pressures should back up our outlook at others follow T2′s lead…

At the end of the day, sentiment is a crucial element to the market’s movements – it’s human supply and demand that drives prices for stocks, after all. Don’t sweat the pullbacks; with sentiment barreling in bulls’ favor right now, and technicals showing few overhead price barriers, we’ll keep going long this market.

Sincerely,
Jonas Elmerraji
Penny Sleuth

February 10, 2011

Why the S&P Is Headed for 1,400 was originally featured in the Penny Sleuth.

Before 2008, the VIX wasn’t a household name for most retail investors. But as the index, which measures the implied volatility of the S&P 500 index, rose to new highs amid the crumbling stock market, this unique index got more than its fair share of attention. That said, ask even the most fervent market observers what the VIX really is, and you can expect answers to diverge a bit…

So, what exactly is the VIX?

The VIX’s full name is the CBOE Volatility Index. Essentially, this measure of volatility was created in 1993 for the Chicago Board Options Exchange (CBOE) by then Duke University Professor Robert Whaley to represent the market’s expectation of market volatility for the next 30 days.

Simply put, the VIX is a good indicator of just how much investors can expect prices in stocks to swing. A higher number means bigger moves (both up and down), whereas a smaller number indicates smoother sailing ahead…

But the VIX is actually designed to tell us much more than that – the value of the VIX is actually significant too. It tells us the expected movement of the S&P on a percentage-point basis.

Let me explain…

As I write this, the VIX sits at 19.46. That number is the expected annualized price movement of the S&P 500 in the next 30-days. By digging up a bit of finance class math, that tells us that right now investors are expecting the S&P to move 5.48% (either up or down) in the next 30-days. Although that’s a potentially large percentage move, it’s still far from game changing volatility.

That said, there’s another element of the VIX to look at – where it’s headed:

Taking a look at the chart above, a few things are clear about the VIX’s price action. For starters, the index has been trading in a downtrending channel. And for another thing, it looks like the VIX is finally finding support near its 52-week low of 15.23. With Friday’s test of channel resistance, a change of trend could be underway for the VIX.

For traders, that could be a very big deal – especially if volatility moves back toward previous highs:

• In May, the VIX hit a near-term high of 48.2, which suggests expected single-month moves of 13.9% in the S&P 500… That’s major volatility.

• In October 2008, the VIX hit a blistering all-time high of 96.4. That means that the markets were pricing in monthly expected volatility of 27.8%!

From a technical perspective, every time the VIX has tested support in the low 15 range (weekly), the index has bounced back significantly higher. Since the last few weeks have been another retest of 15 (see the chart above), that’s indicative that higher volatility may come back into play.

If that’s the case, it’s going to be crucial to wait for a broad trend in the S&P 500 and Dow before jumping into stocks. Remember, the VIX indicates movement in either direction, so unless an uptrend is defined, stocks can just as easily move lower.

Obviously, this is a theme we’ll be keeping a close eye on in 2011…

Cheers,
Jonas Elmerraji
Penny Sleuth

February 1, 2011

Don’t Be Afraid of the “Fear Index” was originally featured in the Penny Sleuth.

The Fed injected $400 billion last week. It capped its cash infusion on Palm Sunday with a 25 basis point cut to the discount rate ordinarily charged on direct loans to banks, but now also extended to securities dealers.

But $400 billion couldn’t save a mighty Bear. J.P. Morgan Chase, backed by benevolent Ben, stole Bear Stearns, Wall Street’s fifth-largest investment bank, for $2 per share Monday. “The building [itself] is worth $8 per share,” a midlevel Bear Stearns executive told The Wall Street Journal.

So it goes.

The Dow “plunged” on the news.

Thankfully, Messrs Goldman, Lehman and Morgan fared much better. Their shoes, for the moment, are still varying shades of white. The survivors beat the street by 25%, 13%, and 45%, respectively, Tuesday. The Fed quickly threw fuel into the fire. It slashed rates another 75 basis points later that day.

Mr. Market, that duplicitous little imp, smiled. The Dow Jones industrial average rocketed by 3.5%, or 420 points, its largest gain in more than five years, on the day’s events. He, like our friends at The Daily Reckoning, knows America’s central bank now bestows greenbacks at about half the rate of consumer price inflation.

We said the Fed had a choice: a debilitating recession or destructive inflation.

We vote for recession. Bernanke, however, opts for inflation.

Inflation benefits debtors at the expense of creditors, since debtors can pay back their borrowing in a less valuable currency. Wise investors flee bonds and their negative real returns. They often buy stocks, or better yet, stocks tied to tangible assets (commodities).

But what thou giveth thou can taketh away. The Dow fell 293 points Wednesday. Commodities also took the plunge. Oil retreated $5 per barrel, its greatest one-day fall since Jan. 17, 1991 — the day the first Gulf War started. Wheat and gold also took a dive. Commodities as a whole, as measured by the CRB Index, dropped 5.7%.

Profit-taking? Perhaps? Up, down and all around, nobody knows where the market may land. That’s because Wall Street keeps holding its cards close to the vest. No one really seems to know which financiers owe what, and to whom.

The market, unfortunately, can’t shrug. That’s because, for better or worse, the financial services industry has morphed into becoming the harbinger of the American economy. Our friends at The Economist point out: “The American financial services industry’s share of total corporate profits [rose] from 10% in the early 1980s to 40% at its peak last year (see chart below). Its share of stockmarket value grew from 6% to 19%.”

In the ‘60s, Americans made widgets. Tangible assets bought and sold on the world market. Today, we make the structured products, and increasingly complex financial instruments whose tangible value often depends on the merits of an untested equation. The devastation at Long-Term Capital Management should have taught us that equations, like humans, are often flawed.

But Mark Twain once said: “History doesn’t repeat itself, but it does rhyme.” That’s certainly true. But we doubt even he could imagine our tendency to repeat the same foolish behavior so quickly.

A dichotomy exists in the American economy. We’ve substituted financial services production for real production. And we’ve done this by aggressively playing with debt. Risk, in the minds of financial wizards, was not a four-letter word.

U.S. financial assets as a percent of GDP keep growing at a seemingly interminable pace:

The S&P 500 depends a great deal on the financial service industry’s success. Financials serve as the S&P’s largest component (nearly 20%). In fact, 40% of the S&P depends on big banks, Big Oil and big discretionary spending:

We believe those three will have a tough time running together much longer. High oil and overall spending can’t go on forever. Less spending means fewer financial transactions. In other words, the ripple effect could be rather painful for S&P holders.

Despite conventional wisdom, rising tides do not raise all ships. It’s no secret that certain sectors can carry a market. Nathan Lewis, author of Gold: The Once and Future Money, notes that during the great bull market of the late ‘90s, most stocks actually fell.

“The stock market,” Lewis points out, “as measured by popular market indexes, headed into stratosphere from 1997-2000, but most stocks actually fell, and most businesses stagnated. At the end of 1999, the year the S&P 500 gained 19.5% and the Nasdaq composite index 85.6%, a full 70% of NYSE-listed stocks were lower than they were the year earlier.”

We believe big banks and Big Oil have carried this market the last five years. See this chart of the S&P 500:

Going forward, we believe the S&P will need something else. In the ‘90s, it was dot-coms. This decade offered big builders and big banks. Going forward, another sector must carry the flag.

Perhaps health care will take the lead. There are plenty of baby boomers that need plenty of attention.

Materials, specifically those destined to fix our public roads, bridges, schools and dams, are another place to look. It’s no secret that American infrastructure keeps crumbling…collapsing bridges, exploding steam pipes, Cajun levees.

The American Society of Civil Engineers now warns that the United States has fallen so far behind in maintaining its infrastructure that it would take more than $1.5 trillion over five years just to bring it back up to standard.

It’s a win-win for Wall Street, too. The municipal underwriting business takes off. Banks now repackage municipal debt like mortgage debt. The fees keep rolling. Seven-figure-bonus days are here once again.

The banks knew that if disaster struck, as it has, someone else (usually taxpayers) would bear the cost. Washington facilitates the deal. And the game goes on.

Good Friday,

Christopher Hancock
March 21, 2008

Watch Out for this Market was originally featured in the Penny Sleuth.

When company insiders (CEOs, CFOs, major shareholders, directors, etc.) are bullish enough to spend millions of their own dollars to buy stock on the open market, it means they think stocks are cheap and worth owning.

However, when those same insiders are selling stocks en masse, the market is generally overextended and stocks (on a whole) are expensive. That’s when you want to exit stage left. Or at the very least, you want to sit on the sidelines and observe from a distance.

Now is one of those times when you should either be a seller or sitting on the sidelines in cash. Take a look at the chart below. It shows the ratio of insider buying to selling compared with the performance of the S&P 500:

Notice insider buying inversely correlates to the general market’s performance. In other words, when the market plunges, insider buying peaks. And when the market peaks, insider buying dries up. For instance…

During the crash of 1987, the number of firms with insider buying almost doubled. While the mainstream was panicking (and selling for massive losses), the smart money was piling in.

The same thing happened during the collapse in 2001.

The ratio of insider buying to selling spiked twice between September 2001 and September 2002. During that time frame, the S&P 500 fell from 1,155 to 800. That was a good buying opportunity. The S&P 500 is at 1,250 today.

By comparison, insider buying has been all but nonexistent lately. This is no big surprise when you think about it. On May 8, the S&P 500 hit a new five-year high. So there aren’t many bargains on Wall Street. And as you would expect, the insiders are selling stocks at a greater pace than anytime in the last six years. The ratio of buying to selling is approaching 0.2 today, compared with well over 1.4 in 2001-2002.

This is a very telling sign.

The people who are running the companies you and I are investing in are selling their own stocks right now. These are the guys who know about future orders coming in. They know specifics market trends long before you and I have a clue. They know everything about their own balance sheets, income statements and cash-flow situations. Armed with all of this information, the insiders are saying, “Screw this, we’re getting the heck out of Dodge.”

Yet retail investors keep buying.

Even after the recent correction from early May to mid-June, the market immediately rebounded. Your average investor was (and is) convinced that we are still in a raging bull market and that stocks (even really bad ones) will keep rising.

This is a classic sucker’s rally. And I can say it is a sucker’s rally with a high degree of certainty because the smart money has been eerily absent from the equation. Only fools are buying now. They bid the prices up, and the people in the know sell out for a nice profit.

This situation can only end badly for the fools.

Now is a good time to take profits — especially on speculative stocks that are selling way ahead of their underlying fundamentals.

Of course, there are still a handful of stocks that the insiders think are very attractive. Insider buying has not dried up completely.

This morning, I discovered an ambulance company that does business in some of the fastest-growing states in the country. It has growing sales, healthy net income, above-average profit margins and very strong cash flows. The company is paying down debt ahead of schedule — which caused Moody’s to upgrade its credit rating. And the CEO of the company recently bought nearly 30,000 shares at market prices of well over $200,000.

As it turns out, this stock is down 29% from its highs last year. So it is already beaten down. It is exactly the kind of stock that should outperform the market — even as most stocks crumble.

As an investor, I’d much rather put my money in stocks the insiders are bullish enough on to invest in alongside of me — especially in this ugly market.

Best regards,

James
July 13, 2006

Make Sure You Aren’t the Fool in This Market 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.