Portfolio Rebalance / 20 December
Following the Signal Sigma Process
Administrative Notice: This is the last Portfolio Rebalancing Article for 2023. We’ll keep an eye on markets and alert you to any changes over the holiday season via Trade Alerts. The next Portfolio Rebalancing is scheduled for January 10 2024.
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.
With the year drawing to a close, bulls have been vindicated. No recession has officially been recognized in 2023 and the Fed has all but admitted to executing a “pivot” in the near future. The only element truly missing from the bullish puzzle is the elusive return to revenue growth for the average US company.
This return to growth is fully priced in at the moment. With median P/E ratios returning to cycle highs, we need to consider if current valuations incorporate a view that is too optimistic. Our models are as bullish as ever, since valuation is a terrible market timing tool. But we can’t completely dismiss the warning that valuation presents us with: large cap equities look expensive here, even by their own historical standards.
Median P/E ratio for S&P 500 companies near 2 standard deviations extension
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 slumped, and are nearing support;
SPY is enjoying a great run as of late. The ALL-TIME-HIGH value of $477 is within striking distance, and downside appears to be well contained, as nobody is really interested in selling. We’ll need to adjust our usual chart with a $470 Price Target and 7% CAGR in order to offer a proper perspective. The fact remains that a correction is more likely than usual, as extreme deviations don’t last forever.
The MACD Signal is reaching extreme values, ushering in a new era of “trend-following”; since 2021, “range trading” strategies have been the only ones providing positive returns;
Commodities have failed to maintain a positive bias heading into 2024. DBC, the benchmark ETF for many commodity futures, is trading near support at $22.13 and is extremely oversold. The bounce in mid-December did not “stick”. We’ll need to see support hold before attempting to play a bounce here.
Gold has bounced above the pivot level ($185) and remains in a holding pattern in an overall bullish trend. It is rumoured foreign Central Banks are aggressive buyers, while retail traders are selling. Our view is that strength in Gold reflects the Dollar’s momentary weakness and unreliability as a global settlement currency, which is set to continue.
Bonds look overbought in the medium and short term. TLT is working its way through a cluster of resistance at the $97 - $100 area. In theory, the 200-MA (also at $97) should act as support for TLT, but this remains to be confirmed. Overall, we still think bonds are the best asset class for 2024, but we’d rather wait for a better entry point or a confirmed breakout.
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 been continually reducing equity exposure and has made additions to bonds instead. At today’s session close, it will follow the same pattern by taking profits in SPY and increasing IEF.
Since this model only trades 4 ETFs, we use it to judge overall portfolio positioning. The allocation appears balanced and adequate given current trading conditions.
Cash exposure is minimal, at just 2.5%.
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).
Equity factors look egregiously overbought both in the short and in the long term. The only factors to stand out as not overbought are those whose constituents are non-US companies. Namely Emerging Markets (EEM) and Foreign Developed Markets (EFA). Everything else looks expensive here, no matter how we look at it.
The key factor that we are looking at for 2024 remains the iShares Russell 2000 ETF (IWM). It’s small caps which have the valuation disadvantage versus large caps currently. The upside for IWM is approximately double that of SPY if a recession does not occur. As expected, IWM had a surge in performance after the Pivot level of $186 was exceeded. Now, the ETF is overbought and attempting a breakout above $201. Ideally, we’d like to see a correction to support before committing any further to this factor.
There is no obvious technical trade in terms of factors at the moment. EEM and EFA could be targets for a capital rotation, and IWM certainly looks interesting longer term. But better timing is required. For now, there’s too much enthusiasm in the market.
Here’s how we stand on the Sectors front:
We have included 3 former article editions as well, for your convenience.
Last week we wrote:
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.
The same can be said this week.
Every risk-on sector is deviated to the upside with the notable exception of Communications (XLC). Defensives Utilities (XLU), Staples (XLP) and Healthcare (XLV) are understandably under-performing in a greedy environment, where high-beta stocks are registering all the gains.
Longer term, Consumer Discretionary (XLY), Tech (XLK), Financials (XLF) and Communications (XLC) are overbought.
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).
Communications (XLC) is also an interesting choice for a short term bounce. But overall, a correction needs to happen first, before a real technical trade setup can be identified.
Last week, we criticized Nostromo for buying the SPY aggressively ahead of the FOMC meeting. It turns out that was the right thing to do.
The model is aiming to lever up and diversify holdings using TLT as well. A BUY signal needs to trigger on TLT first, however.
The only issue we see with this approach is that right now, bonds are correlated with stocks to a far greater extent than in the past. As such, the strategy is in effect placing a large bet against the US Dollar using these two asset classes. But real diversification is lacking.
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.
If “trend following” becomes a viable strategy again, Nostromo will do very well in 2024.
3. Individual Stock Selection
Despite the fact that Millennium Alpha has just reached another all-time-high on December 15’th, we’d like to spotlight Vision in today’s newsletter. Millennium Vision returned 20.6% Year-to-Date and is the second best performing model after Alpha.
Positions like Pinterest Inc (PINS), HubSpot Inc (HUBS) Appfolio Inc (APPF) and Snap Inc (SNAP) have had great runs since inclusion in this portfolio. As long duration assets recover in 2024, some of the companies selected in this model might achieve eye-popping returns, especially if they manage to turn a profit.
While the benchmark ARKK ETF has beat Vision Year-to-Date, the point that we’d like to make is that this stock selection style is viable. Cathe Wood needs to employ a team of over 100 personnel in order to achieve a similar-looking equity curve. We can treat this portfolio as a screener, and try to pick out the best ideas for our own use in 2024.
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.
742/1000 stocks we track are trading above their 200-day moving averages. With the peak of the recent range was established at 778 stocks there is little upside to be had. Additionally, the cumulative number of stocks trading above the 20-day + 50-day + 200-day moving averages is now at levels which have previously denoted peaks in the market and preceded at least minor corrections during the last 2 years.
Neutral Signal in Stocks trading above their 200-day Moving Averages
As a contrarian indicator, sentiment works best near extremes. We are entering the third straight week of extreme gread readings, as the number of stocks overbought goes above 2 standard deviations (651/1000). Usually, periods of extreme greed and fear last around 10 to 15 calendar days on average. We are at 19 days currently. Extreme extensions like this don’t persist for very long (12 occurrences in the past 2 years, both bullish and bearish episodes). Will this time be “different”?
Maybe! But we don’t believe that we’ll experience a full reversion to “Extreme Fear” this time around. The highlighted period, in November - December 2022 offers a good roadmap for how we see developments in early 2024. “Extreme Greed” could be followed by “Neutral”, followed by more “Extreme Greed”.
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).
Despite the rally in small and mid caps, this indicator refuses to budge. The stubbornness is truly remarkable, as large caps have rallied almost to the same extent as smaller companies, leading to a stagnation in divergence (lower panel). We’d like to see small and mid caps clearly start to outperform large caps in order to turn this indicator “bullish”.
Bearish Signal in Market Internals Z-Score
Weekly Dollar Transaction Volume has surged, indicating major interest following the latest advance. This is very bullish, as higher volume associated with higher prices tends to “confirm” the tape.
Suppressed realized volatility is indicative of investor complacency, however.
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.
For now, equity markets are enjoying bullish tailwinds and have the technical advantage. Seasonality also helps, as there’s very little reason for investors to aggressively sell in the short term. After a long period of “range trading”, traders looking to turn a quick profit have been conditioned to sell short these kind of “tops”.
However, nothing works forever in the markets. We can safely say that “range trading” has failed, and we are now witnessing a breakout episode, commonly associated with a “trend-following” regime. Fortunately, our models are “trend following” in nature, and have helped us benefit.
Now is not the time to establish new long positions, however. Sooner or later, a correction will arrive. Until then, we’ll carefully take profits in positions which have exceeded price targets, and rebalance away from overbought factors. Did we mention bonds are attractive buys on a dip?
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 slightly negative upside. But right now, markets are optimistic, and equities are almost priced to perfection. Assuming SPY would reach $508 by year-end 2024, just 7.63% upside remains.
However, there is substantial risk involved in getting that 7.6% return. 1 Year US treasuries currently yield 4.95% risk free. The equity risk premium is 4%. Therefore, an investor should require at least an 8.95% potential return in order to justify owning stocks over bonds (4.95% + 4%). Right now, even the “optimistic” scenario does not offer a great risk-reward proposition.
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)
We’ve been taking profits in the month of December, and are running slightly below target on both the equity and treasury side. For now, there’s no reason to be more aggressive with the selling, but we do need to cut one more position this week - the price target has been reached for Eagle Materials Inc (EXP). By adjusting its technical chart accordingly, we can understand there is little upside left (this method also helps a lot with FOMO).
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.
Removing EXP from the portfolio only has the effect of reducing downside, and has no effect on upside.
In total, we stand to gain $11.944 risking $8.664 if our targets are correct. The only other position that requires attention is RRC (exceeding a stop to the downside and getting highlighted). IWM has passed our initial target of $200, and we’ll update the target if a clear breakout occurs.
Correlations to Factors and Sectors can be found on the next tabs:
Factors have been nicely balanced following our latest trades. On the sectors side, correlation to Tech (XLK) is a bit excessive, but nothing to warrant immediate action.
Executing the following order at today’s market close:
SELL 100% EXP (Close Position)
Here’s the updated asset class allocation after the trades go through (our benchmark is a 60% stocks / 40% bonds portfolio).
If you have any questions, please contact us using your favorite channel. Have a great week everyone, and happy investing!
Andrei Sota