BUY BIG STOCKS--NOT LITTLE!

SPX VERSUS SPX EQUAL WEIGHT (click on image to enlarge)

One of the portfolio managers I respect and with whom I frequently agree is Roger Nusbaum. He and I consider the shape of the bond market yield curve as the most important consideration before investing in stocks. Roger recently posted a chart similar to the one above and indicated that he believes the equal weighted index will continue to out-perform the S&P 500 index.

In the equal weighted index the performance of small stocks effects the overall performance just as much as the performance of large stocks. In other words, when Roger indicates that the SPXEW will out-perform the SPX he is in essence saying that small stocks will out-perform large ones.

Numerous studies by Ibbotson, Shaunassey and others have shown that small stocks do indeed out-perform large stocks. Other studies have shown that humans are unique among the animals in that even when we know the probability of success is highest in one area, we cannot resist trying other areas. In other words, if you teach a pigeon to get food by pecking a green or a red light and if it takes 10 pecks on the green light on average to get food but only 7 pecks on the red light, the pigeon in no time at all will peck only the red light. The human will push the red light most of the time but sooner or later he will get bored with it and will push the green light a series or two just to see if the rule still holds. The human will never stop checking out the green light.

A portfolio manager with the discipline of the pigeon, would only buy small stocks. He would not ever try to "out-guess" the market. With a balanced portfolio of small stocks, he would make healthy returns over time. He would not have a lot of fun and his customers would wonder why he is needed but the accounts would do well.

Besides, in the markets, rules do change. At least for long periods of time, when it really is "different this time". And, it is always true that two people can look at the same chart and draw different conclusions; this is such a situation.

It is my opinion that 2005 will be a year similar to 1995. As you can see in the chart, large stocks barely out-performing small stocks in 1995 but in each of the following several years the performance was better and better until well after the peak in 2000. The Russell small stock index has done extremely well since October 2002 as has emerging market stocks.

To out-perform the market one needs to zig when others zag. Data show that mutual fund money is flowing heavily into emerging market and small stock funds. As a contrarian, I say, now is the time to buy into developed country stocks such as Japan, Germany and the US. It is time to buy big versus small and value versus growth.

For the past several weeks, I have written that I am buying the "big, dumb and uglies". I have not done so exclusively. For example, I purchased shares in Gemstar (TV-Guide) and Real Networks. However, most recent purchases have included, PFE, WMT, PEP, and CAL. I also added to AMZN and GOOG in the past couple of months. Granted AMZN and GOOG are not value stocks but they are certainly on the big side. Take-overs took me out of AWE, PFST, and MKWT and I voluntarily cleared out of SIRI and XMSR. I took the biggest gains in SIRI and XMSR; these were tough to sell but it was tough to hold these high flyers.

Time will tell which groups will do the best. The key is to invest in stocks. Interest rates may not go up a lot this year but any increase will take away from bond yields. Note: I am not advocating a massive portfolio shift. Hold your winners but buy big with new money.