Small Capital Investor

Dear Small Cap Investor,

As of 2:00 p.m. Eastern Time press time, stocks in the Dow and S&P 500 were trading up, while the Nasdaq was slightly down. The Dow was trading at 9,550, up 10 points; the S&P 500 at 1,028, up 0.27 points; and the Nasdaq was down 0.80 points, trading at 2,023.

The Russell 2000, an index of the leading small-cap stocks, was down 1.32 points at 582.

Declines lead advances across all three major exchanges at a ratio of about 5 ½ to 4.

Leading small-cap price gainers trading over 1 million shares include Vonage (NYSE:VG), up 37%; Nymox Pharmaceutical Corp. (Nasdaq:NYMX), up 29%; TravelCenters of America (Amex:TA), up 30%; and Trident Microsystems (Nasdaq:TRID), up 18%.

Vonage saw shares surge on growing consensus that the company would survive the recession. One of the first firms to offer Internet-based calling services, Vonage has been challenged with high costs and competition from telephone and cable operators have increasing begun offering bundled services of video, Internet and phone services.

Shares of Vonage are up over 400% since Monday's open.

*****Yesterday, I mentioned that I thought the Cash for Clunkers was a pretty decent idea, as far as stimulus plans go. Rather than simply hand the automakers cash, the government came up with the Cash for Clunkers program that not only got some desperately needed extra cash in the automakers pockets and also took a few low-MPG cars off the streets. It also put cash into the hands of car dealers who have been struggling and a small percentage of that money into local economies.

Of course, the Cash for Clunker program ended Monday. But it occurred to me last night that the rally we've enjoyed since March could well be called the Cash for Clunker Stock rally…

*****There's no way the government can simply replace the wealth that was lost during the financial crisis. Not only would it have to absorb the banks losses, the government would have to reimburse investors for their investment losses and put around 3 million people on its payroll.

No, America must earn its way back to prosperity. And the government has created an environment where many companies can do just that. For banks, accounting rules were changed so that what once was a loss can now be treated as an asset. Without these rule changes, Bank of America (NYSE:BAC) and Citigroup (NYSE:C) would still be clunkers.

Credit card companies have been allowed to jack fees for even their best customers. Government backed efforts to modify mortgages has slowed the foreclosure rate dramatically, and the lag time of foreclosed homes coming to market has allowed prices to stabilize in many areas.

Government guarantees fixed the money markets. And the weak U.S. dollar has put a floor under oil and commodity stocks, even as demand has fallen steadily. (Note: if you're interested in how a continually weak dollar and coming inflation are fuelling a commodities boom and enriching investors, CLICK HERE.)

Amazingly, banks even rejected one of the sweetest Cash for Clunker Stock programs - TARP. TARP would have actually given banks money for their toxic mortgage assets. Imagine that!

*****The Cash for Clunker Stock program has also returned a lot of wealth that Americans lost in the stock market. The government has bent over backward to make it possible for companies to start earning their way out of the hole, and investors are enjoying much improved brokerage reports.

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It's no coincidence that some of the best gains during this rally have been achieved by some of the biggest clunker stocks. Bank of America has rallied from a low of $2.53 to $17.75, a 601% move. Citigroup has run from $0.97 to $4.90, a 405% move.

Heck, even walking dead, ward of the state companies Fannie Mae (NYSE:FNM) and Freddie Mac (NYSE:FRE) have doubled in the last week. Doubled! These two stocks have virtually no purpose except to provide a buyer of last resort for mortgages and make token payments on government loans. And investors are acting like these two companies are actually good investments!

*****Case in point, on Monday and Tuesday this week, Reuters reports that these four stocks - Bank of America, Citigroup, Fannie and Freddie - accounted for 40% of the trading volume at the New York Stock Exchange.

One commentator said, "No one is buying them based on their fundamentals, they're buying based on what the government might do keep them alive."

Yes that's what's moving the stock market these days - the firm understanding that the government has removed risk from even the clunkiest of clunkers.

Reuters is also reporting that short interest for Bank of America is up 28% in August to 118 million shares and at Citigroup, the short position is up 82% to 624 million shares. Makes sense, but I'm not sure I want to take that bet. At least, not until I know the Cash for Clunker Stock program is over.

*****It's Newsletter Advisor Wednesday. Please enjoy the following interview with Jim Nelson of Penny Sleuth.