Hello. This is David Spangler, portfolio manager of the Model Portfolios. Today we're going to be discussing a trade that we will be executing in the models.

The trade is essentially to sell small caps and mid caps and to buy large caps, but with a quality bias to them.

Let's look at our first exhibit. In our first exhibit, we have the spread between the Russell 2000® and the S&P 500®. This is over a trailing one-year basis. As you can see, the red dot at the end of the chart is where the spread of the Russell 2000 and the S&P 500 is at 18% or more. This is something that doesn't happen really that often. It's a relatively rare event. And in fact, the one that we've had more recently is in about the 90th percentile. Given that, it seems a good opportunity or entry point for us to discuss being able to make some changes to the characteristics within our portfolio.

What we're also trying to do is to skew the probabilities to our favor. But when things become this extended, in the case of the Russell 2000 and the S&P 500 – or small caps to large caps – what we're doing is we're skewing to probabilities to our favor and then allowing time to work in our favor as well.

So, what has happened over this year? As we got to March 30, nearing market bottoms with the Iran conflict, the market had what we sometimes call in this industry a V-bottom. It became very, very risk-on, a very high-beta, very low-quality, momentum-driven market where companies with a lot of leverage and no earnings and such became much more in favor. This has really helped to drive the small caps performance relative to large caps.

However, small caps in and of themselves are relatively lower quality. What do we mean by quality? So, quality is a characteristic or a factor in the market. It's often higher profitability, higher ROIC or ROE – those are return on invested capital or return on equity. Companies that are in the Russell 2000 have become, over time, far lower quality.

In fact, just generally speaking, since the early 1990s, about 10% of the Russell 2000 had no earnings. By the time we were into the 2000s, it was about 25% of Russell 2000 companies or constituents had no earnings. Today it's over 40% and it's rising. So, nowadays, we see a lot of zombie companies in the Russell 2000 – companies that have insufficient profits to cover their service costs or their interest servicing costs.

So, while these companies have had a very sharp and very powerful rally as of late, that often doesn't last for really that long. And over the longer term, higher quality companies outperform in the marketplace.

In chart number two, what we have is, to represent the economic conditions, is the ISM manufacturing new orders six-month average. What you can see is that, in the red, this is periods of time where the ISM new orders is declining. In the green is when they're rising. And then in the dotted line, this is the difference in the returns of the Russell 2000 versus the S&P 500. So, it's not going to be an exact perfect correlation, nothing ever is. And we're just using the ISM new orders as a representation of economic conditions.

But generally, what you can see is that as the ISM new orders is falling – and particularly as it gets into contraction territory, which is below 50 – you can see that the Russell 2000 typically underperforms the S&P 500.

As we get to the end of last year, 2025, in December, the ISMs were in the higher 40s, still in contraction but had improved some. And then, as we get into January, the ISMs are into the 50s. And that's what we saw this year was the ISMs improving quite a bit. And the Russell 2000 has outperformed the S&P 500. Now we have ISMs of about 56 or 57.

So, we're not saying that we expected the economy to roll over. In fact, there's a lot of supports to the economy right now. But we're getting to levels with the economic conditions and also with the return spreads of small caps to large caps. This is an opportunity now to rotate some of the portfolio.

What you can also see on the right hand side of the slide is that the Russell 2000 versus the S&P 500 returns in those periods where they're red, where the ISMs are declining, is -13.3% over time. And then it's positive 12.8% in the periods where the ISMs are improving. So, it's not a perfect relationship, but it's a relatively strong relationship.

So, now let's look at our last slide. This is the trade that we're looking to execute. What we'll be doing is selling the Vanguard Morningstar Small Cap ETF. The position is 1%, so we'll be selling that. And also TSME, [Thrivent Small-Mid Cap Equity ETF,] we'll be selling 1% of that across several of the portfolios for a total of 1% in moderate conservative, 2% in [moderate], and then 2% in [moderate] aggressive and 2% in aggressive.

This is just essentially an opening trade, if you will. Trying to call the tops of the markets is really difficult. And we're not suggesting that we think the economic conditions are going to deteriorate. We want to take advantage of a good entry point for this rotation to higher quality. And over time, higher quality companies outperform lower quality companies, especially after these short, sharp rallies that we get in low quality.

We want time on our sides. We may be a little bit early on the trade, so to speak, and if we are, then we may have an opportunity to add to it. But we believe that, over time, the higher-quality companies that you find in the large cap indices, and particularly with the ETF that we're going to be expressing this trade in, which is QUAL, the iShares MSCI USA Quality Factor [ETF], gives us both the larger caps and the higher quality factor characteristics that we think over time will will benefit the portfolios, especially as we've had such a powerful, low-quality rally more recently.

If you have any additional questions, please reach out to your sales associates, and I thank you for your time.