Small Cap Stocks. November 16, 2013

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1 November 16, 2013 Optimal Bear Timing is NOW Small Caps highly overvalued Biotech to an extreme Deflation an integral part of Supercycle Bear Markets Bonds undervalued and oversold Last week we trimmed positions to take advantage of a short-term overbought swing, to lock-in a profit. This will allow us to replace the partial position much cheaper, in this way we get paid to wait, as the market gears-up in our inverse funds & safe havens in bearish mode. More precise timing does not exist. Those doubting Thomas s who wait for further confirmation will miss the Lion s share of the profit. As you likely intuit, most of the time, the market moves in stair-step fashion, two steps forward, one step back. We typically sell at wave (iii) of a Diag II and buy back at wave (iv). Done over and over, this strategy allows profits to compound far more quickly, which would otherwise have been given back, while reducing risk & creating a cushion of profit. The foundation for a long bull move in inverse funds is founded on Diag IIs, which swiftly gear back up to Supercycle degree. Small Cap Stocks While Small Caps are the first out of the starting gate to kickoff a new bull run, they are also the first to feel an economic pinch. Both long and short, they are a levered play on the economy. That is precisely why we added the inverse small cap, TZA in the last six months. Since 2000, small caps have outperformed the large cap indices by over 150%. Page 1 of 8

2 So far this year the small caps are up 31%, versus 23% for the largest 50 listed companies. That outperformance is about to reverse dramatically. In classic form, individual investors buy distribution, the shares being unloaded by corporate insiders. P/E ratios are far more optimistic for small caps than for their large cap counterparts. Small caps trade at 18x future earnings, while the large-cap blue chips are priced at 14x delusional earnings estimates. Large caps, whose profit margins are near all-time highs, are due to revert to the other extreme, rather than to the mean. Small caps are more levered to begin with, and also have fewer financing options. In an economic contraction, small caps cannot get bank financing, while the large caps continue albeit at higher interest rates. As interest rates rise in an economic contraction, small caps get shut-out from capital, due to their greater propensity to go bust. Imagine a consensus earnings rise of 33% for small caps, versus 11% for the S&P 500. Bottom line, small-caps are terrific shorts, utilizing our swing trade strategy, which opportunistically makes the most of volatility & delays. Biotech small cap the most overbought Figure #1 Page 2 of 8

3 Above you see a magnification of B-C, which corresponds with the A-B-C of a wave 2 correction. To arrive at the long-term perspective, we simply chart the NASDAQ Biotech index, and overlay it with the ProShares long Biotech fund, BIB, since inception in As you see, all boats rise with the tide. Although we have insufficient data for BIB alone, we can patch it up with the longer index, to find our bearings. As you see it mirrors or echoes the Index s count. Our subscribers begin to receive trading signals for the inverse Biotech ETF, BIS tomorrow. Figure #2 T-Bonds Bonds - technical analysis & strategy Below is the chart for levered long bonds, TMF. The larger structure is the (A)-(B) reversal of a 30-year Bond Bull Market, into a Bearish Supercycle mode. Wave 2 is just beginning the identical A-B-C pattern, which just terminated in small cap tech stocks above. Treasuries are the first safe haven to provide short-term refuge for wary investors. As you see, the move from the low kicked-off with a Diag >, to indicate the beginning of a terminal move. While the far larger Diag II, which initiated wave 1, predominates to indicate a long Bearish move, interrupted by a Wave 2 correction, to continue in a far longer wave 3, a second correction in wave 4 and finally bottom in Page 3 of 8

4 wave 5, concurrent with a Spike in interest rates. Obviously, in the meantime, rates will drop back near the lows as wave 2 progresses to terminate in the likely area highlighted by aqua. Our strategy involves selling partial positions at (a), and buying them back near (b). In the meantime, we will continue to trade the Diag >s, for short-term opportunistic profits. As a guide, we use the RSI in the lower chart, which compares the current status with its historical pricing. As you see in the long Biotech chart in figure #1, tech is 3x oversold, which in Elliott is usually the max. Bond the Fundamentals Although the Fed has specified not to expect any bond-market fireworks for the rest of the year, and despite 80% of the Big Money Professionals having pooh-poohed bonds, that s precisely why bonds will soar. With talk of tapering in September, Interest rates soared to 3% from 1.63% in May. While bond yields remains near generational lows, they must re-test the low for one last time, as part of the reversal. Bonds have begun a long climb by creating the solid foundation of Diag > to mark the beginning of a terminal move. The three-decade bull market in bonds had its orthodox top back in 2009, since then it s been gearing-up for the magnitude transition to Supercycle Bear. We are buying bonds not for the yield, but rather the capital gains, a little yield is just icing on the cake. Rather than the rate rise the market expects, a rate rise will only come after a plunge to near all-time lows. From here, that s a gain of 20%, plus accumulated interest which can easily annualize at 30-45%. Compared returns of 6% for the average hedge fund, this is a high-return/low-risk investment. Initial Public Offerings denote a frothy Market Initial Public Offerings heat up near the end of a long bull run, as high-end market multiples allow corporate Treasurers to meet future capital needs at far bargain prices. US Corporations have shifted from buying back their own shares, to selling secondary offerings to take advantage of these overvaluations. Insider sales are outpacing buys in Page 4 of 8

5 line with previous market tops. Although Janet Yellen denies bubble-like conditions, as we learned in 2007, exuberance is not required for a market plunge. In fact, the market multiple of 15 is identical to that of the 2007 top. Remember, there are two components to P/E ratios, when earnings drop, price must also plunge to maintain the same market multiple. Market gains like the current are only found in series in a Bull Market, and become nonsequential as Bear Market Rallies, like the present. Thus gains of 34% in 1995, 20% in 1996, and 31% in 1997 are not likely going to be repeated at this juncture. If you take a good look at the long chart, you see this series of bull figures occurred after the wave magnitude had shifted to Supercycle Bullish. Currently the market has instead shifted 360 degrees to Supercycle Bearish. Like the swing of the pendulum, prices never got from overvalued to fair market values, without first becoming oversold and under-priced. Deflation an integral part of Supercycle Degree Bear Markets Falling prices mean deflation, the result of businesses competing harder & harder for lower disposable incomes of fewer gainfully-employed consumers. In this cut-throat climate, companies either compete on price, or go under. Annualized inflation across the Eurozone was just 0.7% in October, well below the 2% target. In Spain, inflation has turned negative to -0.1from last year s 3.5%. It s not just Spain, but the entire global economy. When deflationary expectations become selffulfilling, prices spiral down in a corrosive manner, as consumers wait for inevitable bargains. Page 5 of 8

6 In the CPI/inflation chart above, note that by 1919 prices had deflated to the level of 1850, pre-civil War, concurrent with Wave (A) of Supercycle (II) Bear Market. Markets which were previously gently self-regulating, became highly inflated in response to the Money Supply-capping Gold standard, & the institution of the intrusive Fed. Page 6 of 8

7 Note the effect of inflationary expectations on the q ratio above, which measures replacement costs for plant & equipment. It reached a low for the Century in Wave (A) of Supercycle (II), only to flash back in Wave (C) ended Deflation continued to erode prices in Cycle Wave II and Primary Wave 2, in expectations of a greater calamity, after the storm had passed. With the S&P up 162% since the 2009 intermediate trough, it s been a long bull run. As Greenspan avowed in his The Map & the Territory, just a week prior to Lehman s collapse, JP Morgan was forecasting 15% growth, this time is no different. Besides we have not had a significant correction since June 2012, this long stretch of smooth sailing, simulates the smoothness of Bull Markets, when degree of trend drops volatility by 75%, so that closing prices appear to climb in a near straight line. Page 7 of 8

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