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February 01, 2005

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.

Posted by Steve Birenberg at February 1, 2005 11:17 AM in Models