« Time Warner Officially Jettisons AOL | Main | Liberty Media Entertainment: New Long Position Provides Cheap Play on DirecTV and Other Goodies »

June 01, 2009

June 2009 Model Signals Still Favor Small Cap and Growth

There are no changes to Northlake's Market Cap and Style models for June. The signals remain small cap and growth. As a result, client positions in the Russell 2000 (IWM) and the Russell 1000 Growth (IWF) will be maintained.

The Market Cap and Style models provide monthly signals projecting relative performance of small cap vs. large cap and growth vs. value over the coming six months. Each model uses a combination of economic, interest rate, and stock market indicators that have historically shown predictive ability for identifying future relative performance of the market cap and style themes. The models use a weight of the evidence approach so that the signal generated is determined by the majority of the indicators.

The small cap signal has been in place since September 2008 and continues to register very strongly. Eight of the ten indicators are flashing small cap for the third consecutive month. The only holdouts are bond momentum and relative forward P-E ratios. Small caps often struggle when interest rates are rising over the prior three months. Presently, large caps have much lower P-E ratios.

The overall message of the Market Cap model is that we are near the bottom of economic and stock market cycle. The model has a contrarian aspect. When the economy and market get to the point that they are so bad the next move is likely to be up, small cap stocks typically perform well as their business operations are more sensitive to economic trends and their stock prices are more responsive to market trends.

During May the small cap signal proved inaccurate as the IWM gained 3.4% against a 5.5 % gain for the S&P 500. For the second quarter, the signal has proved accurate, with IWM gaining approximately 3% more than the S&P 500. Year to date, the small cap signal has been neutral, with IWM trailing the S&P 500 by less than 1%. Since the current small cap signal began in September 2008, IWM has lagged the S&P 500 by about 4%. The extremely rapid deterioration in the economy and stock market last fall moved many of the indicators to extreme readings and triggered the small cap signal early. As the economy has stabilized and hopes for recovery have grown, small cap stocks have begun to perform much better over the past few months.

The Style model has been showing more movement over the last few months even though it has flashed a growth signal since February. The current growth signal has been weakening and could now be classified as weak. Both models use the two month average to determine the current signal. The June only Style model reading is right on the border line between growth and value so it could change next month.

Two indicators moved in favor of value for June, the consumer/cyclical ratio and insider activity. Consumer/cyclical measures the performance of consumer stocks vs. cyclical stocks. Consumer stocks are a proxy for growth while cyclical stocks are proxy for value. As investor sentiment toward the economy has improved over the past few months, cyclical stocks have rebounded strongly, outperforming consumer stocks. The gains for cyclical stocks in April and May were enough to shift this indicator to value. Insider activity had consistently been more favorable for growth stocks over the last few months but insider transactions became more balanced in May so this indicator moved from growth to neutral.

The Style model now has four indicators favoring value, three favoring growth, and two neutral with the most recent signal having been growth. There is no clear message from the current set of indicators. Rather they represent the somewhat muddled view of the outlook for the economy and stock market now that it appears the worst has passed and the doomsday scenario is off the table.

Last month, the growth signal was inaccurate as IWF gained 5.2% while the Russell 1000 Value (IWD) gained 6.7%. Since the current growth signal began in February, it has proved extremely accurate with IWF producing a return almost 6% higher than IWD.

As always, thanks for Ned Davis Research for originally developing and continuing to maintain the Market Cap and Style models.

Disclosure: IWM and IWF are widely held by clients of Northlake Capital Management, LLC including Steve Birenberg's personal accounts.

Posted by Steve Birenberg at June 1, 2009 01:22 PM in Models