Portfolio Rebalance / 13 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. 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.
The market action lately seems to be driven by an unstoppable bullish steamroller. At least when it comes to equities and bonds, which have outperformed all of the asset classes lately. Commodities are in pain and Gold is no longer as hot. Our systems (which are trend-following at the core), are going risk-on all the way, like sharks sensing bear blood in the water. However, pricing may be getting detached from economic fundamentals and sentiment is dominated by greed - no one is selling.
At the end of this article we’ll discuss our current positioning and short term outlook + the trade plan for the following months. But first, we’ll go step by step in this decision making process.
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 failed to maintain a technical uptrend and have fallen into a slump
We’ll turn to a fundamentally adjusted SPY chart, assuming our 2024 Year-End aggregated price target and historical 7% EPS growth rate. Technical fair value for SPY sits at $443, while the maximum value for year-end would be $474. As is evident from the chart, risks are skewed to the downside for the time being.
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 broken down from the recent trading range and are facing a large potential drop to support (near $21.7). Despite being extremely oversold, commodities (and commodity related stocks) are not investible at the moment.
Gold has cooled off recently, dropping from an extreme deviation reading. GLD sits close to support at $180 (near the middle of the trading channel, “M-Trend” in our terminology). At $180 and below, GLD becomes 100% investible.
The U.S. Dollar (UUP ETF) remains caught in a very tight trading range ($29.64 - $29.36) and a breakout or breakdown in either direction will be very telling. Watch the US Dollar for an understanding of where every other asset class goes. Pressure appears to the sell side, favoring a breakdown to $28.59, but it’s a very close call.
Bonds are close to reaching technical resistance ($98 on TLT) as the rate cut narrative gets priced in. There has been a bit of a let up in buying pressure recently, but a deeper correction or consolidation would be needed here before exposure can be safely added.
Enterprise (our core investment strategy) is only focusing on equities, treasuries and gold. Commodities have been excluded from the portfolio for the time being as DBC is deemed uninvestable.
This model has recently reduced equity allocation, as bonds are becoming more and more attractive. Gold exposure has also been slightly upgraded and cash exposure is also slightly higher now.
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, in what is becoming an exceedingly bullish environment. All factors are trading above all key moving averages, except Emerging Markets (EEM).
On a short term basis, the Dow Jones Industrial Average (DIA), Value Stocks (IVE), Momentum Stocks (MTUM) and the Equally Weighted S&P500 (RSP)
We believe the fate of this market will be be determined in 2024 by the behavior of small caps. That is why we would like to pay special attention to this factor (IWM) in every edition of this newsletter. The idea is that market breadth will make or break the current rally, and IWM is much more representative of the state of affairs than SPY is currently.
$186 is the key level on IWM, as it sits halfway between resistance at $201 and support at $173. There is sufficient “gas in the tank” for this factor to go higher, even though it looks overbought by our standard metric (96/100).
Longer term, factors are well behaved, with only Nasdaq (QQQ) and Growth Stocks (IVW) looking extended. These two are also the only factors to outperform the SPY on a relative basis on a 1 year horizon. A rotation trade would imply capital moving from the mega cap tech stocks into small cap stocks (IWM) and emerging markets (EEM), and is our working thesis going forward.
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 of sectors. 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. However, a bet on energy companies would act as a hedge.
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) and Communications (XLC) fit this bill, but their deviations are not that extreme anymore.
Energy (XLE) becomes a viable candidate for a rotation, when commodities find a bottom. Long candidates for a rotation trade also include defensive sectors like Utilities (XLU), Staples (XLP) and Healthcare (XLV). The mid-market sectors (Financials, Industrials, Transports) also look good from a momentum perspective. On the short side of a rotation, capital would come out of Tech (XLK) and Communications (XLC), sectors which are longer term overbought.
Nostromo, our tactical allocation model is buying into the breakout possibly at the worst time. The model will trade a huge 90% chunk of the portfolio in one go at today’s market close.
The reasoning for this move is the MACD signal that just crossed over to the BUY side today. However, as we have pointed out on several occasions, upside is limited from current levels, and this trade would never go through in real life on our own portfolio.
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.
The model tried to avoid a repeat of September - October of last year, when a similar pattern concluded to the downside. That is why it kept cash at 98% exposure until today. As a crash did not occur, Nostromo is “caving in” to the same FOMO that some traders are also feeling.
3. Individual Stock Selection
Our flagship Millennium Alpha model hit an all-time-high on December 04 2023. All positions save for LNG and LBRT (both energy names) have outperformed since the inclusion in this portfolio.
In factor terms, the portfolio is highly correlated with Nasdaq (QQQ), Mid-Caps (MDY) and Foreign Developed Markets (EFA). From a sectors perspective, these stocks are mostly correlated with Industrials (XLI), Tech (XLK) and Energy (XLE).
On the latest rebalance (December 12), the model bought into relative losers LNG, AMPH and LBRT, while selling outperformers AVGO, MSFT, META, GWW and QLYS. Bringing positions to target weight is a weekly process.
Over the last 5 years, the model returned 20.5% annually (153% total return) excluding dividends. This is our best performing model and it’s our pick for a continued bull market scenario.
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.
659/1000 stocks we track are trading above their 200-day moving averages. This is a healthy number that puts this indicator in the “bullish” camp. Previously, the peak of the recent range was established at 778 stocks, so there is still 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 another “Extreme Greed” reading today, as the number of stocks overbought goes above 2 standard deviations (596/100). Usually, periods of extreme greed and fear last around 10 to 15 calendar days, and we are in the middle of this period right now. Extreme extensions like this don’t persist for very long (12 occurrences in the past 2 years, both bullish and bearish episodes).
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. However, “Extreme Greed” sentiment is bearish.
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).
Same as last week, our instrument highlights that just a handful of stocks are driving the 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.
It appears that our thesis laid out in early September is playing out almost as anticipated (back then we set a 2023 year-end price target of $477 and have since moved it 10 points lower, on fundamental grounds). Automated models are as bullish as possible (98% system exposure) and greedy sentiment is making our palms sweat in the short term. Profits need to be booked at some point, but we also don’t want to miss out on further gains.
We need to balance 2 distinct time frames: a 1-year perspective (longer term view - laid out in this article) and a short-term perspective. There is nothing to indicate that we need to become exceedingly defensive just yet, but we can calculate risk/reward in the equity market relative to treasuries.
Automated Strategies and Market Outlooks
If one believes that fair value for SPY at year-end 2024 is $470, then it makes no sense to invest in equities at the moment, with just 1.27% upside available for the whole of next year. In an alternate “bull market scenario”, where SPY runs up to $508, then 9.46% can still be realized in potential gains.
However, there is substantial risk involved in getting that 9% return. 1 Year US treasuries currently yield 5.14% risk free. The equity risk premium sits at 4%. Therefore, an investor should require at least a 9.14% potential return in order to justify owning stocks over bonds (5.14% + 4%). Given that we arrived at a $508 target for SPY by making optimistic assumptions, there is also a substantial possibility of disappointment involved.
As we said earlier, it’s time to take profits and move closer to our target allocation (60% stocks - 40% bonds). Let’s review our present positioning:
The Sigma Portfolio (Live)
The Sigma Portfolio contains a couple of key major sub-components (All ETF positions are classified as medium risk due to the diversification they offer):
CLICK HERE TO SEE THIS PORTFOLIO SET UP IN THE TRACKER WITH RISK-REWARD AND CORRELATIONS
EQUITIES (70% total weight):
HIGH RISK (23%):
NVDA
NOW
MSFT
GWW
MEDIUM and LOW RISK (39%):
EXP
QQQ
MTUM
IWM
LLY
PRGS
AMGN
HEDGE - Energy (8%):
XOM
RRC
BONDS (25% total weight):
TLT
HYG
SHY
GOLD (5% total weight):
GLD
We can determine the statistical risk-reward for each position using the Portfolio Tracker. 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 $12.922 risking $9.073 if our targets are correct. Positions that require attention are RRC (exceeding a stop to the downside and getting highlighted) and NOW, where potential reward exceeds potential risk.
Correlations to Factors and Sectors can be found on the next tabs:
As can be seen, correlation to Nasdaq (QQQ), Momentum Factor ETF (MTUM) and Growth Stocks (IVW) is high on the factors side, while Tech (XLK) and Consumer Discretionary (XLY) have high readings. This leaves our portfolio prone to a rotation trade, as some factors have had a great run so far.
In order to improve risk / reward and reduce some QQQ and XLK correlation, we can take profits in NOW. We will use the proceeds to further bring our portfolio more in line with our 60-40 target and buy shares in low risk SHY (iShares 1-3 Year Treasury Bond ETF).
Executing the following orders at today’s market close:
SELL 100% NOW (Close Position)
BUY 6% SHY (Add 6% to Existing Position)
Here’s the updated asset class allocation after the trades go through:
If you have any questions, please contact us using any channel. Have a great week everyone, and happy investing!
Andrei Sota