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August 08, 2005

August Model Signals

I was out of town and unable to post on the August Model Signals last week. As clients have seen by now, the new signals led to a trade in the ETF portion of their portfolios. Specifically, the Market Capitalization model shifted from a mid cap signal to a small cap signal. Consequently, all holdings in the S&P 400 Mid Cap (MDY) were sold and swapped into the Russell 2000 Small Cap (IWM). The Mid Cap holdings were sold for almost a 5% profit. There were several shifts in underlying factors that led to the new signal…

…First, the strong market rally off the April lows that accelerated in July had very strong breadth. This means that a very high percentage of all the stocks listed on the major exchanges participated in the rally. Since most listed stocks are small and mid cap, good breadth is a sign of broad based investor confidence. In the stock market strength begets strength. Historically, periods of strong breadth have been followed by continued relative gains for small cap stocks vs. large cap stocks.

Second, the strength in July in small caps reestablished the long-term trend going back to 2000 favoring small cap stocks. As with breadth, trends tend to stay in place on Wall Street so confirmation that the trend favoring small caps was still in place suggests that in the future small caps will perform better than large caps.

It is interesting to note that both of the indicators that led to the shift in the Market Cap signal are technical or trend indicators. These types of indicators play an important role both the Market Cap and Style models by providing shorter term factors to complement the economic and interest rate indicators that tend to change more slowly. The idea is that the technical indicators will prevent the models from being too early or too late.

The new Market Cap signal is just barely into small cap territory, so no changes in the Style allocations were initiated this month. The Style model remains firmly in growth mode with client holdings split evenly between small cap growth and large cap growth. When the market cap model sends out a strong small cap or large cap signal, the style holdings are shifted in favor of the market cap signal. For example, a strong small cap signal would lead to style holdings favoring small cap growth or value.

It is worth noting that a shift toward small caps is an aggressive trade and will work best if the market uptrend remains intact. Small cap stocks are more volatile than large cap stocks and rise more in bull markets and fall more in bear markets. In the short-term, I think interest rates will be the key determinant of whether the small cap signal turns out to be accurate as small cap stocks are particularly sensitive to trends in interest rates. This week's rate decision and commentary coming from the Federal Reserve will thus be a key datapoint to watch.

Posted by Steve Birenberg at August 8, 2005 12:06 PM in Models