Portfolio Rebalance / 06 December
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.
As markets heat up and sentiment gets extended, some of our models indicate that the time to sell has arrived. Total system exposure has dropped from 85% to around 75% this week, as our automatic strategies have started to take profits. In this article, we’ll take a look at the various indicators on the platform and square their signals with our own fundamental view.
For the moment, the equity market is underpinned by bullish technicals, and treasuries have recovered nicely as financial conditions loosen. The question facing investors in the next period is whether we’ll see another period of reversal, or a breakout will finally ensue in 2024 toward all time highs.
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.
Equities, Treasuries and Gold are investible; Commodities have lagged recently, as oil has slumped due to global demand concerns.
We’ll turn to a fundamentally adjusted SPY chart, assuming our November 2023 aggregated price target and historical 7% EPS growth rate. Technical fair value for SPY sits at $445 (also support, -2.4% below the last close), while our upside for year-end is pinned at $467, or +2.4% above the last close. Risks are balanced as technicals suggest that dips will be bought.
The MACD Signal is rolling over from a very high reading; combined with still overbought levels of sentiment, the rally from late October looks to be all but over for now;
Commodities have succumbed to selling pressure, led to the downside by the large decline in oil (-6% on the week). DBC is now below immediate resistance, at $23.6, and is max oversold (1 / 100). If the benchmark commodity ETF cannot bounce quickly, downside is quite far below the last close, at around $22.4, near the June 2023 lows.
Gold has experienced a technical “blow off top” recently, as prices spiked to historical all time highs. With yields on treasuries moving lower, the penalty for owning gold (an asset that provides no yield) is lowered. As a consequence, bullion price jumps. Technicals remain bullish for the yellow metal, with downside at $180 and support at $184.
The U.S. Dollar (UUP ETF) has recovered slightly from its recent downturn. The bounce has not really weighed on every other asset class so far, but the trading range has become very narrow. Breaking this range higher or lower will definitely have consequences (lower = bullish, higher = bearish for everything else).
Bonds are close to reaching technical resistance ($98 on TLT) as the rate cut narrative gets priced in. TLT is highly overbought (99/100), and a consolidation or selloff is needed before continuing to ramp higher.
Enterprise (our core investment strategy) is only focusing on equities, treasuries and gold. Commodities have been excluded from the portfolio for the time being.
Cash is also sitting at low levels (just 2%), as technical trends favor all of the other asset classes.
Since this model only trades 4 ETFs, we use it to judge overall portfolio positioning. The allocation is quite aggressive, with the model comfortably taking on equity risk via its position in SPY (82%). For the time being, this allocation makes sense, as the stock market is well supported by technical conditions.
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).
All factors are now experiencing positive Medium-Term Trends - such comes as no surprise, as the correctionary period in late October had all of these trends reading “Negative”. Now, in a sort of whiplash action, the all-positive environment leads us to believe some differentiation will become the norm going forward. In other words, we are picking up a clue that a rotation is in order rather than another all-out correction. All factors are trading above all key moving averages.
On a short term basis, the Dow Jones Industrial Average (DIA), Value Stocks (IVE), iShares Russell 2000 ETF (IWM), Mid-Caps (MDY) and the Equally Weighted S&P500 (RSP) are extended to the upside.
This is a net positive for market breadth, as these factors are highly correlated with the “broad market”. In the IWM chart below, we have removed the usual trend-lines in order to focus solely on the levels. We believe the fate of this range trade will be the fate of the market in 2024. As small caps have lagged badly and market breadth has suffered, these economically sensitive stocks should outperform if a recession evades the economy (and break above $205).
Conversely, breaking below $172 yet again will probably in response to bad news.
Longer term, factors are well behaved, with only Nasdaq (QQQ) looking extended. A rotation trade would imply capital moving from the mega cap tech stocks into small cap stocks (IWM) and emerging markets (EEM).
Here’s how we stand on the Sectors front:
We have included 3 former article editions as well, for your convenience.
All sectors except Energy are now registering a positive Medium Term Trend. This is a testament to the fact that Energy (XLE) is the sole true diversifier among the whole group. This is logical, as the Energy complex relies on commodity prices, which are linked to inflation and growth expectations. Energy companies cannot sustain current valuations if commodities retreat further.
Financials (XLF), Industrials (XLI), Real Estate (XLRE) and Transports (XTN) are highly deviated to the upside in the short-term.
Longer term, none of these sectors look overbought. Instead, Tech (XLK), Communications (XLC) and Consumer Discretionary (XLY) fit this bill, but the deviations are not that extreme anymore.
To us, Energy (XLE) does not seem buyable just yet. Long candidates for a rotation trade are Utilities (XLU), Staples (XLP) and Healthcare (XLV) - the defensive sectors. The middle of the market (Financials, Industrials, Transports) also looks good. On the short side of a rotation, capital would come out of Tech (XLK) and Communications (XLC).
Nostromo, our tactical allocation model, is almost fully allocated to cash. This is surprising, as we would have expected the strategy to hold on to existing positions for a while longer.
With 98% in cash, the model is looking to buy SPY and TLT on the next available BUY signals. These signals won’t arrive for a while, given that both ETFs are highly extended to the upside currently. They first need to become oversold to a certain extent.
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.
What the model is trying to avoid here is a repeat of September - October of last year, when a similar pattern played out. We don’t believe this is the case right now at all.
3. Individual Stock Selection
Our flagship Millennium Alpha model hit an all-time-high on December 01 2023, beating the S&P 500 by 20.00% over a 2 year period. The excess sharpe generated by the model comes in at 2.00, with a statistical alpha of 12.40%. Over the same time period, the S&P 500 was essentially flat, up just 1.9%. In addition, the model’s drawdown during the 2022 bear market was less severe, exposing our clients to less risk than the benchmark index (-18.3% vs -21.3% for the S&P 500).
While the December ‘21 - October ‘22 period was marked by similar performance, a clear divergence starts forming as stock markets recovered into 2023. Over the 2 year period, our strategy generated 9.9% annualized returns.
In factor terms, the portfolio is highly correlated with Nasdaq (QQQ), Mid-Caps (MDY) and the iShares Russell 2000 ETF (IWM). From a sectors perspective, these stocks are mostly correlated with Industrials (XLI), Consumer Discretionary (XLY) and Tech (XLK).
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.
627/1000 stocks we track are trading above their 200-day moving averages. This is a healthy number that flips this indicator to “bullish”. Previously, the peak of the recent range was established at 778 stocks, so there is still some room to the upside.
Bullish Signal in Stocks trading above their 200-day Moving Averages
As a contrarian indicator, sentiment works best near extremes. We’ve just recorded an “Extreme Greed” reading on December 01. Usually, periods of extreme greed and fear last around 10 to 15 calendar days. While the signal has retreated in the interim (now showing just “Greed”), it is not uncommon to see a reversal higher yet again.
We don’t believe that we’ll experience a full reversion to “Extreme Fear” this time around. Take a look at the highlighted period, in November - December 2022. Back then, we also had an “Extreme Greed” reading, followed by “Neutral”, followed by more “Extreme Greed”. We believe this to be the case now as well.
Bearish 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). We are still not getting a healthy advance in the broad market, as performance leadership is highly concentrated in the top 10 S&P 500 companies. We’ll need to see much stronger small caps participation in order to turn this signal “bullish”.
Bearish Signal in Market Internals Z-Score
Above average Dollar Transaction Volume is looking healthy. Generally speaking, volume is a confirmation indicator for price. As long as we are seeing higher transaction volume on higher prices, the equity market is said to be well supported. Also, note the flattening of the polynomial average, as real liquidity conditions have stabilized.
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.
Right now, the equity market is in a neutral state. Despite being “overbought”, there is plenty of breadth and transaction volume support in the short term to be optimistic about the general direction of prices. Dips can still be bought for short-term upside.
Rather than call for a full “crash”, we believe that the most likely path forward would be a rotation trade. In this scenario, money would flow from the overbought tech sector into smaller cap companies and “mid-market” sectors. In an optimistic scenario, the gap between factors will close, without the overall market moving too much.
As a result, we’ll tilt our portfolio toward these types of stocks slowly, by taking profits in positions that have reached their potential (like FICO yesterday). In an overbought market, we’d rather rotate into ETFs at first, as downside is better managed this way, while upside is maintained.
Also, we are looking to increase our bonds exposure heading into the first half of 2024, just in case bad economic news starts to hit. This would realign our current exposure to the benchmark 60-40 stocks-bonds portfolio.
Automated Strategies
The Sigma Portfolio (Live)
Our latest trade alert from earlier this week reads:
"We will slowly scale out of positions that have reached their fundamental price targets. As a replacement to these positions, we will add to short term treasuries and broad market ETFs with as little technical downside as possible."
Executing the following orders in the Sigma Portfolio at today’s close:
SELL 100% FICO (Close Position)
BUY 3% SHY (Add 3% to Position)
BUY 4% IWM (Initiate 4% Position)
As reference, here is FICO's adjusted chart, justifying the SELL for the time being. Booking 33% profits on this position.