August 2008 Model Signals

Once again there were no changes to Northlake's monthly Market Cap and Style models. The Market Cap signal remains mid cap and the Style signal remains growth. As a result, Northlake continues to own the S&P 400 (MDY) and the Russell 1000 Growth (IWF) for assets devoted to this strategy.

The Market Cap model remains a split decision with half the indicators favoring small caps and half favoring large caps. The resulting signal is mid cap. The indicators did move significantly in favor of small caps for August. In fact the unsmoothed signal month reading is just barely in small cap territory. The two month average remains in mid cap but leaning toward small cap. The only indicators to shift this month were the technical trend measures.

The Style model remains firmly in growth territory as it has been for over one year. The growth signal has weakened form earlier this year due to the steepening of the yield curve and the valuation measure which is reflecting the massive underperformance of value during the last twelve months.

Last month the mid cap and growth signals were inaccurate....

....Both large caps, as measured by the S&P 500, and small caps, as measured by the Russell 2000, produced a return great than MDY. Mid cap indices have been big beneficiaries of their relatively greater exposure to the energy and basic materials boom and relatively lesser exposure to financials. In July, those sectors pulled back sharply and financials rallied. Growth lagged last month as well as financial heavy value indices got a boost from the sharp bounce in that sector and technology stocks lagged.

March 2008 Model Signals

There were no changes for March to Northlake's Market Cap and Style models that I use for ETF allocation. The signals remain mid cap and growth. The mid cap signal remains a weak one that could shift back to large cap next month. The growth signal is moderately strong and got a little stronger last month. It is strong enough that it seems unlikely to shift to value next month. Entering March I thought a shift to value was possible. Given the current model signals, I continue to own the S&P 400 Mid Cap (MDY) and the Russell 1000 Growth (IWF) in client and personal accounts. As always, special thanks to Ned Davis Research who developed the original models and continues to maintain them.

There was little movement in the underlying indicators in either model. The only shift in the Market Cap model was the Advisory Service Sentiment indicator moving from small caps to neutral. The model is picking up the most recent drop in sentiment but also now shows that bearish sentiment is high enough to trigger a move back in favor of small caps next month. The concept behind this indicator is that small caps are favored when bearish sentiment reaches an extreme and then reverses. The extreme is in place. The reverse is not. Coming off an extreme bearish sentiment bottom, you want to own small stocks for the benefit of the beta effect.

There was a similar lack of movement in the underlying indicators in the Style model. The only indicator to shift was Insider Activity which moved to growth from a neutral reading.

Overall, the indicators reflect a slowing economy that favors large caps and growth, an interest rate environment that increasingly favors small caps, and stock market internals that favor large caps and growth. The weak dollar also favors large caps and growth. The mid cap reading is a result of mixed readings on market cap....

....The mid cap signal went into effect on January 1st. So far it has been a good call. Through the end of February, MDY (mid cap) has outperformed the S&P 500 (SPY) by about 156 basis points. February was particularly favorable to MDY, which fell 1.1% against a drop of 2.6% for SPY.

The growth signal has been in effect since July 1, 2007. For the entire period it has been a great call with growth (IWF) down 8% and value (IWD) down 15.5%. Year to date, value has outperformed growth by 150 basis points thanks strong relative performance in January when the Fed aggressively cut rates. Growth made a comeback in February with IWF falling just 1.7% against a 3.9% drop for IWD.

February 2008 Model Signals

There were no changes to Northlake's Market Cap and Style models for February. The Market Cap model continues to flash a mid cap signal while the Style model remains in growth mode. As always, thanks to Ned Davis Research who originally developed and continues to maintain these models.

The Market Cap model swung to mid cap for January after an 11 month run at large cap and remains at mid cap for February. There was absolutely no movement in the underlying factors for February leaving the model with what I classify as a weak mid cap signal. The Market Cap model is picking up conflicting signals on the economy and interest rate trends that are beginning to favor small caps but have yet to be confirmed by the technical indicators. Falling rates and bearish sentiment extremes favor small caps but slowing economic growth and the weak dollar favor large caps. The model defaults to mid cap in this situation.

The Style model remains in growth mode but the underlying indicators made a significant move in the direction of value for February. The one month reading is right on the borderline between growth and value but the two month smoothed reading is still probably deep enough in growth mode to give growth at least another month. The only big shift in an underlying factor was in the trend indicators which shifted to value after value massively outperformed growth in January. The value signal generated by rapidly rising and now well above historic level credit spreads also has contributed to the shift in favor of value.

The January signals offered a mixed performance picture....

....The mid cap call was neutral as both the S&P 400 Mid Cap and S&P 500 fell by about 6%. For most of the month, the S&P 500 was easily beating the S&P 400 Mid Cap but in last week's rally the S&P 400 along with the Russell 2000 easily beat the S&P 500. The growth call was poor in January with the Russell 1000 Growth ETF (IWF) falling by 8% against a 4% decline for the Russell 1000 Value ETF (IWD). Weak tech stocks and rebound in financials in conjunction with the Fed easing caused the divergent performance. The growth signal has been in place since June 1st and remains a very good call. Since June 1st, IWF has fallen 5.5% vs. a decline of 11.7% for IWD.

January 2008 Model Signals

Northlake's Market Cap model (courtesy of Ned Davis Research) shifted from a large cap signal to a mid cap signal for January. There was no change in the Style model which continues to flash a growth signal. As a reminder the Market Cap and Style models I use send monthly signals predicting relative performance over an intermediate term time frame which I define as several quarters. The change in the Market Cap model led me to sell positions in the S&P 500 (SPY) and reinvest the proceeds in the S&P 400 Mid Cap (MDY). Northlake's long position in the Russell 1000 Growth (IWF) remains unchanged.

The new mid cap signal is a weak one, just barely moving across the line separating mid cap form large cap. The large cap signal had been in place since last February. It was an exceptionally strong signal from April through September, peaking in August and September at readings matching the strongest large cap signals in the 25 year history of the model. Since September, the large cap model has gradually weakened until it flipped for January.

The Market Cap model measures ten factors based on historical data for small cap and large cap performance. A mid cap signal is flashed if there is spilt decision. Since September when all ten factors lined up for large caps, five of the factors have shifted to small cap camp. These factors are widening credit spreads, rising bearish advisory service sentiment, the steepening of the yield curve, the collapse in consumer confidence, and falling interest rates. Each of these factors now correlates with relative performance favoring small caps.

Turning to the Style model, the reading remains firmly in the growth camp.
The signal is as strong now as it has been since the model shifted to growth in June. There was virtually no movement this month in the underlying indicators....

....During the 11 months the large cap signal was in place, as measured by the ETFs, the S&P 500 rose 1.7%, the S&P 400 Mid Cap rose 2.4%, and the Russell 2000 fell 4.4%. While the Mid Cap was the top performer, I consider the large cap call a win, especially when one adjusts for higher volatility in the mid cap index.

The Style model's call in favor of growth has been a home run so far. Again using the ETFs, the Russell 1000 Growth has gained 2.6% while the Russell 1000 Value is down 7.8%. The large representation of financial stocks in the Russel 100 Value index has really hurt its performance.

I want to reiterate that the new mid cap signal is a weak one and could flip back to large cap next month with little movement in the underlying factors. That said, I always follow my model. No reason to have a model if you aren’t going to follow it.

December 2007 Model Signals

There were no changes to Northlake's Market Cap and Style models for December. The signals remain on large cap and growth. As a result, client portfolios continue to own the S&P 500 (SPY) and the Russell 1000 Growth (IWD).

It looks like we could get a move in the Market Cap signal fairly soon, however. The model reading is on the very cusp of switching to a mid cap signal. If that occurs, positions in SPY will be sold in favor of the S&P 400 Mid Cap (MDY). For December five of the ten indicators in the model favor large cap and five favor small cap, a shift of two indicators in favor of small caps. Falling rates and widening yield spreads led to shifts this month. Lower rates definitely favor small caps which presumably have less access to capital. The credit crisis has widened spreads enough that they are now in a mode where in the past small caps have outperformed. These two indicators join bearish market sentiment, the steepening yield curve, and low consumer confidence in the camp favoring small caps. As a reminder, small caps often perform best when sentiment and the economy look worse. The model attempts to look ahead toward the next big move and when things look bleak the next big move is often up which creates an environment where the added volatility of small caps works in favor of investors.

The Style model, on the other hand, looks unlikely to make a shift away from growth any time soon. The model is still firmly in growth mode reflecting sluggish economic growth where unit growth stories are more valuable to investors. For December, two of the underlying indicators moved from value to growth mode: measure of relative strength for consumer stocks and the return of the yield curve to a normal upward sloping shape.

I find the current model signals consistent with my own views of how to invest in a weakening economy. My big worry about the current signals is that a countertrend rally in favor of small caps and value (financials are a big component of value indices) seems overdue.

November 2007 Model Signals

There were no changes to the signals from Northlake's Market Cap and Style models for November. Large cap and growth remain favored over small/mid cap and value. There was some shift in favor of small/mid cap and value in the underlying indicators, however. I think the large cap growth trend is likely to stay in place for several more quarters but a temporary shift toward small cap and value would not surprising given the outperformance for large cap and growth over the past several months. Since the July 19th S&P 500 high, the S&P 500 is down just 3% compared to a fall of over 6% for the Russell 2000 and a 4% decline for the S&P 400 Mid Cap. In the style arena, the model shifted from value to growth on June 1. Since that time, the Russell 1000 Growth ETF is up 5%, while the Russell 1000 Value ETF is down almost 5%! That is basically technology stocks over financial stocks.

In the Market Cap model for August, all ten indicators were flashing growth. Four of the ten indicators now favor small cap. The shift has occurred in indicators which consider the shape of the yield curve, sentiment, breadth, and consumer confidence. In general, the indicators are picking up extreme readings that suggest a reversal could be at hand. This contrarian call would favor small caps.

The Style model is also drifting away from its long standing signal. In this case, the severely lagging performance of value over the past few months is driving a weakening of the growth signal.

I'd be surprised if either model moves enough this month to flash a new signal for December. January, on the other hand could see a shift to mid cap and value if current trends continue. If and when the signals change, I'll happily follow along. No reason to use a model like this if you are going to second guess it and neither model has given me any reason to second guess for the last three years.

As always thanks to Ned Davis Research for the initial development and ongoing maintenance of these models.

October 2007 Model Signals

There are no changes to the signals from Northlake's Market Cap and Style models for October. The market cap model continues to flash a strong signal in favor of large cap outperformance. The style model is now flashing its strongest signal since the late 1999/early 2000 market peak for growth stocks. To capitalize on the signals, I continue to own the S&P 500 (SPY) and the Russell 1000 Growth (IWF) in client and personal accounts.

The market cap model did undergo a slight shift toward small caps as two of the ten factors went form a large cap signal to a small cap signal. Advisory Service Sentiment got extremely negative and then turned up in the past two months. This is normally bullish for small caps. In addition, consumer confidence has fallen to a level that favors small caps. This is a contrarian indicator. The concept is that low consumer confidence leads to the next move by the Fed or in the economy being favorable to investors. If so, why not own beta. Low and falling consumer confidence also often leads to falling interest rates. Falling interest rates are one of the strongest indicators of small cap outperformance. I still expect the large cap signal to hold for another month or two at least but the model suggests that outperformance of large caps may moderate.

And large caps have been outperforming. Since the current large cap signal went into place on February 1st, SPY is up 6% while the Russell 2000 as measured by IWM is up less than 1%. In the third quarter, SPY rose 1.5% while IWM fell over 3%. Even as the market rallied sharply in September, SPY was king, rising 3.4% vs. 1.6% for IWM.

As mentioned the Style model now has its strongest reading and its longest string of growth readings since the period from August 1999 though March 2000. The only change to the underlying factors for October was a shift in the insider activity indicator from value to neutral.

Since growth signal went into place in June, the Russell 1000 Growth (IWF) is up over 4% vs. a loss of almost 1% for the Russell 1000 Value (IWD).....

...In small cap style indices, it is also firmly growth over value although the Russell 2000 Growth (IWO) is down about 1%, but that looks good next to an almost 7% loss for the Russell 2000 Value (IWN). For September both growth indices decisively outperformed their value counterparts.

September 2007 Model Signals

For the third consecutive month there were no changes to Northlake's Market Cap and Style models. The signals remain large cap and growth. Client portfolios own the S&P 500 Spyder (SPY) and the iShares Russell 1000 Growth (IWF) to take advantage of the current signals.

The large cap signal from the Market Cap model remains one of the strongest readings in the monthly data I have going back to 1980. All ten factors covering a breadth of economic, interest rate, and stock market technical indicators are flashing a large cap signal. On their own, each factor has in the past shown predictive ability for anticipating relative performance of large caps vs. small caps as measured by the S&P 500 and Russell 2000. With the weight of the evidence from a broad array of previously accurate indicators lined up so solidly in favor of large caps, I feel very good about the prospects for large cap outperformance to continue for at least a few more months. The fact that large caps tend to hold up better when the market gets whacked is all the better given the uncertainty that remains in the market and economic outlook.

The growth signal coming from the Style model is not as strong but it is a solid reading in favor of growth. This marks the third consecutive month where the growth signal has sent a pretty strong reading. The three month stretch of solid growth readings is first since 2005, and only the third since the model started flashing value in the spring of 2000. With tech stocks acting better and concerns rising about economic growth and the balance sheets and earnings power of financial institutions (finance makes up over 30% of the Russell 1000 and Russell 300 Value indices), I also find the growth signal to be a comfortable place to be.

For July, the accuracy of the model signals was mixed....

....The Russell 2000 ETF (IWM) outperformed the S&P 500 Spyder (SPY). In Style, the Russell 3000 Growth ETF (IWZ) gained 1.5% vs. a gain of 1.1% for the Russell 3000 Value ETF (IWW).

Since the current signals were put in place, both models have been accurate. The large cap signal has been in place since February 1st. Over the seven months ending August 31st, SPY has gained 2.7% vs. a loss of -0.7% for IWM. The growth signals has been in place since July 1st. For the two months ending August 31st, IWZ is down -0.3% vs. a drop of -3.7% for IWW. The damage return differential in style indices has been consistent across market cap but there is a bigger advantage for growth in small caps.

August 2007 Model Signals

There were no changes of Northlake's Market Cap and Style models for August. The signals continue to be Large Cap and Growth. The large cap signal remains one of the strongest in the close to 400 monthly readings I have going back to 1980. The growth signal move from weak to solid this month and is the strongest reading in favor of growth since the value trend kicked of in 1999. There have been a couple of false starts since then but ultimately the trend reverted to value. I think this time the growth signal will hold for awhile. Both signals were accurate in July when the market dived lower. Large caps fell 3% last month but the decline in mid caps and small caps was 5% and 7%, respectively. Growth fell about 2-4% last month vs. declines 5%-8% for value.
Given the lack of changes in the models, I decided to offer you a post I did for Real Money describing the latest reading on the Style model and providing some background on how the model works and the theory behind it. The comments work for the Market Cap model as well. This might be a good refresher course.

Posted On RealMoney.com on August 2, 2007 at 8:08 ET:

I've posted before that I use monthly models originally developed by Ned Davis Research to rotate substantial funds between the Russell Growth and Russell Value ETFs. My definition of growth and value is whatever Russell puts in these indices. I am buying growth or value as an index, not an individual stock. The model chooses one index or the other with the goal of being in the best performing index.

The model shows an unmistakable trend toward growth after favoring value for much of the past seven years....

The latest update came out Wednesday morning morning and is the strongest growth reading since March 2000. There have been several readings close to this strong since mid-2005 when the long period of strong value readings ended. This may be another false start but I am betting against it.

Yesterday, Bob Marcin, Noah Blackstein, Norm Conley, and Tom Au were debating growth vs. value. While it seemed like they were on opposite extremes (Noah and Norm vs. Bob and Tom), I think that something Bob wrote is actually common ground. Bob said, "Growth is not due, value is not due. No style is ever due. There are just sets of conditions, i.e. fundamental growth rates and valuations. Period."
The key part of Bob's quote is "there are just sets of conditions." The Ned Davis models measure economic, interest rate, stock market, and technical indicators to see if conditions that have previously had predictive value are coming into alignment in favor of one or the other. Over the past few months, the conditions that in the past have favored growth are coming into alignment again.

In particular, narrow but expanding credit spreads, a weak dollar, decelerating economic growth, and a steepening yield curve are conditions that historically have favored growth. Additionally, growth as a class is cheap on a relative P-E basis, trading below the typical premium growth stocks are accorded compared to value. Several months of outperformance by growth have also pushed trend and technical indicators into positions that in the past have presaged additional periods of growth outperforming.

I don't know if we are at the beginning of a multi-year trend favoring growth but I believe for the next few months at least growth will be the place to be.

July 2007 Model Signals

I received the latest monthly updates Sunday night from Northlake's Market Cap and Style models. The Market Cap model continues to flash a very strong signal in favor of large caps. My data goes back to 1980 and the strength of the large signal is in the top 5% of all monthly readings. The Style model is now flashing a growth signal following a five month run in favor of value.

As a result, yesterday I sold all client positions in the Russell 1000 Value ETF (IWD) and moved it to the Russell 1000 Growth ETF (IWF).....

The style model has been pretty evenly split for much of the last year sending either a weak growth or weak value reading. The shift this month is reflecting recently improved relative performance of growth stocks picked up by the model's technical indicators. As a reminder, the technical indicators are designed to make the models more timely since most of the underlying indicators measuring economic growth and interest rates are longer term in nature.

In general, I see the message from the underlying factors in the models reflecting a slowdown in economic growth. This is an environment where it pays to take less risk (large caps over small caps) and seek out companies that are less sensitive to economic activity (growth over value).

The latest value signal form the style model proved to be less than perfect. During the five month period it was in place, the Russell 1000 Growth ETF rose 4.5% while the Russell 1000 Value ETF gained 3.6%. On the other hand, the large cap signal that is now in place for the sixth consecutive month has been a pretty good call. During this period large caps as measured by the S&P 500 have gained 4.7% vs. small caps at 4.6% as measured by the Russell 2000. Performance parity may not be anything to get excited about but in a strongly uptrending stock market environment, small caps typically outperform. As a result, I think the market model has allowed client to earn the generally available return in the stock market at a lower level of risk.

June 2007 Models

There were no changes to Northlake's Market Cap and Style models for June. The signals remain large cap and value. The large cap signal remains very strong, while the value signal remains weak. As a result of the updated signals, there are no changes to the holdings in the portion of the portfolios I manage using these models. Clients continue to own the S&P 500 (SPY) and the Russell 1000 Value (IWD).

This is the fifth consecutive month that the market cap model has flashed a large cap signal. The average holding period for this model based on data since 1980 is four to six months. For the last several months, the signal has been very strong favoring relative outperformance of large caps over small caps. In fact, there have only been 13 months with stronger signals in favor of large caps out of the 339 months that I have data on the model. All ten indicators in the market cap model are flashing a large cap signal. The model is picking up a moderately growing and slowing economy, rising interest rates and the recent technical deterioration of the Russell 2000 versus the S&P 500.

This is also the fifth consecutive month that the style model has flashed a value signal. The average holding period in the style model is five to seven months based on data since 1981. The value signal remains a weak one with just five of the nine indicators in the model flashing a value signal. Flipping of just one indicator or changes in the strength of one or two underlying indicators would be enough to change the model to a growth signal....

Performance of the models has been mixed since the current signals have been in place. The market cap model has been pretty good with the S&P 500 slightly outperforming the Russell 2000 since February. For May, the Russell 2000 slightly outperformed the S&P 500. I take comfort in these results given that one would expect the beta effect to cause small caps to outperform with the market in such a strong uptrend. In my opinion, the large cap signal has allowed my clients to earn as good as returns as the Russell 2000 while taking less risk. The model has not been perfect, however. Mid cap has been the pace to be over the past four months. The S&P 400 (MDY) has outperformed the S&P 500 by about 350 basis points. I believe the combination of private equity deals and strong performance from energy stocks has driven the outperformance of mid caps.

The weak signal from the style model in favor of value has fairly reflected the compression of performance among value and growth over the past four months. During that time, as has been the case for most of the past year, there has been very little variance in the performance of the major growth and value indices. In fact, over the last four months, the returns have been almost identical. For May alone, growth outperformed value.

May 2007 Model Signals

There were no changes to Northlake's Market Cap and Style models for May. The Market Cap model continues to flash an extremely strong signal favoring large caps. The Style model continues to flash a weak signal in favor of value. As a reminder, these models are designed to predict relative performance and have minimal predictive ability for the stock market direction. The latest signals leave my exposure in the S&P 500 (SPY) and the Russell 1000 Value (IWD).

There was almost no movement in the factors underlying the two models this month. The only change was a shift to small cap from large in the NYSE Breadth factor reflecting steady, if unspectacular improvement in breadth during April's market rally. Despite this change the overall model actually moved a touch deeper into large cap territory. The large cap signal has not been this strong since the end of 1995. Since the start of my data in the spring of 1979, there have been only about a dozen monthly readings more strongly in favor of large cap outperformance. The current reading will take several months to switch to a small or mid cap signal even if the underlying factors begin to move in favor of small caps. I think it is a good bet that the model won’t shirt again to small caps without a large move in either the stock market or the economy. It seems most likely those moves would be to the downside as the small caps are favored at extremes rather than in moderate or soft landing scenarios....

The Style model, on the other hand could easily shift over to growth as soon as next month. The current value signal came into effect in February but has been a weak signal for all four months. The latest movement was in favor of growth and it won’t take much more to turn the signal for June.

The large cap signal first went effect in February. For the three months ending April 30th, the S&P 500, as represented by SPY is up 3.2% vs. a gain of 1.8% for the Russell 2000, as represented by IWM. Mid cap has actually been the best performing category over the 3-month period so the signal has not been perfect.

The value signal has not been very accurate so far but since I have limited client exposure to large cap value the damage has not been great. For the three months, large cap growth (IWF) is up 3.1% and large cap value (IWD) is up 3.05%. This period continues a trend of performance compression among growth and value that has been in place for most of the past year. In the small cap area, growth has outperformed value considerably over the past three months. Fortunately, the strength of the Market Cap signal has kept me out of small cap value.

April 2007 Model Signals

For the second consecutive month there were no changes to Northlake's Market Cap and Style models. The signals are still flashing large cap and value. As a result, in the portion of the portfolios Northlake manages that are dedicated to the ETF rotation strategy, I continue to own the S&P 500 (SPY) and the Russell 1000 Value Index (IWD).

Despite the lack of changes in the signals, there is some exciting news. The Market Cap signal favoring large cap is at its strongest level since November and December of 1995! In fact, the signal strength is in the top ten going all the way back to the beginning of my measurement period in 1980. For what it's worth, the 1995 signals proved accurate as large caps outperformed small and mid caps over the next three months and especially in months six through eighteen following the signal. The models are designed to offer signals over an intermediate time frame which I define as six to twelve months. The average holding period for the market Cap model in the 25 plus years of back testing is five months....

The Market Cap model contains ten factors, all of which now favor large cap. I divide the factors into three buckets: economic, interest rate, and stock market/technical. In general, the model has favored large caps when the market returns are about average. Small cap signals usually occur when the market and economy have been doing poorly for awhile. The idea is to move into what is going to work next so there is a contrarian aspect. The stock market/technical indicators include some trend based factors to keep me from being too late or too early. Ned Davis Research developed these models and continues to maintain them.

The Style model had no changes this month to any of the underlying factors leaving the reading exactly the same as last month. I'd classify the reading as a "weak value" signal. Over the past six to twelve months, the Style model has not been sending strong signals as it has rotated a few times between growth and value. Over this time frame, returns on the major growth value indices have not shown significant variation.

So far in 2007, the signals from both models have been pretty accurate. Thanks mostly to a call favoring mid cap to start the year, the Market Cap model produced a price-only gain of 1.07% in the first quarter vs. just .19% for the S&P 500. The Style model benefited similarly from a good call on value to start the year and produced a first quarter gain of 1.89%.

March 2007 Model Signals

There were no changes to Northlake's Market Cap or Style models for March. The signals remain Large Cap and Value. As a result in the portion of client portfolios dedicated to Northlake's ETF rotation strategy (generally ranging from 40% to 80% of equity portfolio value depending on account characteristics), I continue to own the S&P 500 (SPY) and the Russell 1000 Value (IWD).

Despite the lack of changes in the signal, there is one notable item when looking at the factors underlying the model. The current reading in favor of large caps is one of the two strongest signals since a five year run in favor of small and caps ended in 2005. Since then the model has rotated between mid cap and large cap with more recent data trending generally toward large caps.....

The Market Cap model contains ten factors that I classify as economic, interest rate, or stock market indicators. Presently nine of these factors large caps. Some of the factors are sending stronger large signals than others but the message is clear.

The Style model had few changes for March. The signal in favor of value is a little stronger but I would not classify as a strong signal. It could easily flip back to growth next month if just one or two factors changed.

I am uncertain whether this week's sharp stock market decline is the beginning of a bearish or just part of a stiff short-term correction. However, one thing I think we can for certain is that for awhile volatility is likely to be greater and the downside risk has increased. In this type of environment I am pleased that the Market Cap model is sending a strong large cap signal. As a long only manager/fully invested manager, the best way I can protect my clients assets is to own less risky assets when risks to the downside are highest. I feel the current position of the models is closely aligned with the new market environment. I can’t ask for much more than that whether the signals turn out right or wrong.

February 2007 Model Signals

Both of the models in Northlake's ETF rotation strategy sent new signals for February. The market Cap model shifted from Mid Cap to Large Cap and the Style model shifted from Growth to Value. As a result of these changes, I swapped client positions in the S&P 400 Mid Cap (MDY) for the S&P 500 (SPY) and the Russell 1000 Growth (IWF) for the Russell 1000 Value (IWD).

Several indicators in the Market Cap model shifted in favor of large caps this month including many of the indicators that I refer to as stock market indicators. The measure of Advisory Service Sentiment moved from small cap to large cap as it dropped below recent highs indicating that peak in bullishness maybe at hand. Not surprisingly, history shows that large caps outperform small caps when bullish sentiment roles over. The indicators that measure breadth and trend also moved in favor of large caps. These indicators are picking up the lagging performance for small caps since the lows last May and June. The final indicator to change is the 3 month measure of bond momentum. Small caps underperform when interest rates are rising so the sharp rise in rates over the past month and a half clearly favors large caps.

Only one indicator shifted in the Style model: Advisory Service Sentiment. This indicator also has had predictive ability on the growth vs. value question. Similar to the Market Cap interpretation, this indicator favors value when it appears that bullish sentiment has peaked. Once again, the interpretation is that at peaks in bullish sentiment the next big move might be lower and it will pay to lower your risk value. Value, like large caps, is the place to be when risks are higher.

Both of the just vacated Mid Cap and Growth signals were in place for three months. The Mid Cap signal proved very good as over the 3 month period, MDY gained 5.77% to 4.33% for SPY and 4.09% for IWM. The Growth signal was inaccurate but did not prove too costly. As measured by the Russell 3000 Growth and Value ETFS (IWZ and IWW), value outperformed growth by 5.35% to 4.66%. Using the Russell 1000 or 2000 Growth and Value ETFs, the returns were about the same, growth underperformed value by 50-75 basis points.

January 2007 Model Signals

It's a new year but there were no changes to Northlake's Market Cap and Style model signals for January. The Market Cap Model continues to favor mid caps and the Style model remains firmly in the growth camp. Within my personal and Northlake client accounts, I am implementing the Market Cap signal by holding equal amounts of the S&P 500 (SPY) and the S&P 400 Mid Cap (MDY). The entire exposure to the Style model is in the Russell 1000 Growth (IWF).

Both signals are the results of a somewhat muddled group of indicators looking at economic, interest rate, and technical measures. My interpretation is that the indicators are picking up the slower economic growth increasingly evident over the past six months but the implications of the slowing are mixed for major investment themes. In other words, the market is operating without a major theme with all investment strategies rising and falling together. This is far different than the consistent themes of small caps and value that were evident from the bottom in the market in 2002 until the breakout last summer. I suspect the correct interpretation is that we are transitioning to new leadership. Large caps seem likely candidates but I don’t the evidence is strong enough yet to make a big bet on that outcome.

Since we are at year end, I thought I'd offer a look back at performance of the models in 2006....

Overall, despite poor signals in December, the models were pretty accurate. As implemented in real accounts, the Market Cap model beat the S&P 500 by about 160 basis points and the Style model beat the S&P 500 by about 400 basis points. The key to the good results was the value signal that was in place for most of the first half of 2006, my use of small cap value early in the year to leverage a persistent Mid Cap signal from the Market Cap model, and great performance from Mid Caps until the sharp decline in the market in May.

I'll close with a quick thanks to Ned Davis Research who developed the models I use, continues to maintain them and provide me with consulting, and allows me to write about them on here and on StreetInsight.com. Special thanks to Alex White, Ed Clissold, and Tim Hayes.

December 2006 Model Signals

My attendance at the UBS Media Conference led to the delay in getting the latest model signals up on the website. Fortunately, the models did not signal change for this month. Here is some detailed commentary:

There were no changes to the signals from Northlake's Market Cap and Style models for December. The Market Cap model continues to send a mid-cap signal, while the Style model moved to a stronger growth signal. As a result of this month's update, I made no changes to client ETF holdings. The Market Cap allocation continues to be split evenly between the large-cap S&P 500 (SPY) and the mid-cap S&P 400 (MDY). The Style allocation remains 100% Russell 1000 Growth (IWF).....

Looking at the underlying factors that make up each model, on the market cap side, I think it is fair to say that the signals remain mixed. This model flashed a mid-cap signal from January through June and then switched to a four-month run favoring large cap. The move back to mid caps in November was largely a function of better relative performance for small caps in the late summer and early fall. I consider the current signal from this model to be weak which is why I am splitting my exposure between large and mid caps.

The Style model is more interesting as it has moved firmly into growth territory. The current signal is the strongest in favor of growth since the fall of 2005. Before that, the last time the growth signal was this strong was in mid-2003. Almost all the underlying indicators are lined up in favor of growth including narrow credit spreads, a below-average relative P/E premium, outperformance by consumer stocks, bullish overall market sentiment, the weak U.S. dollar, and a variety of intermediate-term technical indicators that are picking up improved performance for growth stocks over the past six months.

The only factors favoring value are the inverted yield curve and continued moderate economic growth. The yield curve favors value either when it is very steep or inverted. Historically, growth has performed best with a normal upward sloping yield curve in place. With recent indications that 4Q06 GDP growth may slip toward 0%, the coincident indicator that measures GDP growth in this model will likely flip to growth soon, leaving only the shape of yield curve favoring value.

Northlake's models are implemented in a disciplined manner, leaving me little flexibility to adjust my dedicated ETF holdings. However, I also use the models to influence the limited assets managed outside Northlake's ETF rotation strategy. The strengthening growth signal has me considering a trading position in the Nasdaq 100 (QQQQ) if last week's volatility leads to a more substantial pullback in the broader market averages.

November 2006 Model Signals

Both Northlake's Market Cap and Style models sent new signals for November. The Market Cap model moved from large cap to mid cap and the Style Model went back to growth from value. The mid cap signal is fairly weak, while the growth signal is moderately strong. As a result of the new signal, I swapped all client and personal positions in the Russell 1000 Value (IWD) into the Russell 1000 Growth (IWF). Since the mid cap signal was weak I swapped only half of the positions in the S&P 500 (SPY) into the S&P 400 Mid Cap (MDY)....

The new mid cap signal follows a four month run where the model favored large caps. The prior call was a good one as SPY rose 8.26% for the period vs. 2.93% for MDY and 6.27% for the Russell 2000 (IWM). It is especially satisfying to have invested in the highest performing index when the signal is large cap. Looking back over the 25 years of history I have on the Market Cap model, bullish periods overwhelmingly had small cap signals. But don’t read that as a market call. Northlake's models are meant to predict relative performance, not market direction.

The new mid cap signal is the result of rebounding technical conditions for small cap indices over the last few months. There were no changes at all in the economic or interest indicators this month. Those remain fairly evenly split between large and small cap signals (the model kicks out a mid cap signal when the underlying factors are fairly evenly split between small cap and large cap signals).

The new growth signal is the second in the last three months following a long stretch of only value signals. The current growth signal is stronger than the September one that broke the 8 month streak in favor of value. It is also driven largely by the technical indicators but there is an unmistakable trend in the economic and interest indicators in favor of growth over the past six months.

I follow the models regardless of whether I agree with their signals but in this case I agree that the environment favors growth. In general, the models favor growth in a slowing economy when growth companies can presumably sustain better performance with less of a tailwind from the economy. Growth has been outperforming value since July. The one month shift from growth to value for October proved slightly inaccurate as IWD underperformed IWF by about 60 basis points.

October 2006 Model Signals

The weak growth signal given by Northlake’s Style model for September turned into a weak value signal for October. As a result, I swapped all client holdings of the Russell 1000 Growth (IWF) into the Russell 1000 Value (IWD) at the open yesterday.

The one month swap from IWD to IWF for September turned out to be an OK trade from an absolute and relative basis. During the month, IWF rose 1.8% vs. a gain of 1.1% for IWD.

The average holding period for Style model based on back tests going back to 1980 is about 5 months so the one month flip flop is a bit unusual. Usually the volatility occurs when the signals are weak or in transition. I remain of the belief that we are transitioning to an environment favoring growth despite the reversion back to a value signal this month. In general, an environment of moderating economic growth favors growth and that is exactly what I expect to be the dominant economic theme for the next several months.....

Only one of the factors underlying the Style model changed this month, the index of coincident indicators moved from growth to value, but that was enough to switch the signal given the weakness of the prior month’s reading. This factor changed because the 12 month rate of change in the coincident indicators moved from negative territory to positive territory. This measurement is fluctuating very close to 0% and might remain volatile from month to month. None of the other 8 factors changed their signal for October.

Switching to the Market Cap model, the signal remains Large Cap although for the first time in six months, there was movement in favor of small caps. The movement was driven by the rally in bonds as the three month rate of change of the Lehman Long-Term Treasury index moved above 5%. Historically, bond market momentum (falling interest rates) of this magnitude has favored outperformance by small caps. Seven of the ten indicators in the Market Cap model are still flashing a large cap signal. My position in the S&P 500 (SPY) remains unchanged for October.

Debating Growth and Value

Last week on Real Money, there was a debate on the growth vs. value question. It began when my colleague, Ed Stavetski asked, “As the economy slows and earnings growth tails off, does one want to own value or growth?” Ed asked the question after reviewing year-to-date returns for the Russell growth and value indices that show a big edge for value (this edge was captured by Northlake’s Style model which flashed a value signal from February through August). His conclusion appeared to be that the market had spoken and a slowing economy was rewarding value.

Another colleague, Gary Dvorchak, jumped into the debate the next day looking at valuation of growth vs. value. He showed some charts indicating that growth is close to an all-time low on a relative value basis vs. value. Obviously, his conclusion was that growth is now the place to be.

Northlake’s model, courtesy of Ned Davis Research, offers a similar split decision but did shift to a weak growth signal this month. The shift follows a summer that started with just three of the nine factors favoring growth. Entering fall, there are now five on nine factors favoring growth. That is barely enough to shift the signal, but it shifted nonetheless.....

Northlake’s model includes both of the factors that Ed and Gary mentioned. While I agree with Gary’s view that growth is cheap, I take issue with Ed’s view that a slowing economy favors value. I think a slowing economy favors growth. Here is a chart that shows the performance of growth vs. value based on whether coincident indicators are rising or falling on a year-over-year basis:

Download Growth vs. Value and Coincident Indicators

It might be hard to read but based on this data going back to 1979 when the 12 month rate of change for the coincident indicators has been below 0%, the Russell 3000 Growth has returned 16.1% annualized while the Russell 3000 Value has risen at an annual rate of just 7.3%. Intuitively, this makes sense to me. Growth is more valuable when the economy is decelerating because growth companies don’t need the economy to produce positive year-over-comparisons in revenues, operating income, earnings, and cash flow. When data lines up with common sense, I fell pretty strongly that the thesis makes sense.

Looking at valuation, as I noted, Gary is correct that growth is looking cheap at the moment. However, at least based on this measure of relative forward P-E rations for the Russell 3000 Growth and value indices, growth is not yet really cheap on a historical basis:

Download Growth vs. Value Comparative Price-Earnings Ratios

Now I’ll admit that I might be cherry picking data here to support my positions. For example, Gary showed a chart that indicated that on price-to-cash flow basis growth is cheaper than value for the first time in at least 30 years. I am sure that Ed can probably offer a chart that shows that the current economic environment, albeit slower growth than it was a year ago, favors value.

The bottom line, however, is that after five plus years of value or growth when the predictive factors all lined up largely in favor of value, many of those same indicators are now suggesting growth. Northlake’s Style model made the switch. We shall see if the call is accurate and whether it proves sustainable by recurring next month and beyond.

September 2006 Model Signals

After seven months signaling value, Northlake’s Style model shifted to growth for September. There were no changes in any of the underlying factors this month. Rather, the two month rolling average calculation shifted to growth when June’s value bias was dropped and August data confirmed the shift to growth first picked up in July. As a result of the new growth signal, I sold all client positions in the Russell 1000 Value Index (IWD) and the Russell 3000 Value (IWW) and swapped dollar for dollar into the Russell 1000 Growth Index (IWF).

There were no changes to Northlake’s Market Cap model for September, which for the third consecutive month is providing a large cap signal. The large cap signal remains strong and accounts for the use of the large cap Russell 1000 in the implementation of the new Style signal.....

For September, five of the nine factors that make up the Style model favored growth, making it two straight months with a majority for growth. As recently as June, only three of the nine factors in the Style model favored growth. The shift to a growth signal is being driven by factors picking up slowing economic growth, a weak dollar, cheap relative valuation, better technical action for growth stocks, and unusually narrow credit spreads. While I never second guess the models, I personally concur with the slowing growth scenario so this shift is comfortable for me.

I should note that the growth signal is a weak one at the moment. The movement of just a single factor next month could shift the model back to value mode. While that could happen, the average length of a signal from this model has been seven months based on backtesting to 1980.

By coincidence, the prior value signal was in place for seven months, and it proved to be a very accurate signal. Looking at the Russell Growth and Value ETFs, from February thru August, the Russell 3000 Value (IWW) gained 5.5% against a loss of 2.2% for the Russell 3000 Growth (IWZ). The story was the same in the narrower indices as the Russell 1000 Value (IWD) gained 5.9% against a loss of 1.7% for the Russell 1000 Growth (IWF) and the Russell 2000 Value (IWN) gained 3.6% against a loss of 5.1% for the Russell 2000 Growth (IWO). Northlake’s benchmark is the S&P 500, which gained 2.5% during this same period, so no matter how it was implemented the value signal proved to be a good one.

August 2006 Model Signals

This note was originally written and published on StreetInsight.com on August 2nd. With all the trauma from my the complete crash of my pirmary PC on July 30th, I forgot to post it here. I apologize for my oversight.

There were no changes to the signals from Northlake's market-cap and style models for August. Northlake clients continue to own large cap and value represented by the S&P 500 (SPY) and the iShares Russell 1000 or 3000 Value Index (IWD/IWW). There was some interesting underlying movement in the models, however.

A Decisive Shift in Favor of Large Caps in Market-Cap Model

The market-cap model made a more decisive shift in favor of large caps this month and now sits very firmly in large-cap territory. Not surprisingly, the cause of the further shift is that the trend indicator finally moved in favor of large caps. The lag for this indicator might surprise some folks, especially since small caps initially collapsed in May, but keep in mind that the models are designed to predict relative performance over a six- to 12-month time horizon. I am trying to capture the major trend, not all the wiggles. Consequently, the trend indicators look back six to 18 months.....

Small Caps Could Bounce

There was one contra-trend shift in the market cap model worth noting. The advisory service sentiment indicator moved in favor of small caps due to plunging bullish sentiment. Sentiment dropped far and is now so negative it suggests that bullish behavior will be rewarded. I am glad that the overall model is deeply in large-cap territory, but this indicator may suggest that a dead-cat bounce of relative performance favoring small caps is around the corner.

Style Model Moving Toward Growth

The more interesting results this month were in the style model, which made a fairly strong move toward a growth signal. The model is not at growth yet and might not reach growth, but this is the first move in favor of growth in many months.

Consumer/Cyclical Ratio and Coincident Indicators Shift Toward Growth

Two indicators shifted from value to growth this month: the consumer/cyclical ratio and the coincident indicators. The consumer/cyclical indicator measures the relative performance of the two infamous Morgan Stanley indices. Consumer stocks lifted their heads recently, and maybe a change in well-established, long-term trend favoring cyclicals is at hand. The coincident indicators shifted toward growth because the index is no longer growing on a year-over-year basis. Both of these indicators might be saying that slowing economic growth is the emerging market theme.

Trend Indicators Still Favor Value

These two indicators join relative P/Es, the weak U.S. dollar and tight credit spreads in favoring growth. The complete shift in favor of growth is being held back by the trend indicators, which still favor value.

Trends Favoring Capitalization or Style Persist

One of things I like about my models is that the trend indicators add a timing element that hopefully keeps me from being too early or too late. Again, I am looking for major trends, not monthly wiggles. A look back at market history shows that trends favoring capitalization or style tend to be persistent, often lasting years, and provide large variation in relative performance.

Small Caps Could Bounce

There was one contra-trend shift in the market cap model worth noting. The advisory service sentiment indicator moved in favor of small caps due to plunging bullish sentiment. Sentiment dropped far and is now so negative it suggests that bullish behavior will be rewarded. I am glad that the overall model is deeply in large-cap territory, but this indicator may suggest that a dead-cat bounce of relative performance favoring small caps is around the corner.

Style Model Moving Toward Growth

The more interesting results this month were in the style model, which made a fairly strong move toward a growth signal. The model is not at growth yet and might not reach growth, but this is the first move in favor of growth in many months.

Consumer/Cyclical Ratio and Coincident Indicators Shift Toward Growth

Two indicators shifted from value to growth this month: the consumer/cyclical ratio and the coincident indicators. The consumer/cyclical indicator measures the relative performance of the two infamous Morgan Stanley indices. Consumer stocks lifted their heads recently, and maybe a change in well-established, long-term trend favoring cyclicals is at hand. The coincident indicators shifted toward growth because the index is no longer growing on a year-over-year basis. Both of these indicators might be saying that slowing economic growth is the emerging market theme.

Trend Indicators Still Favor Value

These two indicators join relative P/Es, the weak U.S. dollar and tight credit spreads in favoring growth. The complete shift in favor of growth is being held back by the trend indicators, which still favor value.

Trends Favoring Capitalization or Style Persist

One of things I like about my models is that the trend indicators add a timing element that hopefully keeps me from being too early or too late. Again, I am looking for major trends, not monthly wiggles. A look back at market history shows that trends favoring capitalization or style tend to be persistent, often lasting years, and provide large variation in relative performance.

July Model Signals

Northlake's Market Cap model completed its transition for July by flashing a large cap signal for the first time since June 2005. As a result, I sold all remaining mid cap exposure dedicated to the ETF rotation strategy, swapping it dollar for dollar to large caps. Specifically, at the open on Monday, I sold the S&P 400 Mid Cap (MDY) and bought the S&P 500 (SPY). There was no change at all in the signal from style model which continues to flash value as it has since February 2006.

Current positions within the ETF rotation strategy are now entirely large cap, equally split between SPY and the Russell 1000 Large Cap Value (IWD). As recently as two months ago, clients had 25% in small cap value and 50% in mid cap, so a shift to 100% large cap is a significant change.

The market cap model has picked up on several trends that favor large cap outperformance including....

moderating economic growth, a weaker dollar, a flattening yield curve, rising interest rates, weakening breadth, an unusually high relative P-E for small caps, an extreme readings in investor willingness to accept risk (a contrarian indicator). Over the past six months these indicators have gradually moved in favor of large caps but only with the June and July signals did the weight of the evidence finally shift in favor of large caps.

I use my models to enforce decision-making discipline. I never second guess them and I always implement the signals. Nevertheless, I am glad that in this case, my own opinion squares perfectly with the models. I think we face a tough summer to make money in stocks and feel the risk is to the downside. Therefore, I'd rather be invested is less volatile large caps which should limit losses if the market does fall further.

I am pleased that client accounts now have a lower risk profile. Besides the shift toward large caps in the ETF rotation strategy, I have also adopted a more conservative position by raising cash reserves and eliminating discretionary positions in emerging market and small cap ETFs. My caution may prove wrong but by adjusting risk downward I feel a lot less pressure which usually has allowed me to make better decisions.

Even though the signal last month was the weakest possible mid cap signal it was still a mid cap signal. Therefore, I measure the accuracy of latest mid cap signal from its first appearance in September 2005 through June 2006. During this period, on a price only basis, it was a good call as mid caps gained 6.72% against a gain of just 3.83% for the large cap S&P 500. It wasn't a perfect call though as the model could have flashed a small cap signal which would have kept portfolios invested in the Russell 2000 (IWM) for a gain of 7.82%. But I'm not complaining.

June Model Signals

The June signals from Northlake's models led to significant shifts in client and personal portfolios on Thursday. Overall, the changes moved portfolios from being small and mid cap biased to being large cap biased. The result reduces risk and volatility by moving half of the S&P 400 Mid Cap (MDY) exposure to the S&P 500 (SPY) and all of the remaining Russell 2000 Value (IWN) to Russell 1000 Value (IWD). Looking at this another way, the portion of portfolios dedicated to Northlake's models went from 50% mid cap, 38% large cap, and 12% small cap to 75% large cap and 25% mid cap.

The trigger for this shift was movement in the Market Cap model from a firm mid cap signal to a split decision between mid cap and large cap....

The models Northlake uses score on a 0 to 100 scale based on a two month rolling average. For June, the score rests right on the point that divides a mid cap signal from a large cap signal. There was no change in Style model which continues to favor value over growth.

Over the last two months, two of ten factors that make-up the Market Cap model shifted. For May, a measure of NYSE breadth picked up underlying deterioration in the stock market, while for June the factor measuring the U.S. dollar picked up weakness in the currency. Each of these changes favors large caps relative to small caps. There are a couple of other technical factors that I thought might also shift to a large cap signal, but I believe the bounce we had on Wednesday during which small caps outperformed probably prevented this indicator from changing modes.

I am pleased to have reduced client risk profiles, as measured by relative performance vs. the S&P 500. I think the recent market break is the start of a transition period toward better relative performance for large caps. Even f I am wrong, I think this transitional period carries a lot more risk for small caps as any retest of recent lows would lead to another drubbing for highly volatile indices.

Cash positions in client portfolios are still on the low side. My current plan is to raise cash if the market recovers a bit more. I had feared that I had remained too aggressive via the combination of being fully invested and favoring small and mid caps but the rally the last two days and the fresh signal allowed a "do over" where I could lower portfolio risk profiles on strength. As they say, "better lucky than good."

May 2006 Model Signals

There were no changes to signals from Northlake's Market Cap or Style models for May, which continue to flash Mid Cap and Value. Consequently, the positions used to implement these signals are also unchanged: S&P 400 Mid Cap (MDY) and Russell 1000 Value (IWD) and Russell 2000 Value (IWN). The default position of $3 in IWD for every $1 in IWN is also being maintained.

While the market cap signal did not shift, there was movement in underlying factors that pushed the signal toward a large cap reading.....

In fact, the current reading of the market cap model is closer to a large cap signal than it has been since January 2006, although I am probably overanalyzing it. The only factor to shift was NYSE Breadth, which shifted from a small cap to a large cap signal due to deteriorating breadth as measured by the monthly average of weekly NYSE advances minus declines. This measure of breadth has deteriorated sharply in recent weeks. As mentioned, I am probably reading too much into these small moves but there has been awful lot of discussion on Wall Street about whether large caps will reassert leadership so I thought I would bring it to your attention.

There is absolutely nothing new from the Style model. The signal has now remained firmly in value territory for four consecutive months.

Last month, the mid cap and value signals worked out pretty well. MDY matched the performance of the S&P 500 despite the fact that the small cap Russell 2000 lagged. Usually, the higher volatility on MDY will cause it to move more in tandem with the Russell than the S&P 500. However, I've noticed a high correlation on daily relative performance between the energy stocks and MDY. I think this is because even though MDY is not heavily weighted in energy, it does contain more of the high octane energy stocks.

Value led growth last month, especially in the larger cap areas. IWD easily beat the Russell 1000 Growth (IWF) as the large cap energy and financial exposure in IWD boosted that ETF while IWO suffered as large cap tech like Microsoft (MSFT) and Intel (INTC) performed poorly.

The signals have also been accurate since the most recent changes took place. Mid caps have easily outperformed the S&P 500 since last September when the latest mid cap call occurred. The value signal has been in place for just three months. It has proven slightly accurate but my implementation of $3 IWD for $1 IWN has given the return a boost.

April Model Signals

I am a little delayed getting up the monthly update on the Northlake's Market Cap and Style models because I wanted to check with Ned Davis Research (NDR), the firm that processes the models, about this month's readings. For just the second time ever, in monthly readings going back to 1981, the "score" of both models was unchanged. It is rare for even one of the models to be unchanged from month-to-month. In fact, against the 0 to 100 scoring system, the average monthly swing in the Market Cap model has been 5 points, while the average monthly swing in the Style model has been 10 points. NDR has confirmed the signals for April were correct and referred to the outcome with the "100 year flood" cliché.

With no change in either model, the signals remain Mid Cap and Value. The signals are implemented in client portfolios with holdings of the S&P 400 Mid Cap (MDY), the Russell 1000 Large Cap Value (IWD), and the Russell 2000 Small Cap Value (IWN). The ratio of IWD to IWN remains $3 to $1. Overall, the models are sending mixed signals indicating that trends in the economy, interest rates, and the stock market are split. This is consistent with the up-down action the stock market has seen since January, as the models seem to be picking up the split in sentiment among investors. The models continue to be most heavily influenced by the consistent but moderate growth in GDP, upwardly trending interest rates and a flattening yield curve, and readings which suggest investors are willing to tolerate an above average level risk in their portfolios....

Performance of the models was pretty good last month with the Mid Cap signal continuing to provide a boost. In March, the holding in MDY gained over 2.3%, more than 1% greater than the benchmark S&P 500. The Mid Cap signal began flashing in September 2005. It has also been accurate over this entire period, producing a gain of 11% vs. just over 6% for the S&P 500. For all of 2006 so far, MDY has gained about 7.5% vs. 3.8% for the S&P 500. Returns could have been even better had the model been flashing a small cap signal since last fall but it is tough to complain about the returns that have been generated.

The IWD/IWN combo has been in pace for just two months. During that time, value and growth indices have produced almost identical returns. However, thanks to the ownership in the small cap IWN, the combined IWN/IWD holding has produced a return comfortably in excess of the S&P 500. I use the $3 to $1 large cap growth or value vs. small cap growth or value as a default weighting that roughly reflects the overall weighting of the broad US market. I would add to the small cap holding if the Market Cap model moved to a strong small cap signal. Similarly, I would increase the large cap holding if the Market Cap model moved to a strong large cap signal. Neither appears in the cards over the next couple of months based on the current signal and the position of the underlying factors.

March 2006 Model Signals

There were no changes to Northlake's Market Cap or style models for March. Client portfolios remain long mid caps and value, which I execute using the exchange trade funds representing the S&P 400 Mid Cap (MDY), the Russell 1000 Value (IWD), and the Russell 2000 Value (IWN). Clients continue to own $3 in IWD for every $1 in IWN, a slight bias against large cap in the style allocation. The long-standing mid cap signal, now in place for six consecutive months is the reason I am making a modest relative bet against large caps.

Last month, the model signals offered mixed results. The mid cap signal from the Market Cap model was wrong. As measured by the ETFs or the actual indices, mid caps were the worst performing index, trailing large caps and small caps by up to 1% depending on the particular index or ETF being measured. On the other hand, the Style model flashed an accurate signal as the value ETFs slightly outperformed the growth ETFs....

Year to date, the mid cap signal has been correct and has produced a return in excess of the S&P 500. However, a small cap signal would have provided even better returns. For the trailing five months that the mid cap signal has been in place, mid caps and small caps have returned about 9% on a price only basis, comfortably ahead of the price only return on the S&P 500 of 4.6%.

The Style model has not offered any excess return on a year to date basis as the small excess return for value over growth merely regained the lost return in January when the model flashed an inaccurate growth signal.

There was little underlying change in the models for March, consistent with the lack of change in the overall signal. The strength of the mid cap signal from the Market Cap model was almost identical for March as it was for February. The only factor that shifted was advisory service sentiment which moved from favoring small caps to a neutral reading. This factor attempts to identify initial shifts from overly bullish or bearish sentiment readings. Presently, the sentiment readings are muddled, which is pretty consistent with the discussion on Wall Street, in my opinion.

None of the factors in the Style model shifted for March. However, the model did register a stronger value reading. Narrowing credit spreads, the continuing flattening or inversion of the yield curve, and strength in the U.S. dollar, all contributed to the stronger value reading for March.

February Model Signals

For February, Northlake's Market Cap model continued to flash a Mid Cap signal as has been the case for every month beginning in September 2005. As a reminder, this model measures ten factors which I group as economic, interest rate, and stock market indicators. Each indicator has historically had predictive value for the relative performance of small caps vs. big caps. The model uses a weight of the evidence approach so that if the indicators generally favor small or large caps that is the signal that will be flashed. A mid cap signal is flashed when the indicators are split as they are currently. One interesting observation from the current status of the underlying signals is that most of the economic and interest indicators favor large caps while the stock market indicators which include especially the trend and measures favor small caps. Decelerating economic growth and moderately rising interest rates historically have favored large caps but for now investors still are supporting small caps. A key question is when will investors rotate decisively toward large caps on a relative basis if fundamentals continue in their favor?

Northlake's Style model shifted back to value for February after a one month sojourn in growth territory. This change led to the sale of all holdings in Russell Growth ETFs (IWF and IWO) and the purchase of Russell Value ETFs (IWD and IWN). Prior to January, this model had flashed a value signal for three consecutive months. The underlying factors in this model generally favor value across the economic, interest rate, and stock market indicators. However, most of the signals are weak which explains the monthly fluctuation in the overall signal. For February, three underlying indicators shifted. First, the valuation indicator moved in favor of growth. This indicator measures the relative P-E of the Russell 3000 Growth index vs. the Russell 3000 Value index. Historically, the growth P-E has average 1.45 times the value P-E. After three plus years where value looked cheap, recently, the relative P-E has normalized on a historical basis. Last month, growth moved very slightly into the cheap mode, thus the indicator switched....

The second change for February occurred in advisory service sentiment which measures bulls vs. bears using Investors Intelligence data. This is a contrarian indicator that shifts when sentiment moves toward extreme readings. This month the indicator shifted from growth to value as bullish sentiment rose considerably. The model reads this a reason to move into the lower beta, less risky category which in this model is value.

The final shift for February was in the technical indicators. These indicators measure intermediate trends covering 6 to 12 months. This month the indicators actually went from a reading favoring growth, acknowledging the trend mostly in place since last spring, to a reading favoring value, picking up on better value performance over the past 4 to 6 months.

The indicators offered mixed accuracy for January. The mid cap signal was a good one as using the price only performance of the tracking ETFs, the S&P 400 (MDY) gained 5.3% against just 2.4% for the S&P 500 (SPY). However, the most accurate signal would have been small cap as the Russell 2000 (IWM) gained 8.4% in January. The mid cap signal that has been in place since September has proved accurate so far as MDY is up 8.8%, IWM is up 8.8% and SPY is up just 4%.

The Style model did not produce an accurate signal in January when it favored growth. I look at several indices to determine the accuracy of this model. Last month, the Russell 3000 Growth (IWZ) and Value (IWW) and the Russell 1000 Growth (IWF) and Value (IWD) saw better performance for value. Only in small caps was the signal accurate as the Russell 2000 Growth (IWO) gained 9% vs. 7.8% for the Russell 2000 Value (IWN). My implementation of the growth signal for January was weighted 75% Russell 1000 and 25% Russell 2000. This produced a return in excess of the S&P 500 but left a fair amount on the table.

Interesting Datapoint Favoring Growth

Ned Davis Research has an interesting tidbit today in favor of the recent shift in client portfolios from value to growth. As noted in this chart, investors within Fidelity's mutual fund complex currently have fewer dollars invested in growth funds than anytime since 1992. This seems like a good contrary indicator especially in light of the fact that the trend indicators in Northlake's Style model are already picking up the improved performance of growth relative to value that has been in place since May 2005.

It seems there is plenty of money available to shift back towards growth and drive further positive relative performance. My reading of Wall Street commentary makes me believe that a similar underweighting of growth exists at many institutions and hedge funds. Remember no model or indicator is perfect and Northlake's new growth signal is a weak one, however, it appears a good trading setup is in place to support the fresh growth signal.

January 2006 Model Signals

I received fresh signals from Northlake's Market Cap and Style models yesterday that resulted in swapping all value exposure to growth at the open of trading. There were no changes to the Market Cap reading which remains at Mid Cap. The shift to growth occurred after three consecutive months of value signals, a period during which value lagged growth. Current holdings in the ETF rotation portion of client portfolios are the S&P 400 Mid Cap (MDY), the Russell 1000 Growth (IWF), and the Russell 2000 Growth (IWO). Portfolios maintain an equal commitment to each model but within the Style allocation own $3 in IWF for every $1 in IWO....

The shift from value to growth occurred because the prior month's value reading was a weak one and recent performance trends have favored growth. These models score 0 to 100 and the closer they are to the extremes, the stronger the signal. The value reading last month was in the upper 30s, while anything above the mid 40s favors growth. This meant a small shift in any of the underlying factors could have been enough to tilt slightly into growth territory, and that is exactly what happened. The factor that shifted was the trend indicators. These technical indicators measure intermediate trends ranging from 2 to 12 months. They are overweighted in the hope that they will improve the timeliness of a model that otherwise relies on slower moving economic, stock market, and interest rate indicators. The trend indicators are picking up the outperformance of growth that began in May.

Looking back on 2005, Northlake's models proved modestly helpful to the goal of beating the S&P 500 benchmark. Calculating monthly price-only returns based on the S&P 500 (SPY), MDY, and the Russell 2000 (IWM), the Market Cap model earned about 6.5%, comfortably ahead of the S&P 500. The biggest gains were made early in the year when energy stocks and utilities were performing well. I don't have good data on why the Mid Cap varies relative to the S&P 500 but I can tell you from watching it minute-by-minute and day-by-day that there seems be a direct correlation between the relative performance of the S&P 400 and those sectors. I believe the energy and utility exposure in the S&P 400 has a lot more exposure to oil services, natural gas, and independent producers than the S&P 500 and these are notoriously volatile subsectors of the energy stock universe.

The Style model helped in 2005 but only because clients maintained a disproportionately high exposure to small cap during the year by equally dividing my exposure between the Russell 1000 Large Cap and 2000 Small Cap growth and value indices until October. Using this approach allowed portfolios to leverage the more accurate signals from the Market Cap model and beat the S&P 500 by about 150 basis points. However, had clients used broader index ETFs like the Russell 3000 Growth (IWZ) and the Russell 3000 Value (IWW), where the holdings are overwhelmingly in large cap stocks, there would have been no incremental performance from the Style model.

December Model Signals

There were no changes to the signals from Northlakes Market Cap and Style models for December. The signals remain mid cap and value, respectively. Therefore, clients continue to own the S&P 400 (MDY), and the Russell 1000 Value (IWD) and the Russell 2000 Value (IWN). The market cap model has been drifting very slightly toward large caps over the last few months so the ratio of IWD to IWN is 3 to 1...

The indicators in the market cap model are split with six favoring large cap and four favoring small cap. The trend indicators favor small caps due to strength throughout most of 2005 in small and mid cap indices. Since the trend indicators are overweighted in the model, essentially we got a split decision. When the model offers a mixed signal it defaults to mid cap. Looking a little deeper, I categorize the individual indicators into three buckets: stock market, economic, and interest rate. Even at this level, the signal remains mixed with the stock market indicators slightly favoring large caps, the economic indicators slightly favoring small caps, and the interest rate indicators split right down the middle.

In the style model, there was a moderate shift toward growth this month but the signal remains value. Out of nine indicators, six currently favor value but the trend indicators and the advisory service sentiment indicator both shifted from a value signal to a growth signal for December. The trend indicators are picking up outperformance for growth indices since May. The sentiment indicator flipped to growth when bearish sentiment, which had gotten quite high prior to the current rally, bounced off its lows. Overly negative sentiment is a sign that a rally may be at hand. Growth generally leads sentiment-based rallies, probably due to the higher beta in growth sectors like information and communications technology.

Over the last few months, Northlake's models have been mixed in their accuracy. Looking back at monthly data going back to the early 1980s, it is clear that the models are most accurate when the signals are strong. With the weak and fluctuating signals generates since summer, I am not all that surprised that accuracy has been mixed. Nevertheless, I am frustrated. Here is some data:

The market cap model has been flashing mid cap for the last three months. Overall, this has been a decent call offering marginal upside relative to Northlake's S&P 500 benchmark. Last month, MDY was up 5.7%, ahead of the 4.4% return for the S&P 500 as measured by the S&P 500 ETF (SPY). Small caps as measured by the Russell 2000 ETF (IWM) rose 5.8%. The good October performance for MDY allowed it to pull slightly ahead of SPY for the three month period with IWM bringing up the rear.

The style model has just been wrong over the past two months during which it has been calling for value over growth. I monitor style performance looking at the Russell 3000 Growth and Value and Russell 1000 and 2000 Growth and Value. During November, regardless of the measure, growth comfortably outperformed value by 1-2%. October also had an inaccurate call in favor of value so over the two month period the outperformance for growth expands to 1.25-2.75%. Seasonality favors growth off the October lows based on market history but I never outguess the models and thankfully the rising market has provided nice returns even a little something has been left on the table.

NY Times Article Provides Support For Northlake's ETF Strategy

Over the weekend, the New York Times ran an article about a new study of investment strategies. The article supported Northlake's ETF rotation strategy by endorsing a strategy of monthly rotation among actively managed mutual funds based on four separate macroeconomic factors. This article caught my eye because after more than two years of developing and using Northlake's Market Capitalization and Style models I still have seen very few money managers promoting a similar strategy.

What I find most notable about this article is that the authors of the study are using a multi-factor model to rotate among mutual funds using different strategies for active management. This is very similar to the strategy Northlake employs for the ETF portion for client portfolios. Northlake has adapted two models developed by Ned Davis Research which signal when current conditions in the economy and the stock market support that a certain size company or a certain style of company (growth or value) are more likely to outperform. The results of the research in the article and Northlake's own backtests reveal that this strategy can outperform the market by significant margins over a multi-year period....

The article used a backtest period from 1980 to 2002, compared to the 1980 to 2004 period in which Northlake's Market Capitalization and Style models were tested. Further, the backtest in the article closely paralleled the results of Northlake's models, indicating the potential to beat the market by mid-to-upper single digit annualized returns prior to transaction costs.

Here is a link to the article which I copied into a Word document. I have highlighted a few key passages which show consistency with Northlake's ETF rotation strategy.

Why Northlake's Strategy May Be Better

Northlake's models are focused on Market Capitalization and Style and use multi-factor models that contain a dozen or more indicators vs. just four factors for the strategy in the article. Northlake's indicators are a combination of economic, interest rate, and stock market indicators rather than just interest rate indicators used in the strategy outlined in the article. Northlake includes stock market indicators that measure investor sentiment and current trends to add an element of timing to the models. The idea is not have perfect timing but to make sure that the models signals are fresh and are not way too early or way too late.

Finally, Northlake makes use of exchange-traded funds (ETFs) to execute its strategy. This keeps the all-in cost of management fees and commission costs comfortably below the fees charged by many actively managed mutual funds which run from 1.5% to 2%.

November Model Signals

The November signals from the market cap and style models Northlake uses to allocate ETF-dedicated funds were unchanged from October. Consequently, no trades were done for November and client portfolios continue to own Mid Cap and Value. Specifically, clients own the S&P 400 Mid Cap (MDY) for market cap exposure, while style exposure is split 75%/25% between the Russell 1000 Value (IWD) and Russell 2000 Value (IWN)...

....There was virtually no change to the market cap model as none of the economic, interest rate, or stock market indicators shifted their individual signals. Of the ten factors, four favor small caps and six favor large caps. This is a viewed as a split decision by the model and defaults to Mid Cap.

The style model sustained a Value signal for the second consecutive month as the internal reading moved much more decisively in favor of Value. A slight uptick in the ratio of growth P/E's to value P/E's moved that factor from the growth camp to the value camp as relative growth P/E's are now at a very slight premium to their long-term average as measured by the Russell 3000. Several other factors moved to modestly stronger readings for value with strength in the trade-weighted dollar on a year-over-year basis making the biggest move. The style model now is firmly in Value mode but it is not yet at a reading where relative performance has historically been the best.

Performance of the models wasn't very helpful in October as MDY trailed the S&P by about 120 basis points and Value slightly lagged growth and fell about 10 basis points short of my S&P 500 benchmark (worth noting is that the futures fell sharply right after the close on Monday which cost MDY 40 basis points relative to the S&P 500 that was regained first thing Tuesday). Year to date the models have been mixed with the market cap model about 15 basis points ahead of the S&P 500, while the style model is 170 basis points ahead of the S&P 500. Much of the outperformance for the style model has been due to its overexposure to small cap for most of the year. All returns are before dividends and commission costs but include slippage.

Most of this year, especially since spring, both models have been sending weak signals and have sat in the area where the historical performance is decent but not great. Northlake follows the models no matter what their strength is but I'd be a lot happier if the signals were stronger. I think the weak signals are indicative of the muddling market we have had all year with the S&P 500 trading in a tight band of plus or minus a few percent of unchanged.

Swapping Some Small Cap For Large Cap

Although I rarely make a trade intra-month in Northlake's model driven ETF investments, last Wednesday morning I moved half of the small cap value exposure to large cap value. This resulted in a swap of the Russell 2000 Value ETF (IWN) into the Russell 1000 Value ETF (IWD)....

....My rationale was to reduce the aggressiveness of client portfolios by moving toward a lower beta (less volatile) exposure to value. Northlake's Market Cap exposure is already in Mid Caps and with half of the Style exposure in Small Cap Value I just felt there too much exposure in higher risk small and mid caps given their clearly weakening relative strength trend.

ETFs driven off Northlake's Market Cap and Style rotation strategy make up 40% to 80% of client portfolios depending on individual goals and objectives. Prior to this trade, 30% to 60% of client assets were invested in small or mid cap ETFs. This trade moves approximately 5-10% of small cap exposure to large caps. I still look for a yearend rally but with rising risks and the poor market action so far in October, I felt it was prudent to reduce the aggressiveness of client portfolios.

If the market catches begins to rally, I expect small and mid caps to regain some lost ground relative to large caps. If that occurs, client portfolios still have plenty of small and mid exposure to participate in the rally. I hope and expect that to happen sometime this month leading to a yearly close near annual highs.

October 2005 Model Signals

Over the weekend I received fresh signals from Northlake's monthly models. The big change for October is a new Value signal in the Style model after four consecutive months signaling Growth. As a result of the new signal, at the open on Monday I swapped all personal and client positions in the Russell 1000 Growth ETF (IWF) and the Russell 2000 Growth ETF (IWO) into the Russell 1000 Value ETF (IWD) and the Russell 2000 Value ETF (IWN). The prior fourth month run of growth signals proved profitable for clients as IWF was sold for a gain of 3.2% and IWO was sold for a gain of 6.2%. During this time period the S&P 500 rose approximately 3.2%....

....Equal amounts of IWD and IWF were purchased matching the equal sized holdings of IWF and IWO which were sold. Implementation of Northlake's ETF strategy calls for an equal weighted position in large cap and small cap growth or value unless the Market Cap model is sending an unusually strong small cap or large cap signal. In that case, the growth or value holdings will be concentrated depending upon the Market Cap signal.

For October, the market cap model is sending a solid mid cap signal with little change from September. As a result, no changes were made to market cap exposure for October and all personal and client positions in the S&P 400 Mid Cap ETF (MDY) were maintained. This marks the second consecutive month Northlake clients have owned MDY following a switch for September from August's small cap reading. So far that switch has proved slightly favorable for clients as small gains for MDY have exceeded the gain that would have been earned had positions in small cap been held.

The switch from growth to value for October was driven by three factors in the Style model: widening credit spreads, a flattening yield curve, and a strengthening dollar.

Yield spreads have risen modestly in recent months and are now wide enough to suggest that investors are no longer extremely risk tolerant. Narrow credit spreads are interpreted by the model as favoring growth when investors have a large appetite for risk. The move to value for October coincides with the indication that investors are seeking less risk.

The yield curve has finally flattened enough to move from a growth to a value signal. This factor favors value when spreads are narrower or wider than normal. When the curve is unusually steep business conditions are very favorable which is good for value. On the flip side, buying value when the curve is unusually flat or inverted has paid off in the past presumably because investors are anticipating a near-term easing or cessation of tightening by the Fed. This second condition is what the model is picking up in October.

The recent strength in the dollar leaves it up nicely year-over-year versus other currencies on a trade-weighted basis. A strong dollar favors value because many growth industries get a high proportion of their revenues abroad and suffer when the dollar strengthens.

September Model Signals

After getting fresh signals from Northlake's monthly models, client holdings in the Russell 2000 Small Cap ETF (IWM) were swapped into the S&P 400 Mid Cap ETF (MDY) at the open of trading yesterday. This trade was triggered mainly by the technical factors in the Market Cap Model. No changes were made based on the Style model, which continues to flash a growth signal that got stronger with the fresh data from August....

....The small cap signal for August was a weak one and turned out to be inaccurate as well. Northlake's goal is to have client assets in the best performing market cap class each month among small, mid, and large cap. In August, the Russell 2000 fell about 2%, twice the decline of the S&P 500 and S&P 400. The models were whipsawed during August as the strong market breadth in the July rally that shifted the model from mid cap to small cap reversed in August. Breadth (advances minus declines) usually is a leading indicator but it didn't work last month. The weak breadth in August shifted the model back to mid cap mode for September and triggered the trade.

The style model has been flashing a growth signal since June. The fresh signal for September is the strongest yet with the model picking up decelerating economic growth as measured by the coincident indicator of economic growth. Growth stocks make sense in a modest or slower growth environment as presumably they don�t need the tailwind of economic growth to continue to produce earnings growth. The style model shifted from value to growth in June for the first time since the fall of 2003. So far, the call has been good with growth outperforming value (measured by calculating the average return of the Russell 1000 and 2000 growth and value ETFs). The models work best when the signals are strong and while the growth signal is solid, it is not yet showing a reading consistent with the strongest historical performance.

In summary, within the actively managed ETF portion of client portfolios, the holdings are now the S&P 400 Mid Cap ETF (MDY), the Russell 1000 Growth ETF (IWF), and the Russell 2000 Growth ETF (IWO).

August Model Signals

I was out of town and unable to post on the August Model Signals last week. As clients have seen by now, the new signals led to a trade in the ETF portion of their portfolios. Specifically, the Market Capitalization model shifted from a mid cap signal to a small cap signal. Consequently, all holdings in the S&P 400 Mid Cap (MDY) were sold and swapped into the Russell 2000 Small Cap (IWM). The Mid Cap holdings were sold for almost a 5% profit. There were several shifts in underlying factors that led to the new signal�

�First, the strong market rally off the April lows that accelerated in July had very strong breadth. This means that a very high percentage of all the stocks listed on the major exchanges participated in the rally. Since most listed stocks are small and mid cap, good breadth is a sign of broad based investor confidence. In the stock market strength begets strength. Historically, periods of strong breadth have been followed by continued relative gains for small cap stocks vs. large cap stocks.

Second, the strength in July in small caps reestablished the long-term trend going back to 2000 favoring small cap stocks. As with breadth, trends tend to stay in place on Wall Street so confirmation that the trend favoring small caps was still in place suggests that in the future small caps will perform better than large caps.

It is interesting to note that both of the indicators that led to the shift in the Market Cap signal are technical or trend indicators. These types of indicators play an important role both the Market Cap and Style models by providing shorter term factors to complement the economic and interest rate indicators that tend to change more slowly. The idea is that the technical indicators will prevent the models from being too early or too late.

The new Market Cap signal is just barely into small cap territory, so no changes in the Style allocations were initiated this month. The Style model remains firmly in growth mode with client holdings split evenly between small cap growth and large cap growth. When the market cap model sends out a strong small cap or large cap signal, the style holdings are shifted in favor of the market cap signal. For example, a strong small cap signal would lead to style holdings favoring small cap growth or value.

It is worth noting that a shift toward small caps is an aggressive trade and will work best if the market uptrend remains intact. Small cap stocks are more volatile than large cap stocks and rise more in bull markets and fall more in bear markets. In the short-term, I think interest rates will be the key determinant of whether the small cap signal turns out to be accurate as small cap stocks are particularly sensitive to trends in interest rates. This week's rate decision and commentary coming from the Federal Reserve will thus be a key datapoint to watch.

July Model Signals

Fresh signals for July for the Market Capitalization and Style models led to some trades in clients accounts on July 1st. The Market Cap model shifted from a weak large cap signal to a solid mid cap signal for July while the Style model moved firmly into growth territory for the first time since the fall of 2003. As a result of the new signals, positions in the S&P 500 were replaced by the S&P 400 Mid Cap Index. Additionally, half of the holdings in the Russell 1000 Growth Index were swapped into the Russell 2000 Growth Index. This trade gives portfolios exposure to smaller companies to take advantage of the new Mid Cap signal....

....The shift from large cap to mid cap in the Market Capitalization model is a function of recent strengthening in the U.S. dollar and the rally in bond prices that have led to lower interest rates. Each of these factors favors small and mid size companies in terms of relative performance based upon historical performance. Both shifts are logical as dollar strength hurts large cap companies who get significant sales overseas and lower interest rates support broad based economic strength which helps profits at smaller companies.

The technical indicators in the Market Capitalization also shifted from toward smaller companies due to improved performance for small and mid cap indices in June. The technical indicators are the only short-term factors used in the model and are designed to catch just such a move. Effectively, the technical indicators allow the model to respect the market action and the fact that stock prices anticipate future trends.

There were no major changes that led to stronger growth signal from the Style model. Rather, a number of factors moved slightly in favor of growth and pushed the signal a little deeper into growth territory. Given some signs that economic growth may be slowing, growth companies should gain investor attention as they can produce improved profits without a big tailwind from the economy.

Ned Davis Research On CNBC

This morning, the #2 strategist at Ned Davis Research (NDR), Tim Hayes, discussed NDR's latest views on the stock market. A Northlake client astutely noted that Tim was recommending large cap value while Northlake's models just switched from large cap value to large cap growth. Given that Northlake's models are produced by and based on NDR analysis, the client wanted to know why there was a conflict. The answer lies in the disciplined implementation of the models for Northlake clients....

...NDR's own models did in fact recommend a shift from value to growth for June. In an email I received today, NDR notes that the shift from value to growth in the main Style model did take place but in their �opinion� it is a weak reading favoring growth and might reverse given the underlying trends in some of the individual indicators. On CNBC, Tim Hayes was merely expressing this opinion even though it was at odds with his own models.

The whole point of using models is to enforce discipline and EXCLUDE �opinion� from the decision-making process. Opinion is subject to the emotions created daily in the stock market as prices move around. Given the tendency of human emotions to overreact to what is happening now, I think emotions and opinion work against investors. I do not try to overanalyze and anticipate what may happen next. I back-tested the models without second guessing or imposing my "opinion" on the monthly signals and those backtests show superior performance. Now that I have been using the models to manage money for more than 18 months, I am confident this is the right approach and that the backtests work in the real world.

Whenever the models are at transition points, moving from one signal to another, there will be some volatility in the signals. The likelihood of increased portfolio turnover is higher as month-to-month model signals may switch more often. This adds modest trading costs but over the long-term, the average holding period for the models is around six months so turnover and commissions are not an obstacle to performance.

The bottom line is that I do not try to outguess or anticipate the next move in the models. I think that is the best approach and the backtests and real world experience supports that approach.

June Model Signals

Due to a slowing but still growing economy and a decisive turn in the intermediate-trend indicators, the model Northlake uses to allocate between growth and value ETFs shifted from value to growth for June. This is the first monthly signal favoring growth since October 2003! The market cap model had no change for June and continues to favor large caps. As a result of the new growth signal and the ongoing large cap signal, at the open on Wednesday, all client positions in the Russell 1000 Value ETF (IWD) were sold and replaced with new positions in the Russell 1000 Growth ETF (IWF)....

Slower Economic Growth Favors Growth Stocks

Slower economic growth favors growth stocks because presumably they can generate earnings gains with less help from an economic tailwind. Sharp outperformance of growth over value in May confirmed the economic indicators and shifted the trend indicators. In fact, in May, the Russell 3000 Growth ETF (IWZ) gained 5.0% against a gain of 2.9% for the Russell 3000 Value ETF. This was the first decisive month of performance favoring growth in at least a year and came on the heels of 1300 basis points of cumulative outperformance for value in the 11 months ended April 2005 and 500 basis points cumulative outperformance for value over the seven months ended April 2005.

Fundamental, Technical Analysis Working Together

The fact that the trend indicators shifted and caused a change in the model signal is a good example of fundamental and technical analysis working together. Trend indicators play an equally important role to economic and interest-rate indicators in the model specifically to try to make sure you don't arrive too early or leave too late. No model will have perfect timing but combining technical and fundamental indicators hopefully helps to make sure you get most of the major trend right.

No Change to Market-Cap Model

There was no change to the market-cap model for June, which continues to favor Large Cap. In May, the large-cap signal was inaccurate as the S&P 500 Spyder (SPY) gained 3.2%, underperforming both the S&P 400 Mid Cap (MDY: +5.7%) and the Russell 2000 (IWM: +6.5%). The relative gains for small- and mid-cap more than reversed the April outperformance of large-caps when the market produced significant negative returns across the board. The June large-cap signal is pretty stable compared to May, making it three straight months favoring large-cap for the first time since the fourth quarter of 1998. Given the massive outperformance for small-caps over the last five years, this could be a sign that the much debated shift to large-caps is finally underway.

Primer on Exchange Traded Funds

Exchange Traded Funds (ETFs) are central to the execution of Northlake's unique investment strategy. ETFs represent the bulk of client portfolios and are the vehicles used to apply the signals from Northlake's Market Cap and Style models.

I recently received a primer on ETFs from one of the main creators and distributors. Here is a link to a pdf file of the article. You will need Adobe Acrobat to open this file.

I have added a link on the navigation bar on the right hand side of each page of the website to enable permanent access to the article. The link is titled "ETF Primer."

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):

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:

Favoring Growth:

Favoring Growth Just Barely:

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.

April Model Signals

There were only minor changes to Northlake's Market Capitalization and Style Models in the April update. Neither model changed signals from March leaving the market cap signal at Large Cap and the style signal at Value. There was continued movement in both models, with the market cap model continuing its shift toward large cap and the style model continuing its shift toward growth. The models movements did trigger a trade for Northlake clients...

...All remaining positions in the Russell 2000 Small Cap Value ETF (IWN) were sold and replaced with additional holdings in the Russell 1000 Large Cap Value ETF (IWD). This trade was triggered by the shift of the Market Cap Model toward a firmer reading for large cap. Positions in IWN have been gradually shifted toward IWD as the Market Cap Model has moved away from a small cap and mid cap signal to the current large cap signal.

Two model factors shifted from a small cap to a large cap signal for April. Both factors were in the stock market indicator basket (there are also indicators based on interest rates and economic growth). The measures that shifted were NYSE Breadth and Trend Indicators. Each of these measures looks at short and intermediate term performance of the market to try to identify emerging trends. So far this year, large cap stocks have comfortably outperformed small cap stocks, with the S&P 500 falling about 2.5% against a decline of about 5.5% for the Russell 2000 Small Cap index. The underperformance of small cap stocks went far enough to move both of these factors to large cap.

The stock market based factors in Northlake's models play an important role. They are shorter term in nature and are included to make sure that any lag from the economic or interest indicators does not get out of hand. Northlake's models function on an intermediate time horizon of six to twelve months. The goal is get the big trends generally right. If the stock market indicators improve the timing, the odds of capturing most of divergences between market cap and styles is improved.

The Style Model continued to drift away from the very strong value signal. This marks several consecutive months where the model moved in the direction of growth. There were no changes to the signals from any individual factor in the Style Model this month. Rather, the somewhat slower economic growth statistics and upward trend in interest rates has shifted a few factors away from a pure value reading. The Style Model remains firmly in value territory and would require at least two more months to trigger a growth signal if the recent drifting maintained its pace.

March Model Signals

After trending towards Large Cap for several months, Northlake's Market Cap model triggered a Large Cap signal for March. None of the underlying economic, interest rate, or technical factors individually moved to a large cap signal. Rather, the internal measures used for each factor collectively drifted far enough toward large cap that the trigger was met. The Style model continued its movement toward growth from value but the model remains firmly in value territory. As a result of the new March signals, Northlake initiated a trade for client accounts�.

Specifically, all shares of the S&P 400 Mid Cap ETF (MDY) were sold and replaced by shares in the S&P 500 Spyder ETF (SPY). The S&P 500 is the representative large cap index used by Northlake to execute the Market Cap portion of its strategy. SPY and MDY trade within $2 of each other, so client holdings of MDY were swapped one for one into SPY. Some clients with larger cash balances may have purchased additional shares of SPY as part of their unique investment strategy.

The new Large Cap signal did not push deeply into the large cap buy range. Consequently, since the Style model is still flashing value, within the Style portion of client portfolios, no change was made in the 3:1 ratio of investments between the Russell 1000 Large Cap Value ETF (IWD) and the Russell 2000 Small Cap Value ETF (IWN). Nevertheless, some clients with larger cash balances may have purchased shares of IWD or IWN as part of their unique investment strategy resulting in something other than a 3:1 ratio for the time being.

The Market Cap model had been signaling Mid Cap since September 30, 2004. From that date through the end of February, the signal was very accurate as on a price only basis MDY (Mid Cap) returned 12.97%, while SPY (Large Cap) returned 7.94%, and IWM (Russell 2000 -- Small Cap) returned 10.92%. The Mid Cap signal was also accurate for the first two months of 2005 when on a price only basis MDY returned 1.16%, SPY returned -0.20%, and IWM returned -2.49%. Also worth noting is that the five month period during which the Mid Cap signal was in place exactly matched the average holding period in the over 20 year backtest of the Market Cap model.

While I am happy to see that the Market model has worked well since last fall, the signals will not always be so accurate. The goal of Northlake's models is to get it "generally correct." As shown in the 80 year study of large cap vs. small cap performance that was sent to clients on February 22 (link), there are often large and persistent variations in the performance of stocks of different sizes (and styles like growth vs. value). My expectation is not to get it right every month, or every time the signal changes. Rather, I hope the models can get it generally correct and capture a significant portion of the incremental relative performance.

Please remember that the models are a relative , not absolute, performance strategy. The goal is to earn a greater return than the market does when it is rising and lose less when the market fall is falling. If it works, significant excess return can be earned over time periods measured in quarters and years if the market cooperates and produces its historical positive rate of return.

Link To Large Cap vs. Small Cap Graphic

In the extended entry, please find a link to the graphic I sent via email last week. The graphic showed the 80 year history of small cap vs. large cap relative performance. The extremely long periods of performance favoring one group or the other suggests that an accurate model that identified whether small or large caps were likley to outperform could provide significant value for investor portfolios. Northlake uses just such a model.

Here is a link to the graphic I sent last week as an attachment in an email summarizing recent posts. I am posting the link here so that the graphic is preserved for your future access.

February Model Signals

Northlake's Market Capitalization and Style models held firm for February with Mid Cap and Value signals. The Market Cap model continued its drift toward large cap and is about as close as possible to shifting to large cap as it can get without actually hitting the trigger. The Style model held firmly in value mode with no movement at all from the prior month after two straight months of shifting very slightly toward growth....

As a result of the latest signals, client portfolios were modestly repositioned by shifting the value exposure from a 50/50 split between large cap value and small cap value to a 75/25 split in favor of large cap value. Put another way, client portfolios now own about $3 in large cap value for every $1 in small cap value vs. owning the two investments in equal size previously. There was no change to the market cap exposure which remains 100% dedicated to mid cap.

For February, the Market Cap model saw just one change as the market breadth indicator shifted to large cap from small cap. Market breadth measures the number of advancing issues vs. the number of declining issues on the NYSE over the preceding five weeks. When breadth is positive (more advancing than declining issues), the indicator flashes a small cap signal. Conversely, when breadth is negative, the indicator flashes a large cap signal. The concept is that positive breadth is a sign of a healthy market where investors would want to own small cap stocks that tend to produce the biggest gains in bull markets, while negative breadth is a sign of a weak market where investors should own large cap stocks to provide some downside protection due to their lesser volatility.

The market breadth indicator also looks for a breadth thrust, where there is a burst of buying that moves market breadth to an unusually positive reading. A sudden surge in buying that registers as a positive breadth thrust is usually followed by further gains as it indicates rising investor confidence. This is a good time to own small cap stocks which tend to rise faster than large cap stocks in bullish market environments. There is no evidence that a negative breadth thrust provides an edge to small or large cap stocks.

Given the weak performance of the stock market in January, market breadth deteriorated from a modestly positive reading to a slight negative reading. This was enough to shift the indicator from small cap mode to large cap mode.

There were no shifts at all within the Style model for February after two straight months where the Style model moved in favor of growth. The current signal remains firmly in value territory. This is not surprising as value stocks tend to outperform when interest rates are low and economic activity is sustainable or accelerating. These conditions exist today.

Looking ahead, there is an ongoing debate on Wall Street about whether interest rates are poised to head higher, particularly in bonds coming due in 5 to 10 years and beyond. There is also a small but increasingly vocal minority that believes the recent slowing in economic growth is not a shift to sustainable growth but rather the first signs that the economy is headed toward recession. Northlake's models do not indicate a recession is on its way.

January Model Signals

Happy New Year to Northlake Clients and Friends!

Over the weekend, Northlake received the latest signals from its market capitalization and style models incorporating the latest economic, interest rate, and stock market indicators. There were no major changes as the the signals remain Mid Cap and Value. However, there is some underlying movement that is leading to client trading activity....

As of 12/31/04, most clients held 100% of their style investment (growth or value) in the Russell 2000 Value exchange traded fund (Ticker: IWN) (the Russell 2000 is the benchmark index representing small cap stocks). The market cap model still is favoring mid caps but the components have shifted toward large cap for two months running. With the market cap signal mixed but leaning large, half of the funds held in IWN were shifted to the Russell 1000 Value exchange traded fund (Ticker: IWD) in trading on January 3, 2005 (the Russell 1000 is similar to the S&P 500 and represents large cap stocks). Thus, clients now have a balanced exposure to the entire spectrum of value stocks rather than a concentrated exposure to small cap value stocks. This trade reduces the risk profile of client accounts because large cap stocks are less volatile than small cap stocks.

Small cap stocks have outperformed large cap stocks every year since 1999. Many commentators expect this trend to reverse in 2005. Northlake's indicators suggest a shift is possible with recently stable interest rates, a flatter yield curve, and narrow credit spreads for corporate bond issuers being the primary indicators that have moved from favoring small caps to large caps. Northlake's models have excellent long-term records and we never outguess them, so despite the lean toward large cap, for now, Northlake clients remain invested in the S&P 400 Mid Cap exchange traded fund (Ticker: MDY), providing middle of the road exposure in terms of market cap.

In summary, for January, market cap exposure is 100% invested in the S&P 400 Mid Cap (MDY) and style exposure is now split evenly across the entire range of value investments with half held in the Russell 1000 Value index (IWD) and half in the Russell 2000 Value index (IWN).

ETF Dividends

Both of the ETF's currently owned by Northlake clients, the S&P 400 Midcap (MDY) and the Russell 2000 Value (IWN), went ex-dividend in the last week. This has a temporary negative impact on your portfolio values that will reverse in January when the payments are received....

Specifically, MDY went ex-dividend on 12/17 for $0.30589 and IWN went ex-dividend on 12/23 for $0.985035. The MDY dividend is payable on 1/31/05, while the IWN dividend is payable on 1/6/05. When a stock goes ex-dividend, the value of the dividend is subtracted from the stock price. This has the effect of lowering the value of your account temporarily. For example, IWN closed yesterday at 193.58 but that price was adjusted downward today by 98 cents. Consequently, despite the fact that IWN is up about 50 cents today, it apears as though you have less value in your account in IWN today than you did at the close yesterday. Of course, come January 6th, the cash dividend payment will hit your account and the value of your account gets a boost.

Normally ex-dividend dates don't create much noice. However, because Northlake uses a concentrated approach to ETF's the flucuations in market value on ex-dividend dates and payments dates can actually impact portfolio values in a noticable way.

Also worth noting is that the current yield on MDY is 0.88% and the current yield on IWN is 1.38%. These yields are not particularly exciting but are meaningful in a low interest rate environment. More interesting is that the dividend growth for MDY and IWN in 2004 versus 2003 was unusually high at 23% and 33%, respectively. The change in taxation on dividends and several years of strong earnings and cash flow growth are the leading reasons for the high growth rate in dividends.

Please call (847-226-9713) or email (steve@northlakecapital.com) if you have any questions or comments, or just post your thoughts below by clicking on the "Comments" link.

December Model Signals

Northlake's Market Capitalization and Style models are unchanged once again in December, leaving in place the signals favoring Mid Cap and Value. Consequently, current client investments in the S&P 400 Mid Cap ETF (MDY) and the Russell 2000 Value ETF (IWN) will remain in place. Any cash reserves invested in ETFs in the coming month will also be placed in these two investments.....

The underlying indicators for the models made a slight shift toward Large Cap and Growth. However, both current signals are firmly supported and larger shifts in the underlying indicators would have to take place to change the signal. This is certainly possible, but Northlake does not try to out guess its indicators.

In the Market Capitalization model, two indicators shifted toward Large Cap: Equity Risk Premium Proxy and Bond Momentum.

The risk premium proxy measures the willingness of investors to take on risk by looking at the difference in the interest rate on bonds issued by the U.S. Treasury and bonds issued by medium quality U.S. Corporations. The concept is that when the spread is unusually wide, investors should shift assets should shift assets toward riskier investments (small stocks) in anticipation of a narrowing of the spread. When the spread peaks and then begins to narrow, it is an indication that business conditions for corporations are easing because investors are demanding less return as compared to the safety of U.S. Treasury securities. This is a bullish condition for stocks, so investors should shift to small stocks that are more volatile and would provide a greater return in a rising market. Spreads have been unusually wide since 2000, favoring investment in small stocks since the market peaked (a very good call as it turned out). Recently, the spread has narrowed and last month crossed over into a neutral zone where large cap stocks have a slight edge as business conditions are thought to be normal.

Bond momentum measures the 13 week rate of change in interest rates as measured by long-term interest rates. When rates are falling, small stocks are favored as this is a bullish condition. Remember that bullish condiditons favor small stocks due to their higher volatility. During November, interest rates rose, moving the rate of change to virtually zero. When rates are unchanged or rising, investors should seek the safety of less volatile larger stocks. Consequently, this indicator is now flashing a large cap signal.

The Style model remains firmly in Value mode despite the shift of one indicator, Yield Curve Momentum, toward growth. All other indicators continue to flash a Value signal for December.

Yield Curve Momentum measures the difference in interest rates for short-term and long-term bonds issued by U.S. Corporations. When the difference is unusually wide or unusually narrow, the indicator sends off a Value signal.

The theory is that a wide spread (short term rates much lower than long-term rates) represents a favorable economic condition that would drive above average growth in the economy, suggesting good times ahead for corporations. This would be a bullish environment favoring Value stocks, which are typically most sensitive to economic growth.

Although a bit counterintuitive, a very narrow spread or one where short-term interest rates are equal to or higher than long-term interest rates (known as a flat or inverted yield curve) also favors investment in economically sensitive Value stocks. In this case, the theory is that a flat or inverted yield curve is unsustainable and has acted a depressant on ecnomic activity. The next move will now likely be toward a normally upward sloped curve engineered by the Federal Reserve to boost economic activity. In anticipation of improving economic activity, investors would want exposure to Value stocks which have a higher sensitivity to economic activity.

Recently, the yield curve has flattened as short-term interest have risen faster than long-term interest rates. Long rates are now in a normal relationship to short rates. This favors larger companies as economic activity in neither too hot nor too cold. This condition is in place now leading the Yield Curve indicator to shift to a large cap signal.

To reiterate, despite the indicator shifts just described, Northlake's models firmly support investment in mid cap stocks and value stocks for December.

November Model Signals

There were no changes to Northlake's model signals for November. The Market Capitalization Model continues to favor Mid Caps and the Style Model continues to favor Value. There was some movement toward Small Caps in the Market Capitalization model (but not enough to switch the signal), leaving it on the cusp of a shift from Mid Cap to Small Cap. For now, client accounts remain invested in the S&P 400 Mid Cap Index....

As a reminder, in general, sustainable economic growth and low interest rates favor small and mid size companies and value stocks. Economic growth and low interest rates make it easier for smaller companies to grow earnings and finance future growth initiatives. Economic growth and low interest rates also favor Value stocks, which are generally in traditional cyclical industries like materials and manufacturing.

Key to the historical success of the Models is that is that the factors are designed to change their signals at extremes. This allows the signals to stay in place for most of the trend, while also recognizing that an extreme reading generally means the next move is in the opposite direction. For example, if economic growth statistics are too strong, the models anticipate that the next move is likely a slowing in economic growth meaning Wall Street will favor safer, lower volatility stocks. On Wall Street, this would be large cap and value stocks. On the other hand, if economic growth statistics were very weak, the models anticipate that the next move is likely a pickup in growth. Historically, when economic growth accelerates from low levels a bull market begins favoring small sap and growth stocks due to their higher volatility.

For now, the models are assuming that economic growth and interest rates will continue in a zone favoring a decent but not fantastic economic environment. This is consistent with my view and suggests that corporate earnings growth will be strong enough to support higher stock prices in the months ahead.

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.

September Model Signals

No changes to the signals from Northlake's Market Capitalization and Style models for September. The Market Cap model signal favors Large Cap. This model favored either small or mid cap from late 1999 through May of 2004. A Large Cap signal emerged in June but shifted back to Mid Cap in July. August and September now are both in the Large Cap camp, confirming a trend toward factors that favor Large Caps. In particular, the shift in the economy toward a more sustainable GDP growth rate favors Large Caps.

The Style Model remains firmly in Value territory as it has been since the spring of 2000 with only occasional shifts towards Growth. Value has performed very well in this time period, first as a defensive investment against the bear market, and then as the economy recovered and cyclical companies saw rapidly improving earnings prospects. Value is also favored when the economy is in a sustainable mode rather than an accelerating or topping mode.

August Wrap-Up

The market staged a comback at the end of the month on low volume enabling the S&P 500 to eke out a small gain of about 3/10ths of 1%. Our models and special situations worked well last month with all four special situation stocks up and the August signals from both models working effectively.

Northlake's Market Capitalization Model was sending a large cap signal for August. Consequently, we owned a position in the S&P 500 Spyder (SPY). SPY was up 0.2% for the month vs. no change for the S&P 400 Mid Cap ETF (MDY) and a decline of 1.5% for our small cap ETF proxy, IWM (Russell 2000).

Northlake's Style Model also worked well in August. The model had a value signal, leading us to own a position in the Russell 3000 Value ETF (IWW). During August, IWW gained 1.0% vs. a return of -1.2% for the Russell 3000 Growth ETF (IWZ). August continues a good run for our Style Model. Since Northlake opened in June 2004, the model has had a value signal. During the three month period, our the value ETF, IWW, has gained 1.5% vs. a loss of over 6% for the growth ETF. Tech stocks have really struggled this summer which has favored the value signal.

Our special situations stocks,, which our outlined in the Research Samples link were all up in August. Central European Media Enterprises (CETV) was the big winner, gaining 19%. NTL, Inc. (NTLI) gained 4.2%, MB Financial (MBFI) gained 3.5%, and Motorola (MOT) gained 1.4%.

There was no news on CETV but my contacts suggested that a recent report by a well regarded Wall Street media analyst was gaining some traction. There also appears to be general interest in investment opportunities in Central and Eastern Europe. I concur with that and presently I am reviewing several other US listed stocks whose business is conducted in the region.

NTLI reported earnings at the start of August which were generally in line with expectations. The stock took a hard hit, however, in reponse to disappointing news from key competitor Sky. Competitive fears are the big issue for NTLI shares. NTLI rebounded later in the month as rumors of sale of the company's tower business picked up steam.

MBFI reported solid earnings in August as well. No change to the thesis on this well run, high quality, Chicago bank. Upside from operations and future smaller acquisition exists and MBFI remains a preferred acquisition candidate for a larger bank wishing to expand in the Chicago market.

Little news in MOT during August. I feel the turnaround is in place and investors will reward the shares as new mobile phone designs are shipped on time over the balance of 2004.

Overall, a good month for Northlake's key investments.