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September 02, 2011

Markets and Models are Volatile but Growth and Mid Caps Still Favored

Despite lots of volatility in the stock market and the factors underlying Northlake’s Market Cap and Style models, there were no changes to the signals for September. The Market Cap model is still signaling Mid Cap and the Style model remains in Growth mode. As a result of the latest signals, Northlake client positions in the S&P 400 Mid Cap (MDY) and the Russell 1000 Growth (IWF) will be maintained for at least another month.

Market volatility impacts both models primarily through the technical trend indicators. These indicators measure performance of various stock market indices over multiple time periods. Their function is to help the timeliness of the models. Most of the other indicators in the models measure economic data and monetary policy. They are purposefully designed to be focused on the long term. When the technical indicators are added, the models are balanced to a three to nine month outlook with average holding periods of four to six months typical for new signals. Keep in mind that the goal of the models is to identify major themes in favor on Wall Street. Northlake is trying to capture incremental performance over months and quarters and years. The strategy is not to capture performance every day or every week.

I thought the Market Cap model might shift off the Mid Cap signal this month in favor of large caps. Small caps have led the market lower in the sell-off that began in late July. In addition, weaker economic data suggests reducing risk by shifting to less volatile large cap stocks. However, despite an unusually large shift in four of the ten underlying indicators, the model stayed on Mid Cap. The technical trend indicators did move toward large cap as I expected. In addition, the sharp drop in long-term interest rates flattened the yield curve, which signals less GDP growth ahead and is a time to be defensive.

Despite these changes, the rapidly changing market and economic landscape also shifted a couple of indicators toward the increased risk of small caps. The collapse in consumer confidence has been so sharp that the model is now in territory where things are likely to get better before they get worse, signaling that adding risk makes sense. The market bottoms when the news is at its worst. The equally sharp drop in interest rates that triggered the flattening of the yield curve also shifted the interest rate indicator toward small caps. With short-term rates already near 0%, the drop was concentrated in the long end of the yield curve. Regardless, lower interest rates correlate well with small and mid cap stocks outperforming large cap caps. I still expect the Market Cap model to shift toward large cap in the coming months but the unusual and rapidly evolving market and economic environment means predictions are difficult.

There were also a lot of changes to indicators in the Style model. In this case, the change was overwhelming in one direction: toward growth. The Style model shifted to growth for August and the new signal is much stronger. In general, the Style model is shifting in favor of growth stocks to reflect the weakening economy. Growth companies are more valuable in poor economic environments because they require less of a tailwind from the economy. Some growth companies can continue to make progress even during recessions.

For September, the flattening yield curve, trend indicators, and insider buying and selling activity all moved to growth. Only coincident indicators shifted to value but this indicator is right on the border line so I do not much stock in the current signal. Overall, five of the nine indicators in the Style model now favor growth, a sharp shift from as recently as June when six of the nine indicators favored value. The current growth signal appears to be here to stay for a few more months.

During August, the models put in a mixed performance. The new growth signal from the Style model worked well. IWF fell 5% but this was less than the 6% loss for the similar value index or the 5.8% loss for the S&P 500. The Mid Cap signal from the Market Cap model fell 7%, worse than the S&P 500 but better than an almost 9% loss for the Russell 2000 small cap index. On a year to date basis, the Market Cap model has produced a loss of 3% matching the price only return of the S&P 500. The Style model is down over 4% this year, trailing the S&P 500.

Disclosure: MDY and IWF are widely held by clients of Northlake Capital Management, LLC including in Steve Ehrenberg personal accounts. Steve is sole proprietor of Google, an SEC registered investment advisor. MDY is a net short position in the Entermedia Funds. Steve Birenberg is co-portfolio manager of Entermedia, owns a stake in the Funds’ investment management company, and has personal monies invested in the Funds.

Posted by Steve Birenberg at September 2, 2011 11:36 AM in Models