Our Market Cap Model Shifts to Large Caps for December

by: Steve Birenberg, CFA

Northlake's Market Cap model shifted to Large Cap from Mid Cap for the month of December. The current signal is just barely in large cap territory. The shift reflects the lessening impact of a cyclical bottom in the economy and financial market conditions. When the financial markets and economy quickly decelerated following the collapse of Lehman Brothers (OTC:LEHMQ) in September 2008, the Market Cap model began to strongly favor small caps. As the markets and economy have been in recovery mode since spring, the extreme readings seen in many of the underlying indicators have moderated.

One basic tenet of the model is that at extreme readings you should take the opposite trade. In other words when all the indicators were reflecting the disaster in the global economy and markets, the next move was likely to be up. Thus, it was time to favor small caps and bet on their higher volatility. Now that economic and market conditions have eased, there has been a gradually lessening in the desirability of the higher risk small and mid cap indices. This was first reflected in October when the Market model shifted from small cap to mid cap. After a two month run, the model took the next step in reducing portfolio risk by moving to lower volatility large cap.

As a result of the latest shift, all non-core client holdings in the S&P 400 Mid Cap (NYSEARCA:MDY) were sold and proceeds were reinvested in the S&P 500 (NYSEARCA:SPY).

There were actually few changes in the underlying indicators of the Market Cap model. Rather several indicators that were favoring small caps weakened. In particular, the indicators tied to interest rates, while still favoring small caps, are much weaker now than a month ago. On the other hand, technical indicators, which had already favored large caps, grew stronger in that view following a month when the S&P 500 produced a return far in excess of the Russell 2000 (NYSEARCA:IWM) and S&P 400 Mid Cap.

The Style model is unchanged for December and continues to flash a value signal. As a result, client positions in the Russell 1000 Value (NYSEARCA:IWD) will be maintained.

The models had a below average performance in November. The Style model's recommendation of Value worked out OK as IWD rose 5.73% almost exactly matching the S&P 500 return of 5.74%.

The Market Cap model underperformed in November as MDY gained 4.20%, lagging the S&P 500 by about 1.5%. Not all was lost, however, as MDY still performed better than the small cap IWM, which gained 3.1% in November.

The current value signal has been in place since the beginning of July. During that time, the value signal has been pretty good with IWD up 10.3% against a gain of 18.4% for the comparable growth index. The S&P 500 is up 19.1% during the same period.

The expired Mid Cap signal had mixed results. For October and November, MDY produced a price only return of -0.50%. The S&P 500 easily beat this results as SPY gained 4.1%. Once again, not all was lost as the small cap IWM fell 3.6%. Thus, the model's recommendation to move from small cap to mid cap at the start of October was accurate. It was not, however, as accurate as possible.

Disclosure: IWD and SPY are widely held by clients of Northlake Capital Management, LLC including in Steve Birenberg's personal accounts. MDY and IWM are held as core positions by selected clients of Northlake Capital Management, LLC.