Small Stocks, Big Trouble

Everybody loves small stocks. Investors feel that’s where the money is – and that you can’t lose with small stocks…which is exactly why the timing is perfect to bet against them. Steve Sjuggerud explores…

You can make an enormous amount of money in small stocks. Gerry Tsai can tell you…

You may not know his name. But investors in Gerry’s fund made an absolutely ridiculous amount of money in small stocks – so much that people were actually willing to pay up to half of their first year’s investment, just to get a piece of Gerry’s fund.

What was Gerry doing with people’s money to make it multiply so quickly?

Gerry was known as a "gun-slinger." He was the poster-child of an era of gun-slinging portfolio managers – managers who favored new issues, small fast-growing stocks, and "concept" stocks. Some of his big-name gun-slinging contemporaries performed even better…Fred Carr’s Enterprise Fund rose 118% in one year as he jockeyed in and out of various stocks. And Fred Mates’ fund was up 158% a year later.

These maverick young guns all did one thing… they avoided the big old blue chips… or the old "buggywhip companies," as they joked. They wanted smaller, newer, higher-risk stocks. Why? Because they were convinced that: Small companies always beat the old companies.

Gerry was the king of the 1960s. "Gerry Tsai is buying it!" That’s all it took. Whatever Gerry did, the rest of the crowd wanted to do. For example, when Gerry Tsai bought 120,000 shares of National Student Marketing (NSMC) for five million dollars, he put the company on the investment map. And NSMC wasn’t the only stock. It happened over and over again.

At the end of 1965, after making 50% for his investors that year in the Fidelity fund he ran, Gerry Tsai left Fidelity to start his own fund…the Manhattan Fund. Investors clamored to get in – he raised a quarter of a billion dollars from investors…an astonishing amount back then. In 1967, the Cult of Tsai and the other "go-go" managers rolled on…he earned investors a return of 40% that year.

Everyone knew it. Small stocks simply had more upside potential than the big old dogs. Always have, always will. (Or will they?)

"We are at least in a different – if not a new – era of traditional thinking, the standard approach to the market is no longer in sync with the real world… we have never really been here before, and therefore cannot be certain of what happens next." – Forbes Magazine, October 15, 1968

Small Stocks: No New Era

With the benefit of hindsight, we know what happened next…there was no new era. And small stocks got obliterated.

Shares of National Student Marketing are a perfect example. With Gerry Tsai’s stamp of approval, National Student Marketing had become THE stock to own. The stock had soared to $120 in February 1970. An international conference of institutional investors was held at the Hilton in New York in February of that year. The two thousand delegates were polled, and their favorite stock was National Student Marketing.

Then the bottom fell out. From a price of $120 a share, NSMC dropped 95% by July that year – in just five months!

The game was over. Investors who bought Tsai’s Manhattan Fund on its opening in 1966 lost over half their money by February 1973, not counting dividends, according to Time magazine (February 12, 1973). And then the terrible bear market came…

Losses in small stocks piled up. Small stocks lost 35% of their value in 1973. And then again, in 1974, they lost over 25% of their value once again.

The great bull market in stocks peaked in 1968. Yet the real obliteration came five years later… Stocks in general lost half of their value between 1973 and 1974, and small stocks took it on the head even worse.

Fast forward to today. The great bull market in stocks peaked in 2000. Is the real obliteration going to begin today – five years later?

It sure looks like it.

While the NASDAQ has taken it on the chin since 2000, small stocks have hung in there remarkably well.

Small Stocks: Time To Pay the Piper

The time has come for small stocks to pay the piper. Why do I think this?

It all comes down to my three criteria…to enter into a new investment; ideally, I’d like to see all three of these things: Extraordinary value, an opportunity that is hated, and the clear beginning of an uptrend.

In the case of small stocks, we have exactly the opposite of all of these. Really, the timing is perfect. It’s time to bet against small stocks. Let’s take a look:

First of all, small stocks are expensive.

One simple measure of a stock’s value is its price in relation to the company’s sales. And by this simple measure, small stocks (as measured by the Russell 2000 Index) are as expensive today as they were at the peak of the stock market bubble in 2000! With the exception of a brief moment in the late 1990s, small stocks are as expensive as they’ve ever been, going back to the start date of the Russell index back in the 1970s.

Looking at other measures of value, like P/E ratios, small stocks are also expensive. The P/E ratio of the Russell 2000 Index of small stocks is currently over 20 – high by any standard (except tech stocks during the Bubble of 2000). For reference, the P/E of the Russell 2000 Index of small stocks back in 1982, at the beginning of the great bull market in stocks, was 8. Based on current valuations, a fall of 25% to 50% is not hard to imagine.

Second, small stocks are loved. It’s easy to see why…

Investors always love to buy what has already done well. I don’t get it. But it’s what people do. "How’s the five-year performance?" investors ask. And the five-year performance of small-cap "value" stocks has been just great.

So now, after five years of stunning out performance, it’s Gerry Tsai time, all over again.

Everyone is saying, "Small stocks are where the money is…you just can’t go wrong in small stocks." Uh-oh. Here comes trouble…

Small stocks are like real estate on my island here in Florida, where everyone’s saying "You just can’t go wrong in real estate on this island." I’m closing on the sale of a house today here. The trend is still up in home prices locally, so I may be getting out early on that property. Now the home we live in is all the Florida real estate we’ve got, and I’m fine with that.

While the trend is still up on Florida coastal real estate, it is now down when it comes to small stocks…which is part three of our three criteria…

The trend is just now breaking down…this week, the Russell 2000 Index closed at its lowest level in 2005. I’d have to call that a downtrend…and it’s just getting underway.

So we’ve got everything we’re looking for in a sell…small stocks as a group are overpriced, they’re too loved (everyone thinks they’re where the real profits are), and the trend has now turned down. Perfect! To sell…

Regards,

Steve Sjuggerud
for The Daily Reckoning

April 21, 2005

Dr. Steve Sjuggerud has worked in the investment world as a stockbroker, the vice president of a $50 million global mutual fund, an international hedge fund manager, and the director of several research departments.

Shock and awe!

The world’s press seems alarmed this morning. The media was surprised to find that stocks go down…that consumer prices go up…and that the pope is Catholic.

On that last point… the European papers, especially, seem astonished and dismayed to find that the new pope is a traditionalist…a former member of the Hitler Youth who is now a "guardian of Catholic doctrine" as the Times put it. They were all hoping for a groovy progressive pontiff, who would be "tossed by waves and swept along by every wind of teaching arising from human trickery," (as St. Paul put it) along with everyone else. Instead, the old man complains about Marxism, liberalism, libertinism, collectivism, radical individualism, mysticism, atheism, agnosticism…and all the other isms that have infected public thought over the last two centuries.

As for stocks, the bear market that began in January 2000 seems to have resumed. This, too, comes as a shock to many people, who were pretty sure that they couldn’t lose money in stocks – at least, not over the long run. But the short-run losses that most investors have suffered are getting longer and longer…some of the biggest, surest, best-known companies are in retreat…mutual funds are all underwater for this year…and it’s a rare investor who’s made any money at all for the last seven or eight years.

And inflation? Prices of things made in China are still falling. Alan Greenspan’s cheap credit created a capital-spending boom in Asia. The Economist explains:

"Artificially low interest rates stimulate massive capital spending in China, which lowers China’s unit labor costs far more than if interest rates were high. Declining unit labor costs then lead to a fall in Chinese export prices and worsen the competitive position of the U.S. even further."

But things not made in China have gone up, if not dramatically, at least theatrically. That is, they’ve been pushed upwards by Alan Greenspan’s absurd performance – playing the role of someone who’s protecting the dollar, while he actually shoves a knife it its back. The Economist describes the U.S. central bank as "the world’s giant printing press."

"In no other two-year period since 1975 has liquidity increased by so much," says The Economist of the period 2003-2004, in which "global liquidity" – a measure of America’s monetary base, including notes and coins, plus bank’s reserves held at the Federal Reserve, plus foreign exchange reserves held by central banks around the world.

At first, smart traders in the currency markets figured that yesterday’s inflation news would be good for the dollar. The Fed would raise rates, they thought, to protect the greenback. This would bring in more buying of dollars. Then, they came to their senses and realized that the Fed has little interest in protecting the dollar, and no track record of doing so – at least not since Mr. Greenspan has been in office. The dollar fell to $1.31 against the euro.

What will happen next, we don’t know. But we bet there are more shocks coming.

More news, from our team at The Rude Awakening:

————–

Justice Litle, reporting from Reno, Nevada…

"Happily, most commodities and resource stocks have bounced a bit this week. But still, anxieties remain. And still, prudent investors must ask themselves whether the 3-year old commodity bull market has exhausted itself, or whether it is merely taking a well-deserved rest."

————–

Bill Bonner, back in London:

*** Gold is up again…

Our favorite yellow metal is forging higher again. Up $2 dollars yesterday, it’s now trading around $434… maybe we’ll see $500 soon?

*** Dow was down 119 points…it’s the fourth time in six days the Dow has fallen over 100 points in a day. Our trade of the decade – buy gold and sell the Dow – is going back up.

[Ed. Note: We’ve another fine trading suggestion from Dr. Steve Sjuggerud in today’s guest essay, below. He’s recommending his readers short the whole small-cap market. But what would the publisher of Penny Stock Fortunes, James Boric, think? He’s a tireless proponent of the small-cap argument and we had imagined he’d disagree…

"Steve makes a good argument and…sorry to disappoint you, but it’s a trade I like," says Boric. "Two-thirds of the market are small-cap stocks, so it’s a great way of shorting U.S. equities in general. But a sell-off in the small-cap sector doesn’t mean our small-cap stock picks will go down. On the contrary, a sell-off may even help us as investors switch their capital from risky speculative issues to the quality under-valued businesses we buy in Penny Stock Fortunes.

"Again, two-thirds of the U.S. stock market is made up of small-caps. If you look hard enough you can always find quality and value, no matter what’s going on elsewhere."

*** On page three of the International Herald Tribune is a photo of the back of Condoleeza Rice’s head. She is shown speaking with Vladimir Putin. The headline tells us that she "urges Russia to foster reform." In front of her, Mr. Putin’s expression is one of absolute cynicism mixed with a dollop of incredulity. "Why does this woman think she knows what is best for Russia?" his face seems to wonder. "Are not the Russian people as old and experienced as you Americans? Are we not adults? Are we not capable of organizing our own affairs in the way we want? Do we not have more than 250 million Russians? Are there not as many smart Russians as there are Americans? Why would you come here to give us advice on how to run our country? Do we come to your country and urge you to reform? Do I send my Secretary of State to Washington with advice for George W. Bush? Have you lost your mind, young lady?"

*** And over on the editorial page is our favorite columnist, Thomas L. Friedman, with the bad habit of always wanting to kill someone for the "ism" du jour, but the good habit of always being absent when the bullets actually fly. "Can democracy really take root or thrive in the Middle East?" he asks – after urging the government to embark on a war that has cost $200 billion dollars…and as many as 100,000 dead people…to find out. "Lord knows I am rooting for the good guys here. For me, the war in Iraq was always about democracy and the necessity of helping it emerge in the Arab-Muslim world. I am thrilled that things have come this far."

*** We lunched with two members of the House of Lords yesterday.

"The Lord’s power has been greatly curtailed in recent years," one explained. "But it still a considerable restraint. There is always been a significant majority in the House of Lords in favor of protecting traditional English liberties against whatever the current government wants to do. You know, people get all excited about some great new proposal – especially when they become fearful of terrorism or something like that – and they are ready to support almost any measure the government comes up with. But the Lords are more immune from popular pressure. After all, we don’t have to stand for election. So, we tend to vote for things that we think are important for the long term."

Britain’s House of Lords became a victim of democracy two years ago, when it was "reformed" by the Blair government. America’s Senate fell victim to democracy under the Wilson administration. Prior to the constitutional reforms of the Wilsonian period, senators were appointed by the states – which gave them at least a little distance from mob sentiments. Now, they are elected by the lumpenvoters along with the rest of the scalawags and carpetbaggers in Congress.

*** Our Internet connection didn’t work in the office this morning. We had to go to a Starbucks to send out this message. What a disagreeable experience! Why do they think we want to listen to their awful, upbeat music?