Northlake’s Market Cap model shifted from small cap to mid cap for July, ending a five month run favoring the small company theme. As a result of the shift, all Northlake client assets invested in the Market Cap model have sold IWM and purchased the S&P 400 Mid Cap (MDY). There was no change to the Style model, which continues to flash a value signal as it has since July 2009.
The shift to mid cap is the result of the loss of momentum in the economic recovery and a couple of months of lagging performance for small caps relative to large caps. Simply put, recent economic statistics and stock market performance align with a lower exposure to the riskiest asset in the market cap basket. The fact that the economic recovery has stalled as opposed to reversed into recession supports above average risk exposure and mid caps over large caps. That said, the model works in a stair step fashion and it would take highly unusual circumstances to move from small cap to the least risk asset, large cap, in just one month. The current signal is actually closer to small cap than mid cap so even another month of weak economic data and poor stock market breadth is likely to leave the model in mid cap at least through August. Should the economic data and stock market environment improve, a shift back to small cap is very possible.
There were minimal changes in the underlying factors that drive the Market Cap model. In fact, the only factor to shift was bond market momentum which actually moved in favor of small caps due t rapidly falling interest rates. The larger shift to mid cap was driven by many of the other inputs moving toward a less risky posture in light of an apparent sudden slowing in the economic recovery.
There was also minimal change in the Style model inputs for July. The relative P-E measure did shift from value to growth but it was not enough to meaningful move the very strong value signal that has been emanating from the Style model over the past several months. The Style model is suggesting that the economic recovery remains intact despite the recent batch of worse than expected economic data. It is worth noting that many of the soft economic statistics remain in positive growth territory. They are just less growth-oriented than Wall Street had been expecting.
During the five months the Market Cap model recommended IWM, the small cap index outperformed the S&P 500 by more than 5%. IWM even held up well on a relative basis during the May/June market decline. This is somewhat of a surprise and I am more comfortable with the mid cap signal given the suddenly tricky market environment.
The Style model has also sent an accurate signal since the current signal went into place a year ago. Over this time frame, the Russell 1000 Value (IWD) has gained almost 14% vs. a gain of just under 12% for the Russell 1000 Growth (IWF). More recently, the value signal helped relative performance in early 2010 and held its own in the second quarter.
Disclosure: IWD and MDY are widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg’s personal accounts. IWM is a core holding in select accounts managed by Northlake Capital Management. Steve Birenberg is sole proprietor of Northlake.