Our October Models: Small Cap Run Ends, Mid Cap Favored

Includes: IWD, IWF, IWM, MDY
by: Steve Birenberg, CFA

After 13 months flashing a Small Cap signal, Northlake's Market Cap model shifted to Mid Cap for October. I had anticipated this move after steady weakening of the small cap signal over the past several months. The new mid cap signal is a weak one and could shift back next month but the message is clear: the extreme conditions in place in the economy and credit markets have eased reducing the attractiveness of small caps as the play in a market and economic recovery.

As a result of the shift, all Northlake client positions in the Russell 2000 (NYSEARCA:IWM) dedicated to the model were sold and the proceeds were reinvested in the S&P 400 Mid Cap (NYSEARCA:MDY).

The Style model was unchanged for October. The Value signal that has been in place since July 1st remains in a slightly stronger position. All client positions in the Russell 1000 Value (NYSEARCA:IWD) have been maintained. Last month growth slightly outperformed value but since the current signal was triggered, IWD has beaten the comparable growth index (NYSEARCA:IWF) by almost 4%.

Two underlying indicators in the Market Cap model shifted in favor large caps this month while one shifted in favor of small caps. Please keep in mind that the model rates ten factors as favorable for small or large cap and a mixed result leads to a mid cap signal. Also remember that the models almost work in stair step fashion, moving from small to mid to large to mid to small.

The factors shifting in favor of small caps were a peaking in advisory service bullish sentiment and the continued weakness in the dollar. Technical indicators moved back to favoring small caps reflecting the very strong relative performance of small cap stocks over most of 2009.

During the 13 months the small cap signal was in place, the return for the Russell 2000 Small Cap index matched the return of the S&P 500 as both fell 18%. The small cap signal was inaccurate in the fourth quarter of 2008 but fully reversed the lost performance in 2009. In fact, in 2009, the Russell 2000 has produced a return of 22%, about 5% ahead of the S&P 500.