Barrons

UP and Down Wallstreet

Monday, August 22nd, 2005

Goldilocks? Not Exactly

By RANDALL W. FORSYTH

LIKE AGE, THOSE LONG and variable lags eventually catch up to you.

It takes months and even years for monetary policy to affect what happens in the real economy, Milton Friedman taught an entire generation of economics students. And although every central banker on the globe pays lip service to this verity, they still are guided more by backward-looking indicators, such as how many people found jobs last month, than forward-looking ones, such as markets. Quarterbacks know to throw where the receiver will be, not where he is. Central bankers don't get that.

Mark Turner, who probably didn't play what we call football growing up in England, did get it. And as quoted in this space back in March of '04, the chief investment officer of Pentagram Investment Partners predicted the Federal Reserve's easy-money policies -- which then held the overnight federal-funds rate down at 1% -- eventually would wind up dramatically slowing, rather than stimulating, the global economy. That cheap credit would send commodities, and energy in particular, soaring along with real estate.

Since then, crude oil is up more than two-thirds, hitting a record $67 a barrel. And Goldman Sachs in effect said, get used to it; $60 oil is the new normal. Of course, crude sold off on that forecast, not unlike when the firm predicted a spike to $105 earlier this year. What seems more apparent is that while $40 and $50 oil didn't crimp the indefatigable American consumer, $60 crude finally seems to have pinched, as evidenced by last Tuesday's doleful news from Wal-Mart, which allowed how its customers have little left to spend after being drained by filling up their gas tanks.

Greenspan & Co. also have steadily notched up the fed-funds rate to 3½% in the past year or so, which siphons even more cash from the pockets of borrowers on top of what they're paying at the pump. One of those weird and wonderful interest-only adjustable-rate mortgages that cost $750 a month last year now might cost $1,250 a month. Fueling a couple of SUVs costs maybe an extra 50 bucks a month. Just wait 'til heating season.

What we're seeing now is the delayed impact of the Fed's formerly easy policy, combined with the first twinges from its belated tightening. The worst of both worlds -- rising prices (check out the latest CPI and PPI readings) colliding with monetary restraint. Does this sound like Goldilocks?

Even the auto sector has not been able to escape this vise. While GM and Ford are clearing dealers' lots with their employee-discount sales gimmick, their former supply arms are bearing the brunt of the doleful state of the car market. Delphi teeters on bankruptcy, hoping for a bailout from the General, while Visteon, the Ford spinoff, bleeds cash. Pushing its problems down the supply chain clearly hasn't solved Detroit's problems.

Markets around the globe duly took note. Tuesday's triple-digit drop in the Dow also was emulated by other bourses, notably those in Asia and especially Korea, which has tended to be a leading indicator for the Nasdaq. What strikes Turner is how well the bond market trades, even in the face of outsized jumps in the PPI and CPI. "There may be something rotten in the state of wherever," he says. And September, the worst month for stocks, is only 10 days away.

UNTIL RECENTLY, INVESTING in small-capitalization stocks was a different ballgame than in big stocks. Large-caps trade more like commodities, especially with index funds, futures and options being whipped around like currencies or bonds. Even individual traders can buy and sell the SPDR 500 Spyders (ticker: SPY) with a mouse click and for about a penny in commissions for each stock in the Standard & Poor's 500 fund. And they can do so any time of day, as often as they like, unlike with mutual funds.

By contrast, small-cap investing has meant digging for estimable companies with solid prospects and finances, as our small-stock maven, Rhonda Brammer, does with such aplomb. And once you find one of these overlooked gems, you have to be patient. It may take time for the virtues of these small fry to be appreciated. It's hoped that in the fullness of time, these companies will continue to grow and graduate into the ranks of mid- and large-caps. And institutions can't whip in and out of smaller, less-liquid stocks without disrupting their prices. All of which requires you to be an owner rather than a trader in small-caps.

Or so it used to be. In recent years, folks have jumped on the small-cap bandwagon with the same alacrity as they once did with the Spyders, or QQQs (as aficionados of the Nasdaq 100 Trust refer to the ETF, even though its symbol is QQQQ since moving to the Nasdaq last year). Their vehicles of choice are the iShares Russell 2000 (IWM) and, to a lesser extent, the iShares S&P SmallCap 600 (IJR). As the chart here shows, the Russell 2000 ETF's size has risen pretty much in lockstep with the small-cap benchmark index.

Which is driving which? Good question, says Satya Pradhuman, Merrill Lynch's chief small-cap strategist. "The popularity of [the ETFs] is symptomatic of the classic small-cap cycle," he says. Previously, however, when a large-cap manager wanted some exposure to smaller stocks, he'd walk across the hall and ask his small-stock counterpart for his best ideas. Now he can just punch in IWM to get exposure to the sector, Satya adds. Which points up an important point about ETFs: While they were originally aimed at individuals, institutions, notably hedge funds, count for much of the volume.

That can be a two-edged sword, Satya also points out. "The way markets act today, it's more dramatic. Any reversal, as in the January-April period, can be violent because the base or investors can get in and out more quickly." He adds that the fundamentals for small- caps still are positive, with the investor base continuing to broaden.

That said, it seems likely that moving masses of money into, and out of, the small-cap ETFs is apt to have an out-sized impact on this sector. Large as S&P index funds and ETFs are, they pale against the capitalization of those 500 stocks, whose value exceed three-quarters of the U.S. market cap. Even if the Russell 2000 and S&P 600 ETFs didn't comprise a bigger part of the small-cap universe, buying and selling the less-liquid constituent stocks likely has a greater market impact.

And indeed, this hypothesis is about to get an even more extreme test with the debut of two micro-cap ETFs last week, iShares Russell Microcap Index (IWC) and PowerShares Zacks Micro Cap Portfolio (PZI). The former consists of the smaller half of the Russell 2000 while the latter consists of 300 to 500 highest-ranking stocks out of the 2,500 smallest names, based on a Zacks quantitative formula.

John Montgomery, manager of the top-performing Bridgeway Ultra-Small Co. (BRUSX) and Bridgeway Ultra-Small Co. Market (BRSIX) micro-cap funds, says that while he welcomes the competition from these ETFs, he's concerned about the disruption they can cause. And because of bid-asked spreads "wide enough to drive a truck through," transaction costs could eat up the excess returns investors have reaped in tiny stocks.

Those lush gains, of course, are what has attracted traders to small-cap ETFs, especially while large-caps basically have gone nowhere as their fans await the long-predicted "up-in-quality" trade. Whatever the recipe, it will be interesting to see if the momentum players who have piled into the small-cap ETFs barrel into the micro-cap numbers. And what the effect will be if they all try to make for the exits at the same time.

FROM BIANCO RESEARCH comes a daily compendium of articles that the eponymous Jim Bianco and his cohorts think might be of interest to their institutional clients. Among the running topics is Your Daily Installment of "Picking a Top in the Real Estate Bubble," which features the seeming parade of stories warning of the impending collapse in property prices. A confirmed contrarian, Jim doubts that the end of the housing bubble could be at hand if the media are all over the story. After all, virtually every TV outlet and publication (with the exception of the one you're reading) fell all over itself heralding the New Era of Tech -- right until the bubble burst. This time around, the media are making damned sure we won't get fooled again.

And also in keeping with the tradition of the summer silly season, when editors (and columnists) will grab any story to run during the dearth of real news, we hereby offer our contribution to Jim's Top-Picking collection: the Mr. Hou$ing Bubble T-shirt. A takeoff on the kid's bubble-bath package, it has established itself as the top-selling number at T-shirthumor.com in just a week, according to Reuters. The inflated house cheerfully allows, "If I pop, you're screwed!" A disclaimer further avers, "Not affiliated with Mr. Internet Bubble."

Also included inside Mr. Hou$ing Bubble is a "Free Balloon mortgage," a satiric allusion to the wacky loans now available, which have been the instruments that have whipped up the "froth" in the property market. These so-called option loans let buyers basically get into houses or condos they otherwise couldn't afford, by dint of low teaser rates, payments of interest only, not paying the full amount...anything except the traditional fixed-rate loan that you pay off in 15 or 30 years. While regulators and even the National Association of Realtors have warned about the dangers of such creative financing, that hasn't stopped lenders. Peter DiMartino of RBS Greenwich Capital notes with irony the introduction of 103% loan-to-value mortgages from Option One Mortgage, a unit of H&R Block, amidst all the media talk about the housing bubble.