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July 07, 2006

July Model Signals

Northlake's Market Cap model completed its transition for July by flashing a large cap signal for the first time since June 2005. As a result, I sold all remaining mid cap exposure dedicated to the ETF rotation strategy, swapping it dollar for dollar to large caps. Specifically, at the open on Monday, I sold the S&P 400 Mid Cap (MDY) and bought the S&P 500 (SPY). There was no change at all in the signal from style model which continues to flash value as it has since February 2006.

Current positions within the ETF rotation strategy are now entirely large cap, equally split between SPY and the Russell 1000 Large Cap Value (IWD). As recently as two months ago, clients had 25% in small cap value and 50% in mid cap, so a shift to 100% large cap is a significant change.

The market cap model has picked up on several trends that favor large cap outperformance including....

moderating economic growth, a weaker dollar, a flattening yield curve, rising interest rates, weakening breadth, an unusually high relative P-E for small caps, an extreme readings in investor willingness to accept risk (a contrarian indicator). Over the past six months these indicators have gradually moved in favor of large caps but only with the June and July signals did the weight of the evidence finally shift in favor of large caps.

I use my models to enforce decision-making discipline. I never second guess them and I always implement the signals. Nevertheless, I am glad that in this case, my own opinion squares perfectly with the models. I think we face a tough summer to make money in stocks and feel the risk is to the downside. Therefore, I'd rather be invested is less volatile large caps which should limit losses if the market does fall further.

I am pleased that client accounts now have a lower risk profile. Besides the shift toward large caps in the ETF rotation strategy, I have also adopted a more conservative position by raising cash reserves and eliminating discretionary positions in emerging market and small cap ETFs. My caution may prove wrong but by adjusting risk downward I feel a lot less pressure which usually has allowed me to make better decisions.

Even though the signal last month was the weakest possible mid cap signal it was still a mid cap signal. Therefore, I measure the accuracy of latest mid cap signal from its first appearance in September 2005 through June 2006. During this period, on a price only basis, it was a good call as mid caps gained 6.72% against a gain of just 3.83% for the large cap S&P 500. It wasn't a perfect call though as the model could have flashed a small cap signal which would have kept portfolios invested in the Russell 2000 (IWM) for a gain of 7.82%. But I'm not complaining.

Posted by Steve Birenberg at July 7, 2006 09:22 AM in Models