Portfolio Rebalance / August 14
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.
This week, our positioning in the live Sigma Portfolio is very different from what our automated strategies are suggesting. In this article, we’ll explore why we think that holding a more conservative allocation makes sense and why our systems are more inclined to take on risk.
As a reminder to everyone, any algorithmic trading system should be used as a way to understand “what a machine would do” in a given circumstance. Sometimes our thinking is in agreement, and sometimes it’s not.
Either way, the steps in our investing process are here to guide us. Let’s dig in…
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.
All major asset classes are investible this week;
From a technical perspective, SPY has managed to clear resistance at $536 and is now in a critical juncture phase. Since resistance was cleared, Enterprise (our core model) is viewing this as a bullish signal.
However, we’d like to highlight a trendline sitting slightly above the channel median, which has acted as an important level of support and resistance previously. We still haven’t seen any indication that support is confirmed by a “retest” down-move. As such, a more “neutral” wait and see approach makes more sense until the market makes up its mind.
Furthermore, critical to SPY’s rebound rally has been the heavy bounce of Tech (XLK). Tech has recently underperformed by a wide margin and many of its constituents are also influencing SPY’s returns in a major way. In the last month, SPY is down -3.67%, while XLK has lost -9.03% (that is including yesterday’s monster +3.07% surge). Despite this, XLK relative to SPY (chart below) has been trading rangebound for a while. It’s difficult to say yet if this is a buying opportunity or not in Tech shares, as our system doesn’t typically favor relative under-performers.
Commodities (DBC) failed to clear M-Trend resistance yesterday, at $22.53 and remain un-investible as a consequence.
Gold’s (GLD) has been making a steady advance in the last month, well supported at the 50-DMA and eventually headed to $237, where resistance lies. We like gold as a small position in any portfolio at the moment, despite the yellow metal being overbought.
TLT has just traded above its pivot level of $97, supported by technicals as well as fundamentals. Bonds are currently vulnerable to a hawkish stance by the Fed, which may push back against the idea of a 50bps rate cut at the September meeting (as futures imply). We’d rather wait for more data before increasing the position here, but this is one asset class to buy on the dip.
Enterprise, our core investment strategy, has increased equity risk exposure near maximum levels. The logic behind this decision is SPY’s technical resilience (as well as level break), and the favorable stocks-bonds ratio.
Stocks exposure via SPY is increased from 45% previously to 73% today.
Bonds exposure (IEF) is increased from 15% previously to 21.7% today.
The position in GLD is decreased to 2.34%, from 5%, on profit taking.
Commodities are not investible, so DBC is not traded.
Cash now constitutes just 2.8% of the portfolio.
Since this model only trades 4 ETFs, we use it to judge overall portfolio positioning. The strategy has flipped risk on, as it considers the previous correction episode as “over”.
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).
Last week we wrote:
“When so many factor ETFs are buyable, our read is that a technical short term bounce is in the books.”
As expected, that’s exactly what happened. However, despite the bounce, all of the factor ETFs that we are monitoring have now entered a negative medium-term trend. This indicator is slower to turn than the MACD. The interpretation for now is that we need to wait for more clarity, before taking decisive action. Last year, more than 5 consecutive weeks of all factors experiencing a negative trend were recorded, before a tradeable bottom was in.
In the short term, there are no extreme extensions, but the fact that all factors are trading above their 200-DMA is noteworthy. Only the Dow Jones Industrial Average (DIA), Emerging Markets (EEM), Value Stocks (IVE) and the Equally Weighted S&P500 (RSP) are trading above their respective 50-DMAs.
Longer term, the relative underperformance of Nasdaq (QQQ) and Foreign Developed Markets (EFA) is truly striking. While a reversal could be in the books, we would prefer to maintain allocation to outperforming factors like Momentum Factor ETF (MTUM), Growth Stocks (IVW) and the iShares Russell 2000 ETF (IWM).
Among more granular Factor Returns, companies with a high ROIC (return on invested capital) have been favored in the short term. ROIC is a classic performance metric, which is also used in our Millennium Alpha ranking model - it’s no surprise to see these companies outperform, especially in a flat or lower market (1 month and 3 month periods).
As we can see from the ranking, in the past week, high growth / high margin companies have done best.
Over all timeframes, two factors stand out - Earnings Yield and Gross Profit Margin. The rankings for both express investors preference for companies able to pass on costs to their clients (high Gross Margins), while also showing a healthy EPS to share price ratio (Earnings Yield
Here’s how we stand on the Sectors front:
We have included 3 former tables from previous articles, for your convenience.
Among sector ETFs, we can clearly see the market’s preference for defensive sectors. Staples (XLP), Real Estate (XLRE), Utilities (XLU) and Healthcare (XLV) are the only ETFs recording a positive medium term trend, while simultaneously trading above all key moving averages and outperforming SPY on a relative basis.
Utilities (XLU) and Real Estate (XLRE) are extended both in the short as well as the long term.
This setup is not representative of a “risk-on” market.
The high beta sectors - Tech (XLK), Consumer Discretionary (XLY) and Communications (XLC) are all relative underperformers in this environment. On a possible bullish note, all of these sectors have successfully retested their respective April lows.
Nostromo’s back, baby! Our quirky tactical allocation model has outperformed both of its benchmarks in the last 6 months. It has achieved this return with only -3.2% drawdown nonetheless!
The model has managed to find its entry points and is now more than fully allocated to stocks and bonds. If we take away the effect of leverage, the strategies allocation is similar to Enterprise.
On the equity side, the following ETFs are included in the portfolio:
Equally Weighted S&P500 (RSP)
Emerging Markets (EEM)
Basic Materials (XLB)
Stocks make up 87% of the portfolio value (67% if leverage is excluded).
On the bonds side, Nostromo holds a sizable position in TLT, at 42% of portfolio value (33% excluding leverage).
With cash at -29% the strategy holds a respectable degree of leverage (1.3x); its overall allocation echoes Enterprise, with more emphasis on long term treasuries.
3. Individual Stock Selection
The Millennium Alpha portfolio is becoming less and less dominated by Tech and Momentum stocks.
Instead, exposure has shifted towards industrials, healthcare and mid-cap stock picks. Some of the companies in this portfolio are at all time highs as of this writing, despite the market correction.
While the portfolio has taken a -7.4% tumble in the last 3 months, it has managed to outperform the market regardless.
As per usual, you can tweak Millennium Alpha’s selection 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.
Market breadth looks weak when viewed through the lens of the recent rebound rally. We would have expected to see more stocks trading above their 20 and 50-DMAs.
Consider the following: at the bottom of the April correction, 655 stocks were trading above their 200-DMAs; now, after a substantial surge in the past week, 639 stocks are trading above their 200-DMAs. This figure is below the April lows, and shows that resilience is deteriorating below the surface, and despite rally efforts.
Bearish Signal in Stocks trading above their 200-day Moving Averages
As a contrarian indicator, sentiment works best near extremes. We are now at a point where sentiment is almost perfectly neutral (51 / 100), so this indicator is not very useful.
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.
Same as last week, today’s note reads:
For the first time since early 2023, large and small caps are registering the same level of absolute performance, reducing the disparity to around 0. This is great news, as it shows the resilience of the average stock, despite the pullback in large caps.
Bullish Signal in Market Internals Z-Score
Dollar Transaction Volume has collapsed on the recent price surge. Investors were much more willing to transact at lower prices than they’ve been on the way up. Thin liquidity is also part of the reason why prices have been more volatile lately, including on upside moves.
The conclusion is clear on this indicator: low volume on high prices is bearish.
Bearish 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 models are going risk-on in an otherwise neutral market. While we agree with their positioning in the longer term, momentarily the market is perfectly balanced. Substantial risk to the downside continues to exist in the equity space.
Depending on one’s previous positioning, the current juncture offers both the prospective buyer and seller a reason to transact. On one hand, the healthy market rally has broken through a series of technical levels associated with a continuing bull market. That is why our models are maintaining an aggressive exposure profile in both equities and bonds.
On the other hand, for investors who had been excessively allocated toward risk, the present moment is a great time to press the SELL button. We’re not trying to “predict” market movements, but rather rebalance risks to whatever value “neutral” means for each of us.
In our case, we have already achieved this neutral positioning, with both stocks and bond holdings close to their minimal values given a bull market backdrop. In our case, 35% equity exposure is the minimum, but for other investors this can be 60% for example.
Once we get a better handle on where the market goes from here, we will react by adjusting exposure accordingly.
Again - rebalancing portfolio risks is not about “predicting” what the market will do, but making capital preservation the priority. Both positive as well as negative outcomes are equally likely in the short and medium term from here on out.
Automated Strategies and Market Outlooks
The Sigma Portfolio (Live)
Our recent trading actions have emphasised the cutting of laggards out of our portfolio. This process is essential for long term performance, as we want to be adding toward positions which are working, instead of being detrimental to our performance.
The next steps entirely depend on the direction of the market going forward. We have a lot of cash on the sidelines waiting to be deployed, and we need to find the opportunities which will allow us to do so efficiently.
Click here to access our own tracker for the Sigma Portfolio and understand how the positions contribute to the overall exposure profile.
In total, we stand to gain $6.081 by risking $5.945 if our targets are correct. The risk-reward equation is unfavorable and reflects the market’s almost perfectly neutral disposition.
Factors exposure is more tilted toward the Equally Weighted S&P500 (RSP), Value Stocks (IVE) and Mid-Caps (MDY).