Blog : Hot Penny Stocks Flirt With Record Levels

by Ed Zwirn on February 26th, 2014

If you've been seeing some impressive results in the penny stock/small cap portion of your portfolio lately, you are not alone.

Even as the Dow Jones Industrial Average and the 30 blue chip stocks that comprise it have seen their ups and downs, the Russell 2000 index, which most institutional investors use as a benchmark for penny stock investments, has been surging ahead over the past few weeks and in fact hit a record 1,188.06 in intraday trading today.

This follows two weeks of advances on the penny stock front, with the index gaining 1.4% during the week which ended Friday, Feb. 21 and 2.9% the week before that. On a year-to-date basis, the Dow is down 2.4%, while the broader NASDAQ Composite is ahead 2.4% and Russell 2000 ahead 2.1%.

Obviously, this is good news for those owning stakes in the 2,000 Russell stocks (and even better news for those picking the right ones at the right times). But, in a broader context, the recent advance for small stocks is a bullish sign for the both the broader market and the economy as well.

What we are clearly seeing is the return of speculative appetite. In late January, as I pointed out in a Penny Stock Week at that time, the stock market endured its worst week in over a year, as worry over Fed policy, coupled with real problems overseas, combined to make real problems for investments in emerging markets. The emerging markets debacle hit with enough force and suddenness to spill over into domestic speculative investments, driving Russell 2000 down 2.1% during the week which ended Jan. 24.

As we have seen, penny stocks have recovered from this debacle and then some.

The reasons for this recovery are pretty straightforward: For one thing, yield is still hard to come by. Despite minor fluctuations, interest rates, both on a corporate level and for consumers, are still at historic lows. This means that it is cheap for companies, which are sitting on historically high cash levels, to get their hands on even more cash. At the same time, investors, tired of making next-to-no profit on safer investments, are even more willing to take on risk by buying stocks in smaller companies.

At the same time, the evidence shows that, after getting hit by the January debacle, penny stocks are actually gaining in the long run from this very debacle as speculative investment has migrated back home. This migration from overseas investment to down home speculative companies is apparently enough to compensate for the $10 billion of monthly quantitative easing reductions that have been priced into the market going forward.

The quantitative easing program, through which the Fed had been pumping $85 billion monthly into the economy through the purchase of mortgage-backed securities and Treasury paper, has been scaled back, to $65 billion monthly, and is expected to "taper" off, barring any unexpected developments, to zip over the next six or seven months.

This has been the accepted wisdom since the Fed first announced tapering in December and set off a stock market rally through the elimination of much uncertainty over the direction of U.S. monetary policy. The January debacle notwithstanding, the market has learned to live with this outlook.

There are two reasons for this:

1) Some of this tightening on the part of the Fed has been counterbalanced by an easing on the part of the federal government. Uncle Sam's sequestration, which had been taking $85 billion of spending off the table in an across-the-board manner, had been putting a hurt into many of the penny stocks covered by the Leeds Newsletter, particularly those dependent upon military spending and developmental programs.

2) More importantly, as both economic conditions and Fed guidance make abundantly clear, the low interest rates which have been pushing risk tolerance will be with us for some time. Not only has the Fed tapering had basically no effect on rates, the Fed has indicated, both through its most recent monetary policy statement and also during Janet Yellen's Congressional testimony this month, that a near-zero federal funds rate is no passing fad.

In December 2012, the Fed had said that it expected to keep rates low for at least as long as the unemployment rate remains above 6.5% and inflation is projected to be no more than half a percentage point above its 2% longer-term goal. While inflation is obviously heading nowhere for now, the unemployment rate, at 6.6%, is getting closer to this benchmark. This progress on the labor front, "will not automatically prompt an increase in the federal funds rate," Yellen testified. "It likely will be appropriate to maintain the current target range for the federal funds rate well past the time that the unemployment rate declines below 6.5%."