Small Cap Emerges Again, Value Alive but Fading

 |  Includes: DIA, IJR, IJS, IWM, MDY, QQQ, SLY, SPY
by: Steve Birenberg, CFA

Northlake's Market Cap model shifted back to small cap for October. As a result of the change, all client positions in the S&P 400 Mid Cap (NYSEARCA:MDY) were sold and replaced by the Russell 2000 (NYSEARCA:IWM). There were no changes to the Style model, which remains on the long running Value signal.

The shift to small cap comes after a three month run for mid cap. Several underlying indicators in the Market Cap model shifted in favor of small cap but the primary catalyst for the change was in the technical stock market indicators. The big rally in September and a double digit gain for the major averages in the second quarter improved the technical condition of the market and drove trend based indicators to favor the more aggressive small cap index. Technical factors shifting in favor of small cap include advisory service sentiment, market breadth, and trend indicators. There was one change in economic indicators as consumer confidence moved toward small cap. Consumer confidence is a contrarian indicator. The recent lower levels of confidence are interpreted to mean the next move is likely up. At negative extremes, investors want to stress the higher risk asset to take advantage the likely coming improvement. It is often difficult to get more aggressive when news flow is poor. This is one reason why the models are useful and successful as they take emotion out of the decision-making process.

While the Style model again stayed on Value, as it has since July 2009, there was underlying movement in the model factors which put a shift to growth in the possible range for next month. Once again it is trend indicators driving the movement as the September rally was led by growth stocks.

Overall, the models still are giving a message of a low growth economic environment that is conducive to success for corporations and the stock market. The models are not suggesting a good economy for average consumers but the stock market can disconnect from the economy under certain economic conditions. The current environment of extremely low interest rates, record profit margins, and improving corporate balance sheets is one such instance.

September saw mixed results for the models. The mid cap signal worked well, as MDY gained 2% more than the benchmark S&P 500 and just about kept up with IWM. However, as noted, value lagged growth and also lagged the S&P 500 by just under 2%. For the third quarter, when the mid cap signal was in place, the performance was similar. Mid cap was a good place to be but value returned less than growth. The long-term performance of the Style model has slipped slightly but the value signal still matches the return of the growth index. As they say, "no harm, no foul."

Disclosure: None