Portfolio Rebalance / April 05
Following the Signal Sigma Process
The approach to this article follows the step by step process described here. All visuals are sourced from various instruments available in the platform. If you are using the Portfolio Tracker, you’ll be able to see how we set it up for our own portfolio at the end of this article.
We’ve delayed this week’s portfolio rebalance in order to get a better handle on future inflation data. The BLS has released the latest employment figures and here’s how we stand:
303K jobs were added in March 2024, the most in ten months, way above expectations of 200K;
February job additions were revised lower to 270K, but January was revised higher; in total, revisions for January and February total 22K more job gains than previously reported;
Average Hourly Earnings are up +4.1% YoY, as expected; the Unemployment rate was reported at 3.8%, also in line with expectations;
As we write this article, SPY is rebounding and challenging previous support (now resistance) at $519. We’ll need to wait for a confirmation either way before deciding to reduce exposure.
Treasuries are selling off due to increased and sticky inflation expectations, while commodities are gaining as well in reaction to the data.
Asset Class Allocation
The first step in determining optimal portfolio positioning is taking a look at the performance of the main asset classes, and determining which are suitable for investment. The Asset Class Overview Instrument gives us a clear macro picture.
Stocks, bonds and commodities are investible, while Gold is registering a very high deviation, more often associated with pullbacks.
SPY has decisively broken below technical support. Since the beginning of the year, the benchmark ETF has always bounced from the 20-DMA. However, in our view, we are also encountering a technical level break as well, coupled with a negative MACD crossover and previously overbought conditions. In other words, this is a “perfect storm” of technical indicators, leading to the next logical support, at $493 (R1, -3.89% lower). Previous support now turns into resistance, at around $519 (R2, 20-DMA, +1.16%).
After a brief consolidation last week, commodities (DBC) have continued to rally to our pivot level of $23.6. There is scope for commodities to rally further, up to $25.1, but not due to the influence of crude oil, which has already reached its technical limits. Nat Gas has a lot of catching up to do instead.
Gold (GLD) has rallied further last week and hit our price target of $212. Normally, a pullback or consolidation would be in order here, before more gains are realized.
TLT remains under selling pressure, as a “higher for longer” view on interest rates is being priced in. Resistance currently stands at $93, while support rises to $88.
Enterprise, our core investment strategy, has increased equity risk exposure this week, but has sold off commodity related positions.
On Tuesday’s rebalance, SPY went from 56% in the previous week to 64% portfolio NAV today.
Bonds exposure (IEF) is decreased from 35% last week, to 22.7% today.
The position in GLD has been closed.
The position in DBC has been closed.
Both of these will be re-opened next week on the expectation that a slight pullback might occur in the interim.
Due to the overall decrease in risk exposure, cash goes from 2% last week to 13.3% today.
Since this model only trades 4 ETFs, we use it to judge overall portfolio positioning. The strategy’s risk profile is now balanced, with a slight defensive tilt due to the size of the cash position.
2. Sector / Industry Selection
The next step in creating our portfolio positioning is to break down each broad asset class into more granular groups of assets. This will help us understand which pocket of the market is outperforming or underperforming and make our selection accordingly.
Since Equities are an investible asset class, we’ll take a look at how different Factors are performing and check for any notable opportunities.
We have included tables for this week and the prior 3 article editions in order to help you compare developments (click on the arrows or thumbnails to cycle through the tables).
The Nasdaq (QQQ) and the Dow Jones Industrial Average (DIA) continue to trade in a negative Medium Term Trend, but no other ETFs have joined this predicament so far.
Most Factors are now sitting below their 20-day moving averages, with only Emerging Markets (EEM) managing to trade above all key levels. Longer term, the Momentum Factor ETF (MTUM) along with Growth Stocks (IVW) are highly extended. Otherwise, all ETFs are trading within normal bounds.
Among more granular Factor Returns, R&D / Revenue has seen a resurgence in the short term (despite the huge dip at the 2 week mark). Market leadership is still defined by rather expensive growth companies.
Ranking shown for R&D / Revenue
On longer timeframes, it’s interesting and illustrative to note how Market Cap has fallen in terms of ranking from a top 3 factor 1 year ago to 23’rd place at the 6 month mark. This means that the size of a company can no longer simply explain its outperformance.
Ranking shown for Market Cap
Across all timeframes, one of the best performing and consistent factors remains the Pietroski F-Score, as shown below:
Here’s how we stand on the Sectors front:
We have included 3 former tables from previous articles, for your convenience.
There hasn’t been a lot of further deterioration when it comes to sectors ETF performance. 5 out of 12 ETFs are still trading in a Medium Term Trend, same as last week. Financials (XLF) have moved to the top of the leaderboard for 6 month performance, a sight rarely seen in bear markets (in an economic downturn, banks always perform poorly).
Energy (XLE) is highly extended in the short term, trading with large upside deviations relative to all moving averages. Longer term, Financials (XLF) and Basic Materials (XLB) look more prone to profit taking. Bear in mind, however, that a lot of banks are recovering from the CRE crisis that occurred 1 year ago, so the excess performance means they are just “catching up”.
Otherwise, sector ETFs are trading well behaved and within regular extensions. There are no tactical opportunities at the moment.
Nostromo, our tactical allocation model, is only holding treasuries, via TLT, same as last week (and last month).
In fact, this model has done a lot of nothing lately and, as a result, it has underperformed. On the next available BUY signal a position in SPY will be initiated.
Nostromo has completely missed the mark recently, as its primary allocation has been cash. In a market moving ever higher in low volatility, Nostromo’s trade signal system has been unable to catch any kind of break. (no trade signals = no allocation)
For more info about how Nostromo targets sectors or factors within a broader asset class, read this article. The first part sheds some light on the selection process going on in the background.
While underperforming in real life, this quirky model has its uses as a decision support tool. There is a clear case to be made here that equities are overbought and due for a correction. Nostromo is the only strategy to have almost zero drawdown during the Covid-19 crash in 2020, owing to its “unconventional” decision making style.
3. Individual Stock Selection
This week, we will spotlight Millennium Vol Target (Alpha’s defensive cousin system). Given the more precarious situation that the equity market finds itself in, it might not be a bad idea to garner some inspiration from this system going forward. Its 6-month performance has been stellar and smooth in terms of risk-reward ratio and the current portfolio configuration favors a high correlation to Mid Caps (factor) and Industrials (sector).
Solid picks include EMCOR Group Inc (EME), Godaddy Inc (GDDY) and Colgate-Palmolive Company (CL).
As per usual, you can tweak this system using your own inputs if you wish.
4. Market Environment
The next step in our process is to take into account the type of market environment that we are currently trading in. For these purposes we use the Market Internals and the Market Fundamentals Instruments. Comments on the overall state of the market can usually be found in our Weekly Preview Article.
The divergence between SPY and the broad market has been reduced recently. We can’t really tell that the benchmark ETF has had a down day judging by the number of stocks trading above their 200 and 50-DMAs. This is a great thing and it tells us that the broad market is holding up well for now.
Neutral Signal in Stocks trading above their 200-day Moving Averages
As a contrarian indicator, sentiment works best near extremes. Right now, with a reading of 54 / 100, we are close to the middle of the range, and the disposition of the market is truly Neutral.
Neutral Signal in Sentiment
The comparison of Z-Scores reveals the disparity between large cap performance (SPY) and the top 1000 stocks by dollar volume (the broad market), equally weighted.
As we have speculated for a while, the broad market is finally catching in terms of performance! This is visible on the latest down-move, where SPY has underperformed factors like Mid-Caps (MDY), the Equally Weighted S&P500 (RSP) and the iShares Russell 2000 ETF (IWM). While the benchmark ETF has accelerated to the downside, most stocks simply did not fall as much. As a result, the Z-Score Divergence (lower panel) is moving closer to the neutral mark.
A positive development, with more room to go.
Neutral Signal in Market Internals Z-Score
Dollar Transaction Volume is showing a liquidity gap forming, as stocks have plateaued near all time highs. For now, the drop below the average is not yet alarming, but if the rally is to keep going, we need to see much higher volume (on positive weeks).
Neutral Signal in Dollar Transaction Volume
5. Trading in the Sigma Portfolio (Live)
After reviewing all of the above factors, it’s time to decide on the actual investing strategy for our real-life portfolio.
With a neutral landscape for equities in the short term (and far too little reward longer term), we are not in a hurry to make any major changes to our stocks portfolio. In order to reduce exposure on the latest technical break, we also need more confirmation, which we don’t currently have. SPY needs to either re-capture its 20-DMA level or get firmly rejected from it. We will be performing some normal housekeeping, however.
We do need to take profits in Gold and reduce exposure to treasuries, however.
Automated Strategies and Market Outlooks
The Sigma Portfolio (Live)
Gold (GLD) has done all it can do for us in the current environment. It’s time to take profits and close the position entirely. Similarly, our bet on Valero Energy Corporation (VLO) has paid off entirely. On the other hand, the position in Progress Software Corporation (PRGS) has not worked out as expected and we need to honor our stop-loss.
Treasuries have failed to trade above key resistance, so we need to adjust the TLT position to a lower weight until the next breakout attempt.
We are executing the following orders at today’s close:
SELL 5% TLT (Reduce Position by 5%)
SELL 100% GLD (Close Position, Take Profits)
SELL 100% PRGS (Close Position, Stop Loss)
SELL 100% VLO (Close Position, Take Profits)
Following the execution of these orders, here’s how the asset allocation will look like in the Sigma Portfolio:
The latest trades will leave us with an overweight cash position, but we’ll take care of that next week if the market manages to bounce. If not, having more cash on hand is a great problem to have.
Click here to access our own tracker for the Sigma Portfolio and understand how the positions contribute to the overall exposure profile. De-risking the portfolio has deflated both the win and the loss figures.
In total, we stand to gain $11.526 by risking $7.221 if our targets are correct. The risk-reward ratio is better than last week, now standing at 1.59 to 1. This is still well below our desired proportion of 2 to 1 (for every dollar in risk, we should get 2 in return).
On the sectors side, correlations are also fine, overweighting recent winners, Financials (XLF).
If you have any questions, please contact us using your favorite channel. Have a great week everyone, and happy investing!
Andrei Sota