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May 04, 2005

May Model Signals

The updated monthly signals from the market capitalization and style (growth vs. value) indicators showed no change for May. The models still favor large cap and value. Since these models are based on the weight of the evidence, I also look at the month to month trends in the strength of the signals and here there was some movement. The large cap signal got stronger and the value signal got weaker. In fact, the market cap signal moved firmly into large cap territory for the first time since the fall of 1998 while the style signal is barely hanging onto value and is at its weakest since the fall of 2003. These movements did not trigger trades this month in Northlake's ETF Plus strategy. Clients continue to own the S&P 500 Spyder (SPY) and Russell 1000 Value ETF (IWD)....

Review of April Signals

Last month, the market cap signal proved quite accurate, while the style signal had a neutral impact. For April, based on the exchange traded funds, the S&P 500 had a return -1.9%, the S&P 400 Mid Cap had a return of -3.7% and the Russell 2000 Small Cap had a return of -5.7%. April returns for the style ETFs were -2.3% for the Russell 1000 Value and -2.2% for the Russell 1000 Growth.

ETF Plus generally uses a fully invested strategy. The goal is to be in the area of the market that performs the best on a relative basis. If the market is falling, this means a good signal can be one in which losses are the smallest. For the Market Capitalization model, April was one of those months. ETF Plus is designed to limit losses in down markets and switch to the best performing areas of the market in up markets. If everything goes according to plan, as much capital as possible is preserved for periods when the market is rising leading to the best possible returns on an absolute and relative basis over long time periods.

Review of Market Capitalization Model Indicators

Looking more closely at the market cap signal, almost all of the more than a dozen indicators now are flashing a large cap signal. Here are the highlights (every condition favors large caps):

  • Credit spreads have moved back in the normal range (barely) and are rising.

  • The yield curve continues to flatten.

  • Interest rates are stable on a quarter over quarter basis.

  • The P-E of small caps is higher than the P-E of large caps (this is weak signal as the difference is less than one standard deviation).

  • Consumer confidence is within its normal range where economic growth is solid

  • The coincident indicator of economic growth remains solidly positive indicating economic growth trends are solid

  • The dollar remains below year ago levels.

  • Trend and relative strength over intermediate periods has moved to large cap

    • Review of Style Model Indicators

    Switching to the style signal, the May signal is the third consecutive and sixth in the last seven to move toward growth. As noted above, the value signal is at its weakest since the fall of 1998. However, the signal is still value so client position's remain in the Russell 1000 Value ETF (IWD).

    The weak value signal is the result of the style indicators being split evenly. Here is a brief summary of some of the indicators:

    Favoring Value:

  • Coincident indicators are up on a year over basis in a range indicating normal levels of economic growth

  • Insider transactions

  • Intermediate term (six to twelve month) technicals focusing on trend and relative strength

    • Favoring Growth:

  • Credit spreads have returned to the bottom of the normal range and are rising – rising is the key

  • The shape of the yield curve from ten years to 3 months is in the normal range of 100-200 basis points (the market cap indicator also uses the yield curve but focuses on the change in the shape)

  • Short-term relative performance favors the Morgan Stanley Consumer Index over the Morgan Stanley Cyclical Index

    • Favoring Growth Just Barely:

  • The P-E of the Russell 1000 Growth is at a 33% premium to the Russell 1000 Value, below the normal 51% premium

  • The dollar is slightly weak against year ago levels

    • As you can see, no clear signal emerges for either growth or value. In general, I think it is fair to say that a waning of economic strength has led to a shift toward growth but value is still in the game as long as the economy stays on a moderate growth track. Good investors never violate their discipline so as long as the style signal remains value, even weakly so, value is what is owned in client portfolios.

    Posted by Steve Birenberg at May 4, 2005 03:49 PM

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