Both of Northlake’s models changed signals to begin 2017.  The Market Cap model is now recommending small cap after spending eight months at mid cap. The Style model is still recommending value but as a result of the new small cap signal, value exposure will shift from large cap value to small cap value.  The trades initiated by these changes are: (1) sell holdings in S&P 400 Mid Cap (MDY) and reinvest proceeds into Russell 2000 (IWM), and (2) sell holdings in the Russell 1000 Value and reinvest proceeds into Russell 2000 Value (IWN).  All of these trades were executed on January 3^rd.

The shift to small cap was driven mostly by the Market Cap model’s internal indicators that measure stock market technical and trend trading patterns.  Three of these indicators shifted to small cap for January.  A majority of the external indicators that measure economic and interest rate factors were already in small cap mode, so with the internal and external indicators in agreement, the overall model shifted to small cap.

The Style model actually saw very little movement in its underlying indicators for January, registering a second consecutive month with the overwhelming majority of indicators on a value signal.  The two month smoothing measurement for the Style model is now deeply in value territory.  The shift to small cap value is the direct result of the new small cap signal from the Market Cap model.  Back in late 2014 when we updated the models, we did a lot of testing to determine how best, if at all, to link the Market Cap and Style models.  We determined that anytime the Market Cap model recommended small cap that we should use a small cap version of growth or value for the Style model.  A mid cap signal from the Market Cap model worked best with large cap growth or value.  This month marks the first small cap signal since we updated the models (mostly the Market Cap model has been in mid cap mode the past two years) and thus the first use of small cap growth or value.

Small and mid cap stocks performed well in 2016, something that was captured by the Market Cap model which gained 14% in 2016.  Wall Street favored small caps as the dollar strengthened and in anticipation of normalization of monetary policy.  Over the course of 2016, the Style model moved gradually from growth to value mode.  This allowed the Style model to keep up with the market’s gains in 2016.

Northlake follows the model signals whether we fully agree with them or not.  The models are back-tested, have a long history of success, and are regularly monitored for possible updates.  There are occasions when the model signals do not match our personal opinions.  This is not one of those times.  The concept of value and small cap stocks is consistent with reflation of the global and U.S. economies.  Our yearend letter discusses the massive shift in investor expectations from those based on easy monetary policy and low inflation to tighter monetary policy and fiscal stimulus.  We also discuss the shift away from decades of globalization and increasing international trade.  This changing investment landscape supports value and small cap stocks just as the models are now recommending.

IWM and IWN are widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg’s personal accounts.  Steve is sole proprietor of Northlake, a registered investment advisor.  Northlake’s regulatory filings can be found at www.sec.gov.