Portfolio Rebalance / August 2
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.
The past week, our automated models have started to get more defensive in their allocation. Enterprise is cutting Gold exposure significantly, Nostromo is holding more than 50% in cash, while Horizon has cut both Treasuries and Gold yesterday.
The slight red flag we see is related to the U.S. Dollar’s strength recently. Bulls were certainly hoping the dollar would break support levels and boost all of the other asset classes. However, what we got was a decisive bounce, and our systems are picking up on this theme and responding accordingly.
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.
According to our analysis, all major asset classes are technically investible at this point. Commodities have continued to perform well and are hitting up against resistance; meanwhile, Gold has lost some momentum, after failing to breach resistance;
Same as last week, equities continue to grind higher, and it’s anybody’s guess exactly when the rally will end (and why); for the moment, every dip is being bought, but that may be prone to change if we get a correction.
Commodities have continued to challenge the S2 Resistance Level at $24.63, after stagnating for the past week and not being able to clear the level. Watch for weakness in case of a Dollar rally.
Gold has similarly lost momentum and failed to clear its near term resistance. In the process, GLD has triggered a SELL signal and our strategies will reduce positions associated with the yellow metal.
The U.S. Dollar has aggressively bounced from its previously oversold condition. It is now nearing the S1 technical level at 28.56, and whether or not it will be able to break out at this juncture will be pivotal to our risk management process. A break higher would spell trouble for every other asset class. Note: we have adjusted the chart below to reflect a 5% CAGR, which is far more realistic than the “natural” 7.6% slope formed by the pure price action.
We are constantly checking for a break in the current negative correlation regime between the US Dollar (white) and every other asset class, combined (orange).
In the medium term, the correlation is starting to trend positive. Note that the combined asset classes are exhibiting weakness that will test the medium term channel, while the US Dollar still has potential upside.
The fact that the two pairs of assets are trending in the same direction medium term is certainly encouraging, and we would welcome a continuation of this regime.
Enterprise, our core strategy, is reducing its allocation in Gold in favor of cash.
The Enterprise Strategy
Enterprise, our most conservative model, will become 65% long physical Gold, and maintain a 20% position in Treasuries.
Since this model only trades 4 asset class ETFs, we use it to judge overall portfolio positioning.
The model’s treasury allocation is looking to be increased, on the next BUY signal.
Gold allocation, on the other hand, will be decreased substantially at the day’s close. Enterprise has detected a MACD SELL signal and will act on in in order to get a bit more defensive here. As a reminder, Gold is momentarily substituting equities in the strategies allocation since it temporarily benefits from the same tailwind as stocks (USD weakness). The rise in yields is hurting the non-yielding yellow metal.
Cash allocation will become 15%, suggesting a more defensive allocation for now.
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 weeks in order to help you compare developments (click on the arrows or thumbnails to cycle through the tables).
All factors remain positive in terms of Medium-Term Trend this week as well. This is not a piece of good news, as the name suggests, since times when factors were all positive usually align with market topping processes.
Short term, the excitement has cooled down a bit. Only 4 factors are highly extended, compared to last week’s 6: the Dow Jones Industrial Average (DJA), Value Stocks (IVE), Growth Stocks (IVW) and the iShares Russell 2000 ETF (IWM). Notably, Foreign Developed Markets (EFA) have lagged the current advance, logging just 1.86% 6 month returns.
Looking at the near term performance gains for each factor, we notice that the majority of ETFs are performing rather poorly - 7 / 10 factors are logging 6 month returns of 4.5% or lower. The only out-performers by a wide margin remain Nasdaq (QQQ) and Growth Stocks (IVW).
Both of these factors are also longer term overbought (especially QQQ), after last year’s disastrous performance.
The dichotomy for the Dow Jones Industrial Average (DJA) and the Equally Weighted S&P500 (RSP) persists - these factors are simultaneously gross relative-to-SPY under-performers, as well as highly extended on an absolute basis.
Last week, we noted:
A rotation should benefit RSP and DIA, given the current set-up, since these ETFs are the only ones not working…
Let’s take a closer look at the technical set-up for each. We’ll start with the Equally Weighted S&P500 (RSP), as it is more reflective of market breadth. RSP is the worst relative underperformer to SPY, and we can see how this version of the S&P is struggling to clear overhead resistance.
Compare the performance to the iShares Russell 2000 ETF (IWM), another important market breadth gauge. IWM has been able to clear resistance and for the moment appears to be in a better position to rally and test the next resistance level.
Finally, the DOW (DJI) is in the process of a clear technical breakout.
There are no immediate technical opportunities of note for Factors, as in the short term, none are oversold. But if any should dip, without breaking support, we would be inclined to buy IWM and DJI (or stocks that closely align with these).
Here’s how we stand on the Sectors front:
We have included the last 3 weeks of tables as well, for your convenience.
On the Sectors side, we can notice the same positive medium term trend for ALL sectors. We have never witnessed such a perfect alignment across equity sectors and factors, for 2 weeks straight, telling of the extent to which the market is overbought in general.
This week, however, there are a couple of sectors breaking short-term moving average support - Real Estate (XLRE), Utilities (XLU) and Consumer Discretionary (XLY) are all trading below their 20-DMA. Meanwhile, Communications (XLC), Industrials (XLI) and Transports (XTN) continue to be highly extended. All of the other sectors are sitting somewhere in between, but all are trading above key moving averages.
Utilities (XLU) and Staples (XLP) are also the main laggards on a longer term basis. Notably, these sectors have clearly out-performed last year, and the lag in performance is understandable. Tech (XLK), Transports (XTN) and Communications (XLC) are playing catch up on a longer term basis, notching high deviations on a relative and absolute Z-Score measurement as well.
We had our attention focused on Energy (XLE), a sector ETF that has managed to break out last week, on the back of strong commodity prices. While short term overbought, this is one area of the market that warrants attention in case of a buyable pullback.
Meanwhile, the equity rally leadership provided by Tech (XLK) has continued to struggle. There has been no meaningful correction yet, simply a pause in the velocity of rising prices. It remains to be seen if this loss of momentum brings more material downside, but one thing is certain - if XLK hits an air pocket (maybe AAPL earnings as a catalyst) the downside is significant.
There are no immediate technical opportunities of note. In theory, defensives should benefit from eventual profit-taking in Tech and Discretionary. That scenario would come to pass only if more fundamental cracks appear in the bullish narrative.
The Nostromo Strategy
Nostromo, our tactical allocation model, is more conservatively allocated to precious metals, using an equity ETF to achieve that exposure (GDXJ). The model carries a 20% bonds exposure through TLT (Long Term Government Bonds), having sold the LQD position for a slight profit on Monday.
Nostromo has a generous dry powder reserve at 56% CASH.
The strategy is looking for an opportune moment to close the position in Gold Miners (GDXJ) and buy the less volatile underlying commodity - Gold itself. On the fixed income side, the strategy is looking to increase its TLT position.
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.
3. Individual Stock Selection
For this week’s screener, we’ll take a look at one of our presets - the Beaten Up + Quality Screener. This screener selects with a high Piotrosky F-Score, that have suffered a 50% + drawdown recently. Here are the screener’s criteria:
Piotroski F Score => 6; this ensures the “Quality” component
Current Drawdown of 50% or more from All Time High; this represents the “Beaten Up” component
Market Cap > 500 M
Operating Leverage Mean > 0 ; ensures a solid business model
Rising Gross Margins (self explanatory in an inflationary environment)
Sales Growth TTM > 0 (growing revenues)
Just 15 issues make the list:
The combined equity curve looks exactly like we would expect. These stocks that got hammered in 2022 and are now making a gradual recovery, with plenty of upside left.
We can study their financials using the Fundamentals Explorer, and model their Price Target / EPS Growth Rate using the Valuation Wizard. Eventually, we can find possible candidates for our portfolio construction.
The Millennium Strategy
This week, we will spotlight the Millennium Vision portfolio, featuring an assortment of Discretionary, Communications, Small Cap and Tech correlated names. This strategy is benchmarked to the popular ARKK ETF, and manages to track it well, proving that Cathie Wood’s investment method can be replicated right here on Signal Sigma. While the process can benefit from some extra refinement, the basic idea is the same:
Select currently non-profitable companies that have an exciting business model and are developing products that will shape the world of tomorrow. Similar to our weekly screener, this strategy has taken a beating lately, averaging a -69% drawdown from 2021 highs. However, it does appear as if a bottom has been formed and “the lows are in”. We could go about introducing a couple of these positions in ou live portfolio, after a closer examination.
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.
Market breadth has been teasing us with a breakout in stocks above the 200-day moving average. That breakout has not exactly occured, with most stocks confined to the same breadth range for the past 6 months. The cumulative deviations are starting to roll over, suggesting a downturn might be ahead.
Neutral - Bearsih Signal in Stocks trading above their 200-day Moving Averages
As a contrarian indicator, sentiment works best near extremes. While not in “Extreme Greed” anymore, our sentiment measure looks like it’s rolling over as well, which is precisely what we have anticipated all along. The number of stocks overbought is also no longer above 2 Standard Deviations. For the moment, this indicator is Bearish.
Bearish Signal in Sentiment
In terms of Z-Score divergence, there is no change from last week. The broad market and SPY have advanced to the same degree.
Last week we wrote:
There is still insufficient participation in the broad market. A lack of participation from the majority of issues is very challenging at the moment, since the situation can also resolve itself with SPY “catching down” to the rest of the market. Furthermore, the “catch-down” event can be bullish (if SPY corrects more than the broad market, or bearish - if the broad market suffers losses larger than SPY, further exacerbating the divergence).
The outlook remains unchanged at this time.
Bearish Signal in Market Internals Z-Score
Dollar Transaction Volume has recovered, then lost steam again. Liquidity conditions are fine for the moment, but our thesis is that the next spike in transaction volume will occur on lower prices and higher volatility.
Neutral signal in Average Dollar Transaction Volume and Volatility
5. Trading in the Sigma Portfolio
After reviewing all of the above factors, it’s time to decide on the actual investing strategy for our real-life portfolio.
Cash levels are starting to increase in our automated models, suggesting some caution is warranted. The choice of Gold instead of equities is tilting our exposure towards “safe haven” status, uncorrelated with the equity market. Still, maintaining some exposure to stocks makes sense right now, as we need to participate in an eventual year-end rally, and the plan is to increase exposure here on a significant correction.
Automated Strategies
The Sigma Portfolio (Live)
In The Sigma Portfolio, we are boosting our cash levels by closing the position in Gold miners (GDX). This way, we maintain a balanced approach, with many names in the portfolio at risk-reward lows (more upside than downside).
We are executing the following orders at the close:
SELL 100% GDX (Close Position)
Our plan is to eventually add exposure to equities on a pullback (using cash reserves and Gold), and swap short term treasuries for longer term ones, when the right signal triggers.
For the past year, our live strategy has managed to avoid the significant drawdowns of our benchmark (60% SPY - 40% TLT). Now the plan is to pivot the allocation more aggressively and participate in upside, once it manifests.
