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.

Since the beginning of April, we’ve been discussing the overbought state of the equity market and implemented various risk reduction measures in our live portfolio. Our recent Trade History is very revealing in this sense:

We’ve been able to time this turn in the market remarkably well, but not every such inflection will work out in the same way. There are several pockets of the market worthy of our attention on the buy side, while other positions may need to get reduced due to stop loss violations. At the moment, the focus shifts to patient rebalancing and risk controls via fine tuning position sizing and stop levels.

1. 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.

SPY’s ~3.5% current drawdown is nothing to write home about and comes as a consequence of extended positioning, exuberant sentiment and momentum chasing. Support is just -0.5% below the last close and short term oversold conditions dictate that we should get a bounce fairly soon. Any reflexive rally would be a welcome opportunity to rebalance risk into, by selling underperforming positions.

Our medium term view is that equities will decline further, (total 5-10% drawdown) and offer a much better entry point in a couple of months. This remains a “buy-the-dip” environment, where “sellers live higher and buyers live lower”.

For the past week, Commodities (DBC) have continued to consolidate above the pivot level at $23.6 (S2). Sub-components like oil (USO) and agricultural commodities (DBA) look to have peaked (at least temporarily) and Nat Gas (UNG) has had another failed reflexive rally attempt. Normally, this would put pressure on DBC, so more consolidation is likely here. We are looking to buy the dip if support holds in the next couple of weeks.

Gold (GLD) has rallied to such an extent that our technical chart has had a hard time keeping up with the parabolic increase in prices. At the current 2.23 standard deviation, the yellow metal’s price appears speculative and prone to some quick profit taking. Due to this very high extension, gold is deemed un-investible by our system.

Treasuries (TLT) are currently struggling to maintain support at $88.4, with the level acting as a stop-loss. Interest rate traders have scaled back bets on Fed rate cuts from 7 at the start of the year to just 2 implied at the moment. There is a certain understanding among analysts that “permanently higher” interest rates are here to stay in the US.

BlackRock's Ann Katrin-Petersen forecasts U.S. rates of close to 4% for the next five years, saying that "We have entered a new macro market regime and one of the cornerstones of that regime is structurally higher rates".

Experts have a terrible track record of predicting future outcomes, so we’d rather rely on what the market is telling us: if bonds go lower, it’s time to cut exposure. If TLT finds support and gets a bounce, it could be a viable buying opportunity.

Enterprise, our core investment strategy, has significantly raised cash exposure from last week. The main change comes from stopping out bonds, as the downtrend in IEF and TLT is problematic.

On Tuesday’s rebalance, SPY went from 63% in the previous week to 67% portfolio NAV today.

Bonds exposure (IEF) has been completely removed. Last week, the portfolio had 15% exposure and now the model doesn’t hold any bonds.

The position in GLD is maintained, with a slightly lower 4.6% allocation.

The position in DBC is maintained, at almost 2%.

Cash went from 15.14% last week to 26.8% today, as risk continues to be decreased in our core model.

Since this model only trades 4 ETFs, we use it to judge overall portfolio positioning. The strategy’s risk profile is now clearly defensive, with a quarter of the allocation sitting in dry powder.

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).

Almost all factors have now crossed over to a negative medium term trend (EEM being the sole exception). This is a clear signal that the market has turned and we are about to enter a more negative disposition in the next couple of weeks.

All factors are now within normal deviations in the short term. However, there is not a single factor ETF that is trading above its 20 or 50 day moving average. In the span of 1 week, this is a rather shocking technical deterioration.

Longer term, it’s Momentum Factor ETF (MTUM) and Growth Stocks (IVW) which are most prone to profit taking due to abnormally high relative-to-SPY deviations. Once profit taking is done, these two factors are the ones our system identifies for a tactical long allocation.

Among more granular Factor Returns, investors are favoring an increased return on assets in the short term, with dividend paying stocks also high on the list. This makes for quite a defensive profile.

On longer timeframes, we can notice the staying power of high gross margin companies, as investors reward companies that are able to maintain their pricing power even in the face of sticky inflation pressures.

Across all timeframes, the preference for quality is evident, with a factor like the Pietroski F-Score getting high rankings no matter the time horizon.

Here’s how we stand on the Sectors front:

We have included 3 former tables from previous articles, for your convenience.

Most sector ETFs have turned to a negative medium term trend at this juncture. Energy (XLE) is the notable exception, sporting one of the lowest 6 month Excess Returns metrics, having underperformed SPY since November. It is also the sector adequately hedging the resurgent inflation scenario.

The short term situation is a mess. There is a remarkable lack of uniformity across sector ETFs. Energy (XLE) is the only sector able to trade above both its 50 and 200 DMAs. Real Estate (XLRE), Transports (XTN) and Utilities (XLU) are the only sectors trading below all key moving averages. Healthcare (XLV) is displaying a large deviation below its 50 and 20 DMAs, but holds above the 200 DMA. The rest of the sector ETFs fall somewhere in between.

Longer term, there is no notable extreme deviation. Consumer Discretionary (XLY) is showing a surprising relative-to-SPY lack of performance. Financials (XLF) have pulled back within normal performance metrics.

Nostromo, our tactical allocation model, is about to offload bonds at today’s market close.

While the allocation will go to 100% cash as a result, Nostromo’s shopping list is ready. On the appropriate BUY signals, the model will initiate positions in Growth Stocks (IVW), Momentum Factor ETF (MTUM) on the equity side.

In bonds, the model will look for an entry point in TIP, HYG, MBB, LQD and IEI.

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

Millennium Alpha has just performed its monthly portfolio refresh yesterday and some new notable holdings include:

• Broadcom Inc (AVGO)

• International Business Machines (IBM)

• Hubbell Inc (HUBB)

LULU was sold due to underperformance. Some losses are adding up in this portfolio, since its long only structure has no hedging in place. Furthermore, the high correlation to MTUM, XLK and XLC means that the stocks in this portfolio are prone to profit taking.

The current drawdown of -6.7% has already exceeded the 2 year average loss experienced by this model.

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 technical damage so far is becoming evident when looking at the number of stocks trading above their 20 and 50 day moving averages. Just 103 / 1000 issues are maintaining 20-DMA support. Such a sharp drop is reminiscent of periods when the market was undergoing a correctionary process, as well as more volatile periods. Many times, excessively low 20-DMA readings have been associated with reflexive rebounds that soon followed.

The number of stocks trading above their 200-DMAs is healthy, by comparison (658 / 1000).

Neutral Signal in Stocks trading above their 200-day Moving Averages

As a contrarian indicator, sentiment works best near extremes. At the moment, we are nearing the lower part of this indicator, labeled “Extreme Fear” and also “BUY ZONE”. We are not there yet, but when we do reach higher numbers of stocks oversold, we’ll call this indicator “bullish”.

There is a caveat, however. This reading may remain stuck in “Fear” for quite a while. We haven’t had a proper “Extreme Fear” reading since last October, and we’re very close to getting one right now. However, on a longer term basis, the market is not exactly a screaming buy. We would like to see this indicator bottom twice (like in 2022 and 2023) in order to get a confirmed signal.

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.

Good news is signaled by this indicator, as the correction has had more of an effect on SPY than the average stock in the market. As the run up in mega cap growth stocks has propelled the market cap weighted index into the stratosphere, it’s only logical that the same names will drag on the way down. SPY’s underperformance gets translated into a Z-Score divergence reading that is finally normalizing.

Translation: the average stock is weathering this correction episode better than the benchmark market ETF.

Slightly Bullish Signal in Market Internals Z-Score

Dollar Transaction Volume has picked up slightly as the corrective action has gripped stocks. Volume remains close to neutral, however, neither confirming nor denying the lower prices in the equity market.

We would expect a pickup in transaction volume if stop loss points are starting to get hit. If volume drops further, we’d take that as a positive sign, meaning that there is no rush to sell or take profits.

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.

Our trend following systems are understandably pulling back on risk exposure as they are entirely momentum driven. While fear is starting to show up in sentiment readings, this is not enough to justify aggressive buying at the moment.

We’ll conclude in the same manner as we’ve started today’s article - the focus will be on prudent rebalancing, adjusting stop levels and buying beaten up quality stocks.

Automated Strategies and Market Outlooks

The Sigma Portfolio (Live)

We’ve run our portfolio on the defensive side for a while and it has paid off. Our bonds allocation is still large, but 9% of that is made up of short term treasuries and corporates. We are reluctant to close TLT out just yet, since it has not yet violated its technical stop and is highly oversold.

GPN, on the other hand, is a position that has not worked and needs to be closed out. Instead, we will pick up Palo Alto Networks (PANW), a top ranking cybersecurity stock. We will also increase allocation to an energy position which has worked recently (though not spectacularly) - Dorian LPG (LPG). Overall, the equity risk allocation in the portfolio will remain unchanged.

We are executing the following orders at today’s close:

• SELL 100% GPN (Close Position)

• BUY 3% PANW (Initiate 3% Position)

• BUY 1% LPG (Add 1% to existing Position)

Following the execution of this order, here’s how the asset allocation will look like in the Sigma Portfolio (unchanged):

We remain overweight cash and tilting the portfolio to the defensive side by adjusting stop levels (see Portfolio Tracker worksheet).

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 $11.280 by risking $3.101 if our targets are correct. The risk-reward ratio is massively improved since last week, on account of tighter stops for all positions.

In terms of Factor correlations, we are comfortable with the current setup. Mid-Caps (MDY), the Equally Weighted S&P500 (RSP) and Small Caps (IWM) are favoured. QQQ exposure has crept up a bit since last week but it’s not concerning for now.

On the sectors side, correlations are also fine, with many industries holding near the top spot: Financials, Consumer Discretionary, Industrials and Basic Materials.

If you have any questions, please contact us using your favorite channel. Have a great week everyone, and happy investing!

Andrei Sota