Smallcap Rally Is a Leading Indicator

Recently, there's been a lot of hullabaloo regarding the quality of the rally we've been experiencing since April.

However, something to keep in mind is that while the equity markets tend to be a leading indicator, the markets themselves are usually led by small-caps, most of which would fit your average investor's definition of 'junk', or at the very least 'unpopular'. While names like McDonald's (MCD) and Wal-Mart (WMT) continue to stay the course through the worst of the October/November lows and the best of the recent highs, in the past several months we've seen doubling or tripling of names that usually fit a niche investor's portfolio, such as solar or biotech.

Am I advocating a rally that will return us to the 2007 highs? Of course not. I completely agree with Soros' prediction that the market is headed towards a 'reverse square root sign' recovery. But, a recovery it will be, and it will probably be lead and sustained by small-caps, many of which have been beaten into submission with 80-90% declines in the past 12 months.

Instead of looking at S&P 900, or Dow 12000 (or gasp, S&P 666, 333, or 111), I'd advocate looking at representative stocks in various industries and subclasses to get a feel for how this recovery will take place amongst the equity markets.

It's conceivable that as the economy overall recovers to a lower level (that is much higher than where we were in November of last year), the defensive leaders during that bear may suffer a bit as the consumer re-shifts to their snazzy selves - notice how a 20% decline in Wal-Mart (WMT) can only be balanced by a combined tripling of CIEN (a leading telecom equipment manufacturer), SKX (a popular shoe brand), YGE (a leading Chinese solar manufacturer), and DOW (the ubiquitous chemical manufacturer) - stocks that have been beaten down recently, but are in themselves excellent businesses. Don't worry, we'll get to the disclosures later.

Bottom line: small-caps have been unduly hit by the exodus of the 'smart money', and have been long overdue for a healthy recovery. While they may not rise to pre-2007 levels, they certainly do deserve to be fairly valued. Most of the names I mentioned above are either selling below tangible book, below net cash, have p/e ratios in the mid-single-digits, or all of the above. I have not even mentioned Alan Brochstein's recent catch in COLM, which at first glance would make Benjamin Graham salivate in his grave.

Disclosure: I am long CIEN, SKX, and YGE. I recently exited out of a rather profitable call position on DOW. Took on a small position on COLM five minutes before hitting the 'submit' button.

Comments

[Ricard:]

Cetin:

To each his own. Good luck on your investments. I simply know that small cap has led rallies in the past, and that they were sustainable after the tech bust. That bubble also ended in a inverse square root sign type recovery, with most of tech ending much lower than where they were pre-boom. Your 'globalist tech' stocks (INTC, CSCO) have yet to recover even half the value they held in 1999.

May 06 09:59 AM

[redbaron:]

I think the author has it exactly right, as the small caps have been unduly punished since last fall. They have already begun to recover, and I think they have much farther to run.
IMHO

May 06 10:00 AM

[Donkey Kong:]

Once again, long on opinion and SHORT ON FACTS!!! Returns from 12/31/02 - 12/31/07:

(Small Caps) Russell 2000 -- 100.0%

(Large Caps) S&P 300 -- 66.9%


DO SOME ANALYSIS!!!!!!!!!!!!!!...



On May 06 09:27 AM Cetin Hakimoglu wrote:

> Small caps are too risky. Large cap multinationals and globalist
> tech will lead this rally just as they did in 2002-2007 because they
> benefit from global growth and a falling dollar.

May 06 12:11 PM

[Donkey Kong:]

Sorry for the typographical error. The return is for the S&P 500 index.


On May 06 12:11 PM Donkey Kong wrote:

> Once again, long on opinion and SHORT ON FACTS!!! Returns from 12/31/02
> - 12/31/07:
>
> (Small Caps) Russell 2000 -- 100.0%
>
> (Large Caps) S&P 300 -- 66.9%
>
>
> DO SOME ANALYSIS!!!!!!!!!!!!!!...
>

May 06 12:12 PM

[Ricard:]

Thanks for the handy statistics. I'll remember to include some numbers the next time I post.


On May 06 12:11 PM Donkey Kong wrote:

> Once again, long on opinion and SHORT ON FACTS!!! Returns from 12/31/02
> - 12/31/07:
>
> (Small Caps) Russell 2000 -- 100.0%
>
> (Large Caps) S&P 300 -- 66.9%
>
>
> DO SOME ANALYSIS!!!!!!!!!!!!!!...
>

May 06 02:08 PM

[Steven Vincent:]

The performance of small caps relative to large caps is a helpful indicator. I also like to compare the NYA to the SPX. When the NYA and RUT are outperforming the indications are for decreased risk aversion and a bullish trend. When they start to lag, like during the last week (along with NDX), it can be an indication that a pullback is in the offing. I am expecting a pullback to SPX 880 before an assault on the resistance zone around the 200 EMA at SPX 975-1000. Check out my blogs at seekingalpha.com/insta...

May 06 07:11 PM

[Ricard:]

Cetin,

Remember that out of your list, just about all of those companies, and especially RIMM, were small caps that made it during your time period of 2002-2007. They were not "large-cap multinationals," nor were they "globalist tech" stocks during the time period you cite - that title belongs to INTC and CSCO, and to a much lesser extent AAPL and GOOG during that time frame. You've actually strengthened my argument.

May 07 02:31 AM

[Ricard:]

Ah yes, and to prove my point, here are some numbers:

2002 Stock price (1/4/2002) vs 2009 Stock price (today) &
2002 Market Caps vs 2009 Market Caps:

AAPL:
11.84 vs 132.50
10.56 bil vs 118.20 bil

RIMM:
4.41 vs 77.07
2.49 bil vs 43.65 bil

CSCO:
20.83 vs 19.61
121.58 bil vs 114.46 bil

etc...

You get the point. Your picks were either private companies during your time frame (MA, GOOG, BIDU), or themselves small caps (AAPL, RIMM), which lends much more credence to my argument than yours.

I'm also getting a little irritated at doing your research for you. You need to either back up what you say, or be summarily dismissed as a complete know-nothing. I'm not the first person to point this out to you.



On May 06 08:59 PM Cetin Hakimoglu wrote:

> I never recommended INTC, EBAY, ORCL, MSFT, CSCO or other 'old tech'
> because those companies have no growth. I prefer AAPL MA BIDU GOOG
> RIMM which do.

May 07 03:25 AM

[Alphameister:]

Right on the money, and the opportunities among small-cap Chinese stocks are especially amazing. Many of my holdings in this area have doubled from their lows and could do so again without becoming expensive. They trade well below book values and at single-digit P/Es in the range of 3 to 7. I provided names in a posting several weeks ago and they are up more than 30% on average since then (and ripe for short-term profit taking which is why I'm not listing them here). APWR has been my favorite and is encountering profit taking today; take a look and consider buying if this stock becomes available around 9.

May 07 11:33 AM

[Alan Brochs...:]

Hey, thanks for the mention! I saw your title come up because I track anything on Seeking Alpha on COLM (plus lots of others) and because I track your articles. As an aside, I recommend to all S.A. users to set up this daily notification if you haven't already done so (and feel free to include me!)

I quickly (which shows you how far behind I am today) clicked on this morning's email as your title caught my attention. As you may be aware, I have been bearish since the summer of 2007 with a pretty good record of getting out of the way of bull rallies subsequently. I was really fooled last year by the strength in small-caps, leading me to be hoisted on my own petard when I abandoned my previous forecast that the bear would return (last May). Fool me once, shame on you (Mr. Market). Fool me twice, shame on me. Actually, I had shame on me last year!

As a contributor, I know how the editors (my friends) can often change titles and create potential misleading conclusions for those who don't read through. I don't think that you are taking the small-cap recovery as an indicator of better days ahead but rather suggesting that it is conceivable that they could do better than large-caps. I sure agree with that, but even if the market regresses as I expect. I have addressed the issue (ad nauseum): Small-caps have generally better balance sheets and certainly aren't facing the currency headwinds that their big bros face over the next 2 quarters. I also believe that many of them, with their intense focus and adaptability, may navigate the storm better.

Thanks for the heads-up on SKX - I continue to like the whole "shoes" theme, as I don't think we are heading to a barefoot society. I like SCVL, but DSW and SKX sure merit attention here too.

May 07 01:15 PM

[Ricard:]

Alphameister,

Thanks for the compliment. Personally, I'm not very enthusiastic about a lot of the Chinese small-caps that are not ADRs. I went to one of those 'money shows' where micro-cap corporations pitch their stock, and saw an unusual concentration of Chinese companies that went public by buying an American shell. One question kept running through my mind...what business does a Chinese corp have in going public in America...? Is it possible that they could do what tech did in the late 90s, where companies with nothing more than a concept acquired billions, only to go bankrupt? The CEO of Value America (indeed, my first misbegotten endeavor in the stock market) walked away with nearly $50 mil pitching an idea to the likes of Fedex founder Fred Smith that ultimately was worth the paper it was printed on.

I've yet to answer these questions about the China shell companies, and until I do, I steer clear of non-ADR China plays.

May 07 02:37 PM

[Ricard:]

Alan,

I should be thanking you for the COLM mention...lol.

I actually wish I sold and stayed out late 2007. I was actively buying from July to September last year thinking that the bear was about to end, until I saw the writing on Hank Paulson's wall. Thankfully I'm back to the peak levels in my own portfolio right now.

No, that title is my own creation. I tried to mix the theme of a sustained small-cap rally within an overall bearish market sentiment, and mixed in a little marketing magic with what I hoped was an eye-catching title. I could have made it twice as long and twice as accurate, but I'm not trying to bore people *before* the article. :)

If you didn't mention SKX, then I wonder who did...maybe Marc Gerstein...he usually has a bunch of good ideas as well. I'm probably more like Buffett than I want to advertise. I wear Skechers shoes, and have been for at least 5 years now. When I heard the stock was more of a bargain than the shoes, I jumped at it.

May 07 03:00 PM