Portfolio Rebalance / August 23
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.
As stated in our Weekly Preview Article, our automatic systems (Enterprise and Nostromo) were right to be buyers early last week, and we were wrong to be sellers. That puts us in the unenviable posture to play “catch up” with portfolio exposures in the next period, and we have started doing just that this week.
While bullish momentum is clearly building, Powell’s Jackson Hole speech has the potential to act as a ket catalyst to either push stocks above resistance or cause a short term pullback if his tone is hawkish.
On that note, V shaped pullback and recovery moves in the stock market have generally been bullish on the medium and longer term. Sentiment Trader recently did a study on these instances:
“Stocks are already overbought on some measures, and sentiment is quickly recovering from the brief freak-out a couple of weeks ago. The run has been astounding, but past performance after impressive v-shaped bottoms suggests that there should be more gains in store over the next couple of months.
The biggest caveat is that it has been exceptionally unusual to see this type of move during uptrends, and the only other times it happened, gains were capped in the weeks and months ahead. An objective look at what is inherently emotional trading behavior suggests that we should be modestly confident that this rapid shift in momentum should carry stocks even higher. However, since it’s occurring so near record highs, we shouldn’t be overly confident that we can rely on the types of gains after more protracted declines.”
While we agree with the bullish overtones in the mid and long term, a lot of these jarring episodes are followed by a second corrective period:
Against this backdrop, we’ll perform our rebalancing process - keeping an eye on the Jackson Hole developments.
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 remain investible this week, except Commodities.
SPY is trading near the high end of its consolidation range, and depending on how today's session goes we’ll have more clarity on the direction of the market in the near term. We can interpret yesterday’s session as a “rejection” from R1 resistance ($564). This is unsurprising, as volume has been very thin on the V-shaped rebound and the market was becoming short and medium term overbought.
Today’s key catalyst has the potential to resolve the current correction in one of 2 ways: either with Powell sounding dovish and boosting markets past all-time-highs, or expressing some hawkishness and sending stocks lower toward a cluster of support ($538-$546, M-Trend + 50-DMA + 20-DMA, -3.23%).
Commodities (DBC) failed to clear M-Trend resistance during the rally last week, and remain un-investible as a consequence - despite being oversold.
Gold’s (GLD) has continued to trade in a bullish trend, as major investors are clearly accumulating the yellow metal. Both support and potential resistance are slowly moving up, as the price advances.
TLT (along with SPY) is subject to a fair share of volatility today, as the future path of interest rates hangs in the balance. Notably, most professional as well as retail investors are about as bullish as they can be on treasuries at the moment. While technically strong, the rally in long term bonds is vulnerable to any hawkish rhetoric or data which supports a strong economy (and higher yields).
In order to be profitable when trading bonds, investor’s expectations about Fed policy need to differ from those of the market. Therefore, with the Fed seemingly embarking on a series of interest rate cuts, it’s important to appreciate how many interest rate cuts the Fed Funds futures market expects and over what period.
Currently, Fed Funds futures imply the Fed will start cutting rates in September and reduce them by 2.25% to 3.09% in early 2026. Market pricing does not imply a recession, but a normalization of GDP trends. If the Fed Funds futures market is correct, the upside in bond prices may be limited, especially compared to prior easing cycles. The real upside potential for bonds comes from a higher than expected decline in inflation or a recessionary period.
Enterprise, our core investment strategy, has maintained a similar asset allocation weighting to last week.
Stocks exposure via SPY remains at 73% today.
Bonds exposure (IEF) is is slightly increased from 21.7% previously to 22.8% today.
The position in GLD is maintained near 2.5%.
Commodities are not investible, so DBC is not included in the asset allocation positioning.
Cash constitutes 3.07% of the portfolio.
Since this model only trades 4 ETFs, we use it to judge overall portfolio positioning. The strategy maintains a balanced, “risk-on” approach to asset markets, one that we are aiming to emulate in our live portfolio as well.
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).
A recovery is starting to take shape in factor ETFs. In the previous week, all of the factors exhibited a negative medium-term trend, whereas now 3 factors are showing a positive trend.
Furthermore, all factors are trading above all of the key moving averages, without being overbought.
Longer term, most factors are actually outperforming relative to SPY, a positive market breadth development. The underperformance of the Nasdaq (QQQ) stands out like a sore thumb on the bottom right graph, and requires more investigation. The QQQ / SPY chart below reveals that since July 17 2023, taking on more risk via the high beta QQQ ETF would not have yielded superior returns to SPY, as the ratio between the two instruments is roughly at the same level today.
Among more granular Factor Returns, expensive companies are making a comeback! A high Price-to-Sales ratio has been correlated with top performance in the short term.
Over all timeframes, Earnings Yield remains a top factor, especially on longer timeframes. This factor does appear to drop off in performance, especially at the 1 week and 1 month intervals. Buying opportunity?
Here’s how we stand from a Sectors standpoint:
We have included 3 former tables from previous articles, for your convenience.
Similar to the Factors dashboard, we are seeing signs of a recovery in Sectors ETFs as well, from a trend perspective. 6/12 ETFs that we track exhibit positive medium term trends.
In both the short and longer term, defensives --Utilities (XLU), Staples (XLP), Healthcare (XLV) and Real Estate (XLRE) -- are grossly overbought. Tech (XLK), Energy (XLE) and Transports (XTN) are the only sectors trading below at least one key moving average.
This is an otherwise balanced leaderboard, offering little in the way of tactical allocation opportunities.
As Nostromo has come alive this summer, it pays to explore the logic of this quirky tactical model.
The strategy’s focus now will shift to unloading the leveraged exposure it has gained during the past month.
Given the proper SELL signals, the model will sell all of its current equities exposure in Basic Materials (XLB) and the Equally Weighted S&P500 (RSP). In theory, these positions will be replaced with a plain SPY allocation, but that trade has minimal chances of occuring at the moment.
On the bonds side, Nostromo holds a sizable position in TLT, at 41% of portfolio value, but the strategy wants to actually increase this further.
If leverage is excluded, this model mirrors Enterprise in that it’s Stocks - Bonds allocation stands at 66% - 34%.
However, Nostromo is using leverage to invest, as its negative (-21%) cash allocation shows.
3. Individual Stock Selection
The Millennium Alpha portfolio has reclaimed its high water-mark this week, as markets recovered. Its exposure profile has evolved from emphasizing momentum to mid-caps and growth companies on the factors side and industrials + healthcare on the sectors side.
The Vol Target variant of Millennium has also reached a new high watermark, as performance has improved in all models.
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 has recovered nicely during the V-shaped recovery. All values look healthy at the moment.
Bullish Signal in Stocks trading above their 200-day Moving Averages
As a contrarian indicator, sentiment works best near extremes. The current reading (62/100) is tilting slightly toward “Greed”, but there is nothing egregious in this metric just yet. Sentiment can certainly get more overbought.
Notably, we haven’t seen extremes in this indicator in 2024, in a sign that market volatility has taken a turn lower.
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.
This week, the alignment in performance between the broad market and SPY continues, and for a brief moment the broad market actually proved to be more resilient during the August drawdown. We view this as a bullish development.
Bullish Signal in Market Internals Z-Score
The only glaring issue with market breadth at this point is Dollar Transaction Volume. There has been an incredible reluctance on the part of investors to “chase the recovery rally”, leading to some of the lowest trading volumes seen in 2024.
This indicator acts as a major red flag, until either:
Volume normalizes on high-ish prices
Prices drop, and volume does not spike
Either way, the point is to get some confirmation from volume that prices can be “trusted”. In the absence of regular / high transaction volumes, prices in the market may be viewed as “abnormal”. In this case, the V-shaped recovery is questioned.
(VERY) 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.
We have taken various portfolio actions during this week in order to bring our allocation back near target weights. While we’d still like to see a confirmation of a “support retest” in SPY in order to get monstructive on risk exposure, there is no need to be overly defensive at the moment.
At the time of this writing, mr. Powell has delivered his speech at Jackson Hole and his remarks have led to a nice rally. Specifically, on interest rates, he gave his explicit endorsement for rate cuts, saying further cooling in the job market would be unwelcome:
"The upside risks to inflation have diminished. And the downside risks to employment have increased."
"The time has come for policy to adjust. The direction of travel is clear, and the timing and pace of rate cuts will depend on incoming data, the evolving outlook, and the balance of risks."
"We do not seek or welcome further cooling in labor market conditions"
These statements are in-line with the market’s thinking, and we are continuing to increase our exposure as required. The risk of a shallow correction remains, and we should get a better picture by mid-September.
Automated Strategies and Market Outlooks
The Sigma Portfolio (Live)
Today, we are adding Cintas Corporation (CTAS) to our portfolio, with a 5% weight, taking the total risk exposure to 51%.
Executing the following order at market close:
BUY 5% CTAS (Initiate 5% Position)
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 $11.070 by risking $8.799 if our targets are correct. The risk-reward equation has improved primarily by including upside from treasuries.
Factors exposure is well balanced at the moment, with an emphasis on the Equally Weighted S&P500 (RSP).