Ricard's  Instablog

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 McDonalds and Walmart 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 doublings or triplings 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's 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 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.