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 strategies have struggled to gain traction amid a market that has offered little trading opportunities. Reduced overall exposure has helped limit volatility, and in the context of an ongoing correction, this positioning makes sense to us as well. The U.S. Dollar has been able to maintain its footing, although a real breakout is still elusive.

Smart beta models have refreshed their portfolio positions (a process that takes places every month) and we’ll get a chance to review their allocation on a micro and macro level.

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.

As we’ve said in various missives, equities (SPY) were prone to correct, given their extended nature. While a rally to all-time-highs loos likely at this point, such a run does not happen in a straight line most of the time. That is why, we must assume for now that the current corrective phase has not completely run its course. We see sufficient “buy-the-dip” support at $431, just below the 50-DMA.

Despite holding up well, commodities have failed to break above S2 resistance (24.69 on DBC). In our view, this leaves DBC prone to downside, failing a decisive breakout.

Gold is treated by our system as an alternative to equities at the moment. The logic is 3 fold: both equities and gold represent inflation hedges. Both would benefit given lower yields. Both have technically outperformed recently. Gold has a better technical set-up and is preferred as a consequence.

Similar to SPY, GLD has corrected and now stands near technical support. We’ll be looking for buying opportunities soon.

The U.S. Dollar has also failed to break out of the current technical range. While potential upside exists (to $29.4 on UUP), we need to be realistic about its channel slope. Currently sitting at 7.46%, the resulting CAGR appears unsustainable. It would mean all other currencies and assets would depreciate at this rate versus the dollar. This anomaly may continue in the short term, but the overall trajectory appears too aggressive.

Treasuries, which represent deferred Dollars, have been absolutely clobbered. While we do like the asset class overall, we need to wait for the right BUY signal to add to our bonds position.

Enterprise, our core strategy, is looking to re-deploy cash into both bonds and gold.

The Enterprise Strategy

Enterprise, our most conservative model, maintains a 66% long physical Gold position, as well as a 20% TLT position.

Since this model only trades 4 asset class ETFs, we use it to judge overall portfolio positioning.

Enterprise is looking to increase sizing of both Gold and Treasuries, according to the relevant BUY signal.

While no such signal has been triggered yet, both assets are trading near favorable risk-reward levels. Patience is required here.

Cash allocation remains 14%, and will be decreased in favor of Gold and Treasuries.

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).

In contrast to the previous 2 weeks, some Factors are starting to shift no a negative Medium-Term trend (QQQ and EFA). Our selection system would underweight these ETFs for now.

Emerging Markets (EEM) and Foreign Developed Markets (EFA) are both trading below normalized 50 and 20 day moving averages, while all Factors except the DOW (DIA) are showing signs of technical deterioration.

Longer term, Nasdaq (QQQ) and Growth Stocks (IVW) continue to be highly extended, while the Dow Jones Industrial Average (DIA) and the Equally Weighted S&P500 (RSP) are huge relative-to-SPY underperformers.

It’s too early to buy-the-dip in any of the outperforming factors yet. We need to wait for a better entry point, and a proper resolution to the current correction. Meanwhile, we see DIA and RSP as the safest places to hide. The Russell 2000 ETF (IWM) is starting to outperform, but has struggled with technical resistance as so far.

Compared to SPY, you can clearly see how IWM’s performance could be set to improve in the second half of the year.

There are no immediate technical opportunities of note for Factors, as in the short term, none are oversold.

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 notice the same trends of emerging deterioration. Tech (XLK) and Utilities (XLU) have begun negative Medium Term trends, while the downside deviation (both long and short term) for Utilities deserves more scrutiny.

In the short term, many deviations have been cooled, and no sector is abnormally detached from its moving averages. Longer term, however, Transports (XTN), Tech (XLK) and Communications (XLC) remain heavily bid.

The bull market driver (and highest beta sector) - XLK - is nearly oversold, and trading below its 50-DMA. On the right BUY signal, this is a tactical opportunity to add or increase related exposure. We need to be patient and let the current correction run its course: XLK most likely needs to reach key support levels at $165 and $155, in order to properly reverse overbought conditions.

Utilities (XLU) are the lowest beta-to-SPY sector, at just 0.29; you could almost say a negative correlation is forming between the two. As high dividend payers, Utilities companies are usually selected in yield intensive portfolios, as a higher risk version of treasuries. The sector has been trading flat for the past 2 years, and higher yields are really putting pressure on the stock prices for the entire industry.

Despite the “flat” recent performance, Utilities have outperformed treasuries by a huge margin. Compared below, XLU in orange and TLT in white, via our Peer Finder Instrument.

The only notable technical opportunity that is forming is Tech (XLK).

The Nostromo Strategy

Nostromo, our tactical allocation model, is increasing bond exposure today via IEI ETF. The model will initiate a 12% position in the ETF that carries exposure to 3-7 year duration Treasuries. This trade will take the overall bonds exposure to 32% of portfolio value comprised of TLT (20%) and IEI (12%).

The intention is to gradually increase bonds exposure via TIPs, as well as investment grade corporates (LQD), if the proper signal is triggered. TLT would be entirely sold on a violation of support in this model.

The strategy is looking to increase precious metals exposure, now that Gold has reached a more promising risk-reward level. It is looking to diversify into silver, as well as increase the position in miners.

Nostromo holds a generous dry powder reserve at 46% CASH, due to its tactical nature.

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

This week, we will configure the Fundamental screener manually, and see if we can find notable “buy-the-dip” opportunities in the technology space. Here are the settings:

• Correlation with XLK (Sector)

• Operating Leverage > 1

• Pietroski F-Score >= 6

• Z-Score Relative > 0

• Sharpe Ratio > 0

22 stocks make the list:

We’ll plot the first two technical columns (Sharpe Ratio and Z-Score Relative) as A and B on a scatter plot. This will allow us to visually inspect the relationship, and remove outliers which are prone to revert and underperform.

AVGO, AAPL, NOW, PLAB, are tickers that stand out on the list. 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 Momentum portfolio, which has been put a bit on the back burner lately due to its performance drawdown. However, the heavy allocation towards Energy (XLE), Industrials (XLI), Mid-Caps (MDY) and RSP has protected our Momentum model from a heavier drawdown.

It has picked up performance and obliterated its benchmark (MTUM) on a 3 month lookback window, without registering the current correction happening across major factors like the Tech heavy SPY. The portfolio only has a 0.4% drawdown in the near term.

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 in terms of moving averages is recording a pullback. This is typical after short term peaks in performance, and currently points to consolidation ahead.

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

Sentiment has cooled sharply. Compared to just 2 weeks ago, the number of stocks oversold is about equal to the number of stocks overbought.

As a contrarian indicator, sentiment works best near extremes. Right now, we are in the middle of the sentiment band, with a “Neutral” mentality.

Neutral Signal in Sentiment

In terms of Z-Score divergence, there is no change from last week. The broad market and SPY have corrected to the same degree. This is not great news, as we had anticipated a “closure of the gap” in an eventual correction.

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).

So far, the market has corrected about as much as SPY itself, keeping the divergence historically elevated.

Bearish Signal in Market Internals Z-Score

Dollar Transaction Volume has not picked up, despite the recent correction. We are expecting to see a volume spike once participants really start buying the dip. So far, we are not seeing enough interest at current prices, suggesting more downside is available.

Bearish 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.

After a brief dip in defensive territory, our strategies are starting to look for re-deployment opportunities. None have surfaced just yet, and our human logic dictates the current pullback is incomplete. It’s too early to increase risk exposure right now, as the correction still has fuel left. Here’s an overall look at our models allocation:

Automated Strategies

The Sigma Portfolio (Live)

In The Sigma Portfolio, we are maintaining a balanced approach, with exposure to 4 asset classes (Equities, Gold, Treasuries and Cash). Using our Portfolio Tracker, we can determine our exact Sector / Factor exposure for the equities part of the allocation as seen below.

On the sectors side, exposure to Financials (XLF), Energy (XLE) and Industrials (XLI) is high. We are looking to decrease Transports (XTN) and increase Tech (XLK).

In terms of Factors, we are keeping IWM, MDY, RSP and DIA correlation high, while at some point looking to buy more QQQ exposure in order to bring balance to this space.

You can access this correlation distribution for your portfolio as well by setting up the Portfolio Tracker.

For now, there is no need to make any adjustments. We'll keep you in the loop with our trading as necessary.