Comparisons provide us with a frame of reference that helps us figure out where we are and what to do.

• Fundamental investors do a lot of side-by-side valuation comparisons between two companies and their sector averages.
• You might want to look back at history to see how relevant today’s yield is versus some other point in time.
• Technicians and their charts are nothing but a study in comparisons of price and volume.

Sometimes, we make mistakes by using bad comps. Lately, I have been hearing a lot of bulls and bears trying to make their case by comparing the market or individual statistics to what they were in 2000. I am guilty of doing that myself but after much reflection, I have decided to do my best to avoid that bias. 2000 and the bubble were extremes of historical proportions. Using them for comparisons is tempting but I doubt it is healthy to do so. If a statistic is high, but only 70% of what it was at the peak, is it not worthy of concern? If our current valuations are so much less than they were in 2000, does that mean that we are cheap today? In the past, I have often used 2000 Standards as a measuring stick for things like margin debt, valuations, IPO’s, etc. etc. and recently, I decided that my view was clouded by that obscene bias. From now on, I’ll use a broader base for my comps, but don’t worry - you’ll get a healthy dose of 2000 Standards from more exciting commentators.

If enough investors and fund managers keep saying that the Small Cap run is over and that NOW is the time for Large Caps to outperform, it just might come true. But let’s keep it in perspective and talk about hard dollars rather than percentage gains. It’s rare for me to say that, but at times, it is appropriate to change your view and see if the picture still looks the same. Reiterating my recent summary of the topic, I am not convinced that the Large Cap dominance has returned but that is not the focus of this post. Here I just want to talk about the difference between going from $1.00 to $1.65 or going from $10 to $10.70. Which would you rather have?

Since the beginning of 2001, the Russell 2000 is up about 65% compared to the Large Cap dominated S&P which is up about 7%. No matter the index, Small Caps have had higher percentage returns but let’s get real. The HEDGEfolios universe has about 400 Large Cap (over $11.1 billion) stocks with a total market capitalization of $17.5 trillion. On the other hand, I cover about 1800 Small Cap (under $1.95 billion) stocks with a combined market cap of $1.35 trillion. In fact, you can take the market caps of the 5 largest companies (XOM, GE, MSFT, C, BAC) and they eclipse all the value in the HEDGEfolios Small Cap segment. My point is that investors have made more money in Large Caps than they did in Small Caps during the past 6 years even with the differential in percentage gains.

I love Small Caps but they are what they are - small. They are also more volatile, have higher valuations and fewer of them pay dividends. Obsessing about the market’s performance on one size category vs. the other will not make me more money and therefore, it is not something I spend a lot of time on. And clearly, I am not the only one. According to Merrill Lynch, over 90% of foreign investors are biased towards Large Caps. Additionally, most stock brokers have a bias towards Large Caps, there are twice as many Large Cap mutual funds as compared to Small Cap mutual funds, and there is much more analyst coverage over Large Caps. I am not trying to make excuses for their percentage performance but at the end of the day, it’s $$$$ that matters, not %%%%. The vast majority of investors place their money in Large Caps despite the difference in percentage gains and that competition makes performance more difficult.

I believe that much of the gain in Small Caps comes from the shifts in Value and Growth investing. As the Large Cap growth bubble popped in 2000, investors were not willing to make large bets in growth stocks. However, it was possible to keep in the game on a different scale by putting money into Small Caps which gave the taste of growth investing without having to bet a big stake. Even a small percentage reallocation of money from Large Caps into Small Caps is a huge increase in demand and I believe that capital infusion is responsible for some of the gains. Meanwhile, the vast majority of Large Cap performance since 2001 has been focused on Value stocks and trying to make outsized gains is that category is tough for any long term investor. I am not saying it’s easy to make money on Small Caps but when you consider the scale, I think it’s easier than trying to do it with Large Caps.

You would think that Best Buy’s numbers yesterday and their commentary would have had a bigger impact on the analysis of today’s retail sales figures. Retail sales grew more than expected at 1%, but is a 1% gain worth celebrating? Initially, it appears that the market thinks so, and as you probably suspect, I think it is interesting but not overwhelmingly exciting. August sales were flat while September and October had declines so from that perspective, it’s a huge improvement. However, if you add the previous months and compare them to last year, it’s not a huge improvement. You might say that shopping season is getting later and later, but ads and commercials by retailers have been getting sooner and sooner where I live. Which one is it? Or do retailers just have to spend even more to encourage people to shop?

One of the components that contributed to the increase is a 2.3% rise in gas station sales, versus a 5.3% decline in October. Yep - today’s celebration of the retail sales figure is partly due to spending more on gasoline and for some reason, that is not exciting to me. Furthermore, the best category in today’s report came from the electronics component which showed a 4.6% improvement and the strongest gain in that category since the heavy gift card month of last January. Of course, none of this should be surprising since many of the hot electronics products like the Nintendo Wii or the Sony Playstation were not available until November and the Black Friday discounts also suckered people into stores. As Best Buy said yesterday, they had to cut prices to generate sales growth and compete with Wal-Mart and other electronics retailers.

Don’t worry - as the old saying goes… “Sure we’ll lose money on every sale but we’ll make up for it on volume.” I recognize that it won’t be that extreme and that they are not losing money on everything, but it was worth making the point. I agree that today’s report says good things about consumer spending, and that retail is holding up despite the “substantial cooling” of the housing market. However, it doesn’t say much about the health of retailers so if you are looking at today’s data as an all clear to buy retail stocks, make sure to kick the tires really hard and shop around for the few that are good deals.

The injection of the word “substantial” in the FOMC statement provided the opportunity for spinning this in the bull case. Once again, pundits are suggesting that this one word signals that the Fed has become more dovish and is on its way to cut rates next spring. Maybe so. Even Bob McTeer made note of it and with his inside info on the rate decision process, he suggested that the bull case is on target. As you might expect, I find the parsing and spinning to be useless and a one day phenomenon. Nonetheless, I got to thinking about two elements of the statement: housing and energy.

The Fed’s commentary about housing is hindsight and to buy into it as a future cause of the much hoped for rate cut, you have to believe it will continue to get worse. In reality, there is a decent chunk of evidence that the “substantial cooling of the housing market” is substantially done. Look at the performance of stocks in the housing sector and you’ll see that the same market that wants a rate cut due to bad housing data has “substantially” discounted the worst of it. Spin away!!

The second issue is a similar analysis of past, present and future. The Fed release says, “inflation pressures seem likely to moderate over time, reflecting reduced impetus from energy prices…” I get a kick out of that one. Compared to the last statement (October 25th) which contained the same exact phrase, the actual price of a barrel of crude has gone from $61.44(10/25 close) to $61.22 (12/11 close). That’s a -0.3% change and in my book, it’s not a “substantial” interpretation of a “reduced impetus.” I recognize that the Fed is citing effects from previous oil reductions and that the effects take a while to trickle down into the data they used to decide on rates. In that case, they must be considering the benefits of going from $78 to $61, but that was 2-4 months ago. One of my cynical interpretations of that statement is that the Fed must think that oil at $61 per barrel is neutral or “moderating” to inflation. Oh well, maybe they are right. But as it relates to the future, I have an issue with believing that oil is going to continue being a “reduced impetus” to inflation. I know some wishful thinkers are plugging for oil in the $40’s but most of the market (it seems) is factoring in higher prices for the future.

Ok - I am done doing what I criticize others for doing. But it was fun and easy to spin this my way. I leave it up to you to evaluate all the bullish and bearish spin, but there is a difference between spinning the text and spinning the actual data. Please evaluate the data.

Insider selling is abnormally high and while I usually don’t spend much analytical time worrying about what execs are doing with their shares, I am making an exception now. Last week, Michael Painchaud appeared on CNBC and caught my attention with some thought-provoking comments about the current elevated levels of insider selling.

My criticisms of insider trading analysis center on the fact that diversification encompasses many other legitimate reasons to sell. There is only one truly negative reason for insider dumping and trying to divine which execs are selling because they “know when their company is overvalued” is not a skill that I possess. Besides, the ability of insiders to know the fair value of their company is often not much better than outsiders, so follow both insiders and outsiders at your peril. Nonetheless, Painchaud’s commentary was striking and should not be ignored.

His firm, Market Profile Theorems (MPT) uses an aggregate measure of insider information to identify trends and abnormalities and this goes a long way for me. MPT does single stock analysis, but I am less interested in the informational content of one company’s transactions than I am about composite data from all the companies. What one person does is less significant than what a group does and his work on sectors and the overall market is very intriguing. MPT’s analysis uses the Brooks Ratio, which divides total insider sales of a company by total insider trades (purchases and sales) and then averages this ratio for 2,500 stocks. If the Brooks Ratio is less than 40%, the market is bullish while above 60% signals a bearish outlook.

With a current reading of the Brooks Ratio at 84%, it exceeds the upper threshold of 60% and indicates a bearish view. This is record territory since 2003 and has persisted for the last three weeks. While that is worth considering, the seasonality of this figure triggered my investigation. It seems odd that execs would incur tax consequences at the end of the year from insider selling, so I checked with the MPT data on seasonality collected over the past 17 years. As expected, November and December are the two lowest months for insider activity by a significant margin. So not only is the insider behavior exceedingly bearish, but it comes at an abnormal time of year. MPT’s research found at MPTonline.com is worth considering, don’t you think?

****Performance has been updated through 12/08/06 - please read through the following disclaimer and find the updated figures at the end of the post. Before I discuss Hedgefolios performance, I want to cover myself with some cautionary language. So here goes: Nothing in my performance quoting is intended as an advertisement or in any other way meant to encourage anyone to subscribe to Hedgefolios. Regardless, you should be very hesitant to rely on any newsletter’s performance figures unless they are audited or verified by an outside party. To be as transparent as possible and remove any question of Hedgefolios credibility, I am hoping to have audited performance figures by the end of 2006. Until then, you need to be aware that any performance figure on Hedgefolios is NOT in compliance with the CFA’s AIMR Performance Presentation Standards and does not net out any transaction costs such as commissions or management fees. They are not a total return calculation as I do not include dividend yields or any compounding factor. These performance figures cover a hypothetical portfolio of the entire Hedgefolios stock universe with an equal weighting of each security. The calculation is simply the cumulative total of all gains and losses from the signals during the period in question. All this being said and under those parameters, Hedgefolios performance for stocks:

• 2005, the Hedgefolios performance was +19.99% vs. +3.00% for the S&P 500 index
• 2004, the Hedgefolios performance was +31.19% vs. +9.00% for the S&P 500 index

As the year goes forward, I will update this post periodically to let everyone know how Hedgefolios is doing.

UPDATE:

HEDGEfolios stock performance for 2006 year-to-date (through 12/08/06 close) was up 25.69%.

Over the same time period, the S&P 500 index was up 12.94%.

Now is the magical time of year when a lot of market strategists get to pull out their crystal balls and tell everyone what level the S&P 500 will hit a year from now. We get bombarded with the opinions of gurus who did well with their guesstimate this year and amazingly, they get much more credibility because of something that is fundamentally useless. Of course, we forget or forgive their prior track records that were not stellar and just take comfort in another target for a 10% gain. Analysts used to be criticized because they offered nothing but “Buy” signals and yet, I seem to be one of the few that really isn’t impressed with market strategists that rarely, if ever, have projected a downside in their annual S&P forecast.

I do pay attention to the reasons for one estimate or another because that is useful info to evaluate. This year I am hearing a very interesting theme that keeps popping up with many strategists for justification of the 2007 market performance and that is PE Expansion. While it is true that PE multiples typically expand as a bull market ages, I am not convinced that we should be excited to hear that the majority of appreciation will not come from improving earnings and fundamentals. The consolation prize (it seems) is for all of us to be happy about paying higher prices so we can keep stocks in the black and most importantly, achieve the guru’s S&P target. One guest on Bloomberg TV quantified the relationship this way: as PE increases by 1 increment the S&P will rise 7%. Keep that in mind next year as you pay up for mediocre earnings. Maybe it will be make you feel better.

I don’t doubt that PE expansion is likely. Just consider the largest contributors to S&P performance this year and you will see a predominance of low PE sectors like energy, telecom. materials, and utilities. Meanwhile, growth stocks have not required premiums to generate appreciation in the S&P and their PE’s have moderated. In my opinion, this is the biggest reason that we haven’t heard too many people suggest that the market is overvalued. Usually, Value investors are historically the biggest source of this whine and since they have been the big winners, they will not be big whiners for some time. Unfortunately, to believe that we head higher, you have to assume that:

1. these low PE sectors will continue their 20% annualized price appreciation OR
2. growth stocks will have to inflate their multiples OR
3. some combination of the above.

I would prefer to look at earnings increases as the source of an appreciating market but I am not hearing much optimism on that front. We are struggling with many economic statistics that suggest slowed growth and a concensus of mediocre forecasted earnings. So it appears that market appreciation is a self-fulfilling prophecy for next year. It requires that you pay more - so following this logic, our success appears to be more in the hands of investors and less in the hands of the companies we are investing in.

Transfat is the latest fiasco in the world of regulation and the health nuts are getting worse. It amazes me that we glamorize the organic trends and stores like Whole Foods at the same time that our country is getting less and less healthy.  Just look at obesity trends in adults and especially children over the past few decades.  Health nuts would point to that statement and say, “See you just made our point, we need more regulation to make sure that this trend does not continue.”  Get real - regulation’s effect on unhealthy behavior has a terrible track record.
In the most extreme case of regulating health, we amended the Constitution to ban alcohol consumption and it was a giant failure.  On a smaller scale,  I don’t think cigarette label warnings are the reasons someone quits smoking and yet, that little bit of printed regulation must give a bunch of people a weird sense of accomplishment.  I wonder how many alcoholics went cold turkey into soberness after reading that alcohol can impair your ability to drive a car.  I am not saying these things are bad, but let’s not believe they are the answer to improved health.

Health nuts were on a different spree a few years ago with the movement to require McDonalds and other restaurants to post nutrition facts on items like Big Macs.   I guess someone was confused that fast food was actually healthy.  The whole Menu Labeling regulation was a waste of time so now it appears they are trying to win this by removing one unhealthy ingredient at a time, starting with transfat.  What’s next on the health nut list?  I am guessing that salt has contributed to more deaths than transfat, so maybe we should ban that too.  And sugar isn’t good for your teeth or weight so let’s get rid of that.  Of course this is all absurd.  We can try to regulate healthy behavior but it will fail in all ways except spending taxes and allowing people to ignore their personal responsibility to exercise and eat a balanced diet.

Every week I take a quick look at the dollar, interest rates, gold, oil and general commodities as part of my normal market assessment.  I rarely comment on them except when I see some trends that I think are worthy of additional attention which is the case now.  So here goes with my forecasts for the next 30 days or so:

• Dollar - I expect the USD to stabilize at current levels and strengthen.
• Rates - I think we have bottomed on the 10-year Treasury and will head towards 4.8%.  The inverted yield curve or at least a flat chart is much more likely to me than a steepening given that short rates are probably heading higher as well.
• Commodities - The CRB is showing a marginal upward bias but I do not expect a rapid change in either direction.
• Gold -  Gold in the $500’s would not surprise me, but there is a better chance at holding support around $610.  If it gets to that level, I will have to reevaluate but overall, I am slightly bearish on gold for the short term, but still bullish for the long term.
• Oil -  A trading range of $61 to $68 is my best guess.  As I have previously written, the $57 - $60 level is pretty decent support now and absent a dramatic change in weather or geopolitics, we will likely see an upward drift.

I don’t spend enough time in these areas to feel like an expert so take them for they are worth and check back to see how they turn out.