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December 01, 2004

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.

Posted by Steve Birenberg at December 1, 2004 12:50 PM in Models