Wednesday, November 15, 2006

Small Caps And The Broad Market Are Back To The May Highs

For all of the hoopla of this rally and fear of being left behind it was only yesterday that small caps, as defined by the Russell 2000, and the equal weighted broad market Value Line Index bested the May highs. This was after a one month consolidation where both were stuck in neutral. Is this the start of a new upward push? That's an interesting question. We are closing in on the longest period without a 1% intraday decline in the S&P 500 in over a decade. I know I keep repeating this but violent rallies without a pause aren't typically healthy. The last rally where we had this type of run without a correction long term interest rates dropped 30% to fuel the move. In the last six years, we have only had one sustained rally in the Nasdaq that has really generated a significant return to date. That was 2003 which was a strong rally but a very orderly rise. This, by comparison has signs of blow off. Now, this may not be a blow off but unusual activity catches my attention.

One could have predicted a move into mega caps from international markets and small caps in a move to safety as investors anticipated higher risk. A few weeks ago I talked to a compatriot who has $300 million under management and he told me they were moving everything into mega caps. So, the move up in the S&P does not really surprise me. American and European mega caps were the most reasonably valued equity asset globally. Now, that said, if we move beyond 1400, that will surprise me.

In the 2000 bubble, we didn't get a flight to mega cap safety because the bubble was in mega caps. Instead we had a rotation into undervalued small caps which had not recovered from the 1998 drop of 40ish percent as I recall. Two things surprise me here. Ok, maybe not surprise me. Nothing on Wall Street should ever surprise me. Concern me might be more appropriate. The violence of this rally and the fact that everything else is being bid up with mega caps. I've talked about the valuation of small caps likely being a bubble and as extended as the S&P was in 2000. The fact they are rising past old highs is very unnerving for the future of equities in my estimation. Most cyclical earnings in half a century. Earnings at the extreme end of historical norms. Small cap valuations higher than the S&P in 1929 and similar to the S&P in 2000. Dividend yields in a channel of 100 year lows. That is not a peaceful feeling. The stock market is not a casino and many money managers younger than my parents do not seem to understand the concept of value or effective risk management. Equity markets rising under these conditions should be viewed with caution for those of us interested in long term appreciation and capital preservation.

One final note. It wasn't until October 16th that I really started measuring extreme risk taking in this rally. That also happened to be when the internals on the SPX and Nasdaq peaked. Up until yesterday, the broader market had not made any progress since then. Typically a sign of future weakness. What does the future hold? At this point, I'd be inclined to say yesterday's move might be nearing a final thrust. But, most of my short term work still isn't showing any signs of weakness. In fact, it is accelerating. That doesn't engender a feeling of confidence given the pace of this rally and the loss of momentum on market internals.

The good news is that if you are invested in small caps or the broader market, you have recaptured your losses since May.


posted by TimingLogic at 8:23 AM