The Microcap Speculator

1. Nobody knows when the slide will end. If we see any form of a turnaround tomorrow, CNBC will be stacked with talking heads calling it a double bottom. Could be, but the odds favor more downside. I’m especially concerned about the period between now and August 15, when redemption notices are due at many hedge funds. There is a tangible chance of something very ugly happening between now and then, but if it does not, there will still be many bargains to trade when a recovery is confirmed.
2. To respond to an email question: the Russell 2000 is not a safe haven. Sure, it had slightly less bloodhshed today than other indices, but that was probably just the unwinding of long ES/short ER2 positions favored by many hedge funds. The largest sector weighting in the Russell 2000 is the financials. These are mostly community banks, which have suffered every bit as much as their larger money-center brethren. As Richard Suttmeier detailed on RealMoney.com, many are plagued with excessive loan exposure, which will continue to weigh until liquidity fears subside.
3. I have drastically cut exposure and raised cash in the accounts I use for microcap trading. This was mainly to protect profits — the last two weeks have not been kind to my portfolio, but its still been a pretty decent year. However, I had an ulterior motive. These kinds of dislocations create immense opportunities in microcaps, and when the dust settles I intend to place a host of really low bids on thinly traded but highly-profitable stocks and see if they get hit.

Finally, on a personal note, I’d like to congratulate Asif Suria on the two-year anniversary of his excellent newsletter.

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Its hard to believe that only eight trading days ago, the Dow was at fresh all-time highs. While there were plenty of market skeptics, nobody anticipated such a dramatic and quick fall. Now a return to last week’s levels or a second, equally-violent move down both seem impossible — which of course means they are possible.

So with CNBC and Bloomberg putting on a parade of talking heads to tell us what will come next, let’s take a step back and draw a lesson from the carnage: we don’t know. Sure, we can backtest, consider patterns, support/resistance, and fundamentals. We can determine which move is the most probable, but it never is even close to a sure thing. At the end of the day, we don’t know where the market is going. So next time you hear a talking head telling you we are definitively at a double-bottom, or about to begin another down-leg, remember that they don’t know. You don’t know, I don’t know, and as LTCM taught us, even Nobel prize winners don’t know.

Accept that ambiguity. You can make it a part of your trading by limiting risk.

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1. How bad was yesterday? By my measure, which nets out the breadth on the Nasdaq and NYSE exchanges, yesterday was extremely bad. Time will tell whether it was capitulation, but my combined breadth figures for the last two hours of the trading day were both under -4500. This chart shows the combined breadth on an hourly basis, together with the Russell 2000 ETF: IWM. For reference, about half of the trading days will be contained in the -2000 to +2000 level (indicated by the yellow and blue bars in the chart). +/- 3000 is definitely worth noting, and moves beyond +/- 4500 only occur a few times per year. The last time we saw -4500 was during the February crescendo. Usually that degree of selling signals at least a temporary (3-5 trading day) exhaustion.
2. We are not that far from 52-week highs on most indexes. The Russell 2000 and Russell Microcap Indexes are around 5% off of their respective highs. The Nasdaq, S&P 500 and the Dow Jones Industrial Index are within 3% of their 52-week highs. The bears may have won important battles on Friday and Tuesday but to show a shift in control they will have to register more substantial declines.
3. Don’t forget about seasonality. July and, to a lesser extent, August are typically strong months for microcaps. The fall months, however, tend to be rough. In my book that means lightening up before Labor Day.

Bottom line: The odds favor a recovery over the next 3-5 trading days, but I will adhere to stops to control risk. I was a net buyer of microcaps over the past few days. I’ll discuss those trades more in later posts.

DISCLOSURE: I am long Russell 2000 e-mini futures (ER2) as a short-term trade.

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1. Sell in May and go away?

That maxim may test well for the broader market, but microcaps have different seasonal tendencies. Here are the annualized microcap returns by month from July 1926 to December 2004, courtesy of Dartmouth’s Kenneth French and University of Chicago’s Eugene Fama:

January………159.82%
February………25.10%
March……………1.21%
April…………….12.86%
May……………….6.85%
June………………6.57%
July……………..22.64%
August………….8.16%
September…….-7.75%
October……….-14.60%
November……….7.97%
December………-1.94%

Unless the broader market falls apart, any drawdown in the coming weeks may set up a strong seasonal rally in microcaps. I’m positioned cautiously with much more cash than usual, but I plan to be opportunistic.

2. Relative weakness in the Russell Microcap Index

The Russell Microcap Index is by no means perfect. With components sporting market caps as high as $2.4 Billion, the index clearly extends far beyond what most people would categorize as microcaps. Still, for lack of anything better, the index will suffice as a general proxy for the health of the market’s tiniest stocks. The picture is not encouraging. As the chart below indicates, microcaps have steadily lost strength relative to smallcaps the past eighteen months:

The Microcap Index has held up better against the S&P 500 until last month:

3. Is it just a matter of time until we see new highs in gold?

I know most commentators are calling for a sharp, short-term dip in gold and bounce in the U.S. dollar. I don’t see it, at least not yet. Gold is consolidating near recent highs and the dollar consolidating near recent lows. In my book, that tips the odds towards a breakout in the same direction as the prevailing trend.

I’m heavily invested in junior and midsize mining companies. Its not just an anti-dollar play. Consider these three factors:

• large mining companies are buying back their hedges, which should lend support to the market.
• miners are consistently reporting huge increases in lifting costs, which will make buying reserves more cost-effective than exploration.
• gold is a very small market, so a breakout could be explosive if commodity, hedge and pension funds pile in.

DISCLOSURE: I have no position in IWC, IWM or SPY. Not a recommendation to buy or sell any security. For informational and educational purposes only.

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