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September 03, 2008

September 2008 Models: Shifting to Small Caps

For the first time since August 2005, Northlake's monthly Market Cap model is flashing a small cap signal. As a result, I sold all client and personal positions that tin the S&P 400 Mid Cap (MDY) that track this model and reinvested dollar-for-dollar in the Russell 2000 (IWM).

Small caps have outperformed for several months since March or May depending on how you measure it. Given the poor tone to the market and the higher beta of small caps, the switch makes me nervous. However, this model has served Northlake very well over the last four years and discipline requires never outguessing your model.

After flashing a very strong signal in favor of large caps in 1H07, the model moved to mid cap mode where it stayed for all but one month so far this year. The trend toward small caps was evident in the underlying indicators and overall model reading since June but the signal did not grow strong enough to change until this month.

Indicators that now favor small caps include unusually high credit spreads, a slight upturn in advisory service sentiment following a plunge, a steep yield curve, and the sharp drop in consumer confidence and coincident indicators of economic growth, and technical trends. Still favoring large caps are breadth, valuation, interest rate momentum, and the dollar. The dollar should switch soon if recent strength holds.

Several of these indicators are near extremes where the message is "it is so bad the next move will move be up." That is an environment that would favor small caps (the latest rally was a good indication of what is supposed to happen). Since technical trends are confirming the odds of an accurate call seem good.

There was no change this month to the style model which continues to solidly favor growth. Growth has been the signal since July 2008....

....Keep in mind that these models are designed to predict relative performance and the average holding period is 4 to 7 months. As always, thanks to Ned Davis Research who developed these models and help me analyze and adapt them for use as a money management tool.

In the most recent month, the mid cap and growth signals were not great calls. Small caps were clearly the place to be in August although mid caps held their own vs. large caps. Value outperformed growth last month with stability and recovery in financials coinciding with a weak performance by technology.

So far this year, both models have been accurate. Through August, the S&P 400 Mid Cap is down 4.5% vs. an 11.9% decline or the S&P 500. The model could have been a bit more accurate, however, as small caps have been the best performer with the Russell 2000 down 2.7%. For the style model, the Russell 1000 Growth is down 10% vs. a 13% decline for the Russell 1000 Value. Worth noting, however, is that small cap value is down just 1.1% vs. a decline of 4.3% for small cap value.

Posted by Steve Birenberg at September 3, 2008 07:45 AM in Models