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October 07, 2004
October Model Signals
For October, Northlake's Market Capitalization favors Mid Cap, a change from the prior two months when Large Cap was favored. Northlake's Style Model for October remains firmly in Value mode....
The Market Capitalization Model favors Mid Cap because the factors are evenly split between Large and Small Cap signals. Two factors shifted from Large Cap to Small Cap for October triggering the change in the overall signal from Large Cap to Mid Cap. Advisory Service Sentiment and Bond Momentum were the two factors which shifted.
Sentiment now favors Small Caps because during September, bearish sentiment became widely prevalent among investment advisors. This factor is a contrary indicator, favoring more aggressive investment (small caps) when everyone is bearish and more conservative investment (large cap) when advisors are very bullish. The concept is that investors should position their portfolios for the next big move and once Wall Street tends to agree, the opposite happens.
Bond Momentum measures the rate of change in interest rates over the preceding 13 weeks. When rates are falling, as they did in September, investors should be moving into small caps because falling rates are a bullish sign and small caps represent the aggressive investment. The Bond Momentum factors looks for a plus or minus 2.5% move in the bond prices to signal a change between capitalization signals.
The rest of the Market Capitalization Model factors were unchanged for October but the shift in these two factors were enough to move the overall signal to Mid Cap. Consequently, Northlake's Model Portfolio sold its holding in the S&P 500 ETF (SPY) and purchased the S&P 400 Mid Cap ETF (MDY).
There were no changes at all in the Style Model for October, with the signal remaining very firmly in Value mode. Solid economic growth and the low absolute level of interest rates are the key drivers to the Value signal. Value is generally favored well into an economic expansion becuase prolonged periods of GDP growth help the earnings of the predominantly cyclical value stocks. Value is also favored in the latter stages of an economic expansion because value stocks have lower volatility and hold up better if the market begins to fall due to fear of an economic contraction. In other words, in the early stages of a bull market/economic expansion, investors want growth stocks for their high volatilty, while value stocks come into favor as the economic expansion matures.
Northlake's Model Portfolio contains a holding in the Russell 3000 Value Index ETF (IWW) as a result of the Style Model's Value signal.
Posted by Steve Birenberg at October 7, 2004 11:12 AM
Steve,
As usual, I found your reasoning in moving from large cap to mid cap compelling and agree with your thesis. I was wondering what effect you think the lower than expected payroll numbers (96k vs 150-160k) will have on equity markets (long and short term) and whether or not you think the relatively high oil/energy prices will help slow production thus releaving some of the pressure on the fed from increasing rates - and if so, to what degree?
Posted by: spencer at October 11, 2004 11:34 AMThanks for the comments, Spence. I think the payroll numbers are another sign that the economy is not growing as fast as Wall Street expected back in the spring. Oil prices represent another challenge to the conventinal wisdom of strong GDP growth. I remain comfortable with the idea that the economy is growing strong enough to support decent corporate earnings growth and higher stock prices. However, I'm always trying to challenge my own outlook, particularly when it is in line with conventional wisdom. Consequently, I am beginning to examine a more bearish view predicated on economic growth in 2005 that is well below expectations.
As for the Fed, it could counter a slowdown by slowing or stopping rate increases. In fact, a weak November employment report might cause them to skip an increase at the next meeting. If employment is weak and oil has not backed off by the November meeting, then skipping the next increase is very possbile. I'd note that stock market investors would like view that bearishly as it would confirm the slow growth thesis.
Posted by: Steve at October 11, 2004 02:24 PM