Portfolio Rebalance / August 16
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 begun raising some cash in anticipation of further corrective action in all asset class markets. While the adjustments are slim, they are proportionate with the magnitude of the pullback so far. The U.S. Dollar has remained on solid footing and has shown signs of a continued breakout.
Not all markets are prone to the same amount of risk, however. We’ll study each, and draw our conclusions at the end of the article, after going through all of the metrics.
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. Gold has taken the lead from equities (SPY) as the best performing asset class of the past 200 trading days.
Last week, we wrote:
“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.”
Such is why SPY’s break of the 50-DMA yesterday comes as no surprise. We maintain the same view for this week as well, as equities continue to retreat in a broad pullback. The most logical support level remains $431, some 2.4% lower than the last close (R1):
Despite holding up well, commodities have failed to break above S2 resistance (24.69 on DBC). DBC remains prone to downside, after failing decisive breakout; that downside measures about 2%, a bit less than equities.
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 in terms of target allocation.
Similar to SPY, GLD has corrected and has broken through technical support. There is more immediate support at $174 (-1.4% lower than the last close), and further support at $170 (-3.73% lower).
Meanwhile, the U.S. Dollar has broken above resistance at $28.61 on UUP, and has significant material upside. Should this upside manifest fully, it would maintain the Dollar’s 7.2% CAGR, which is not great news for any other asset class bull. More upside for the dollar will coincide with lower asset prices everywhere else in the short term.
Treasuries, which represent deferred Dollars, continue to struggle under selling pressure. Downside appears limited at the moment, with -2.4% downside to the $92 support level. 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 reduce gold exposure following the break of support.
Enterprise, our most conservative model, maintains a 65% 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 add 10% of portfolio NAV to its TLT position, provided with the right BUY signal.
It is also looking to reduce the position in Gold by around half, if the right signal is triggered.
Cash allocation remains at 14%, and will be slightly increased if both positions adjustments occur.
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).
Several factors are starting to form negative Medium-Term Trends (compared to 2 weeks ago, when everything was positive). This is a natural part of the corrective cycle.
All factors, except Momentum (MTUM) and the Dow Jones Industrial Average (DIA) are trading below key 20 and 50 daily moving average levels. For those factors that are relative outperformers, this pullback represents a buying opportunity. Short term, no factor is sufficiently oversold yet, however.
Longer term, Nasdaq (QQQ) and Growth Stocks (IVW) continue to be highly extended, but less so than a couple of weeks ago. These deviations take time to fully resolve, and it pays to stay patient here.
For the iShares Russell 2000 ETF (IWM), the breakout we detected was false, after all. Small Caps have continued to be confined to the range they’ve been trading in since April 2022.
According to our analysis, a tactical opportunity is in the making. The following Factors could be set up for dip-buying:
Growth Stocks (IVW)
Nasdaq (QQQ)
They are both relative out-performers and are currently oversold enough to warrant attention. The proper signals need to trigger, however, since QQQ maintains considerable downside to the next support level ($349, some -4.6% lower than the last close).
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 that half of the sectors are still maintaining a positive Medium Term Trend (Healthcare, Energy, Financials). Interpreted in the context of a continuing correction, this tells us we have a way to go until the drawdown is complete (when most sectors will form a negative M-Trend).
In the short term, many deviations have been cooled, and no sector is abnormally detached from its moving averages. Longer term, however, high beta sectors Transports (XTN), Consumer Discretionary (XLY), Tech (XLK) and Communications (XLC) remain detached from recent prices.
The obvious “buy-the-dip” opportunity here is Tech (XLK). It is a relative out-performer that has pulled back. But is the current drawdown enough or is there more to come?
The bull market driver (and highest beta sector) - XLK - is oversold, and trading well below its 20 and 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 heavily overbought conditions.
There are notable tactical opportunities forming. The high beta sectors that have corrected the most, may offer attractive entry points on a trade signal:
Tech (XLK)
Consumer Discretionary (XLY)
Transports (XTN)
Nostromo, our tactical allocation model, is closing the position in Gold Miners today (GDXJ), on a STOP-LOSS violation. While the model would still like to partly own this ETF, there are strict exposure rules it must adhere to. This trade brings the overall precious metals exposure to 1%.
The strategy would also rotate out of TLT and into various other bond-class ETFs (TIP, LQD, IEI).
Nostromo’s cash reserve has just increased to 67% in quite a defensive move. It is now the least risk-exposed model that we own.
The only notable asset class Nostromo holds are bonds, at 32% portfolio weight.
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 are fixing an issue with our stock screener, so the section will be skipped from the article.
This week, we will spotlight the Millennium Vision portfolio, which holds the most exposure to sectors we would be interested to buy on weakness (XLY, XTN, XLK). Stocks like Zillow (Z), Bill Com (BILL), Alteryx (AYX), HubSpot (HUBS) or Sprout Social (SPT) could make it in the Sigma Portfolio eventually.
In terms of performance, when looking back at the last 2 years, it seems like the worst of the drawdown is over for this style of portfolio. After a harrowing 66% decline from all-time highs, high growth potential companies are becoming stable in terms of price performance.
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, and for the moment the Sigma Score differential between SPY and the broad market is normalizing (this is good). For now, this instrument looks like it is in the middle of a consolidation.
Neutral - Bearish Signal in Stocks trading above their 200-day Moving Averages
Sentiment has taken another turn south. After the euphoric period in mid-July, we are heading straight to the desperation, “doom and gloom” zone. We’re not there yet, but recent history shows us that this bipolar market will eventually reach “oversold” sooner rather than later.
As a contrarian indicator, sentiment works best near extremes. Right now, we are in the middle of the sentiment band, with a slight “Fear” mentality. Doubts are beginning to creep in for the bulls.
Neutral Signal in Sentiment
In terms of Z-Score divergence, there is no change from last week. The broad market and SPY have corrected almost to the same degree. This is not great news, as we had anticipated a “closure of the gap” in an eventual correction (where SPY would fall more than the broad market). We are in a correction right now, and that gap is not closing.
Bearish Signal in Market Internals Z-Score
About the only bullish market internals indicator remains Dollar Transaction Volume. Volatility is suppressed, despite the downturn, while volume itself is slumping.
Lower volume on lower prices is bullish, as it indicates there is not a lot of interest from sellers at these levels.
Bullish 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.
As we noticed at the beginning of the article, our automated strategies are raising quite a bit of cash and getting defensive. The overall cash level stands at 37%.
Automated Strategies
The Sigma Portfolio (Live)
In The Sigma Portfolio, we are also maintaining a raised defensive profile, although we have added to equity exposure in the past week. At 19% cash and 13% short term bonds, there is plenty of dry powder to deploy when the time is right. 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 Real Estate (XLRE) and increase Tech (XLK) and Consumer Discretionary (XLY).
In terms of Factors, we are keeping IWM, MDY, RSP and DIA correlation high, while at some point looking to buy more QQQ and Growth Stocks (IVW) related exposure in order to better balance exposure.
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. Positions are starting to hit the low end of their ranges and risk has effectively been priced out of our portfolio.
