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.

This week, we would like to perform some adjustments to our live portfolio in light of the significant rally that has occured year-to-date, especially in high growth names. The point of our trading shall be to rotate away from higher risk areas into more defensive positions.

On a personal note, as I write the lines to this article and ponder taking profits in NVDA (for example), I’ve come to realize that it takes a certain kind of courage to do so. The risk of selling, of course, is to miss out on further gains. In other words, FOMO. The hesitancy to push the SELL button is real, despite knowing full well that many positions have reached levels where little theoretical reward is left in the near term. Yet stepping away from my own holdings (as I need to do in order to write these articles) reveals that I’m biased in my own way. I’m lucky enough to realize that, objectively, and share this observation with you. -Andrei

1. 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.

SPY has been treading water lately, with many investors understandably antsy in what can only be described as “overbought territory”. It seems like everyone is waiting for something to happen and spoil the bullish advance. Besides offering up an uninspiring risk-reward proposition, the market hasn't done anything wrong per-se. Upside stands at $499, (+1.01% potential gains), while support climbs at $474 (-4.04% to the downside).

Before moving on to commodities, there’s one point that needs to be made. There is a macro risk moving into the investing horizon that analysts are becoming aware of - reacceleration risk.

First of all, we call it a risk because it is a part of an unknown future. In the case of a SELL decision (as we were alluding to, in the article’s intro), re-accelerating growth does mean missing out on further substantial gains, thus risking under-performance. How should we think about potential re-acceleration, and what does it mean for our analysis? In Monday’s Weekly Preview Article, we shared a chart of the LEI (leading economic index):

Re-acceleration would imply getting a bounce in the LEI similar to what transpired in 2001-2002 and 2009. However, equities are at a polar opposite right now in terms of valuation premiums (and indeed price action) than they were during those crisis times. We need to at least consider the impact of economic indicators turning up, and assess the effect this may have on various asset classes.
We would expect commodities to rally again, if world economic growth restarts. Commodities have lagged dramatically in the last year (DBC is down almost -9% over 1 year), and currently trade in a slump (below our stop-level). If growth does pick up, a rally in commodities becomes unavoidable, as real world demand takes hold.

Gold has shown surprising resilience as of late, scaling a series of higher lows and maintaining positive momentum. We need to consider gold’s ascent as a warning of sorts - why exactly are investors bidding up zero-yielding bullion to this extent, when they could be earning a much higher interest in treasuries? Besides equities, gold is the second best performing asset class in the past year (GLD +8.3%).

TLT is struggling just below key resistance currently, and we do like the longer term prospects of this benchmark ETF at this juncture. However, if growth does come roaring back, treasuries (especially at the longer term) will get absolutely slammed. This is a distinct possibility for TLT that we are acutely aware of.

Along with spiking yields, high growth names will also most likely get a reality check. Growth Stocks (IVW ETF) are just asking for it, judging by the 1.89 Z-Score (standard deviations from the mean).

With these risks in mind, we will begin our next major rebalancing phase. It won’t all transpire today, but the overall framework is set for what we’d like to achieve. Meanwhile, let’s check on our automated models.

Enterprise, our core investment strategy, is increasing equity risk yet again this week. The adjustment is not an outright buying of stocks, so much as it is a reduction in treasury exposure. This does run contrary to our own logic and positioning right now. Gold and Cash also get slight upgrades due to the reduction in bonds.

Since this model only trades 4 ETFs, we use it to judge overall portfolio positioning. TLT getting sold here as it’s unable to scale previous resistance is certainly a technical issue that bears watching.

Cash exposure has increased from 1.75% to 4.05% this week.

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).

Emerging Markets continue to be the only factor exhibiting a negative medium term trend. All of the other factors look healthy (perhaps some of them too “healthy” for their own good).

Domestic-focused ETFs are all trading strongly in the short term, with a notable lag from the iShares Russell 2000 ETF (IWM), which is sitting below its 20-DMA. We’ve been monitoring the iShares Russell 2000 ETF (IWM) for a while, and still we are not getting a breakout (similar to what we’ve seen in Momentum for example).

Meanwhile, the Momentum Factor ETF (MTUM) is continuing to experience a huge deviation. We’ve rarely seen an ETF break 4 standard deviations when summing up both the absolute and the relative Z-Scores (as they are presented in our table). The next factor exhibiting a large deviation are Growth Stocks (IVW), also completely detached from their recent past performance.

Value Stocks (IVE) are the relative underperformers here, and the ones we would be interested to rotate towards. The chart below displays IVE relative to SPY - after a surge in early January, the relative performance has dropped off a cliff.

Among more granular Factor Returns, expensive stocks are most correlated with high returns in the short term. This has been the story of 2024 so far, and it seems to continue. Note the dominance of Price to Sales and R&D / Revenue among the top 5 characteristics of high performing stocks in the last 3 months.

On longer timeframes, companies that had a higher Earnings Yield have consistently performed better.

Earnings yield as a factor has not been doing so well in the near term, however. High earnings yield companies are correlated with IWM more than any other factor ETF.

For now, it’s growth stocks that clearly have the upper hand.

Here’s how we stand on the Sectors front:

We have included 3 former tables from previous articles, for your convenience.

Weakness in Consumer Discretionary (XLY), Real Estate (XLRE), and Basic Materials (XLB) continues this week as well, but note the M-Trend improvement for Energy (XLE).

In the short term, Financials (XLF) have pulled back, but a high deviation still persists in Healthcare (XLV) and Industrials (XLI). Healthcare is definitely a surprise, as this sector is still a relative under-performer, when compared to SPY.

Utilities (XLU) is the only sector ETF trading below all of the key moving averages.

Longer term, Energy (XLE) is still down in the dumps, while Financials (XLF), Communications (XLC) and Healthcare (XLV) are doing well.

Nostromo, our tactical allocation model, is only holding treasuries, via TLT.

This model has not targeted any other ETFs for a while now, despite the fact that it can do so freely. What this tells us is that relative value opportunities are missing from the market, so the system needs to stick to its benchmark holdings.

SPY will eventually get added to the model again on the next BUY signal that occurs with markets less overbought.

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.

While underperforming in real life, this quirky model has its uses as a decision support tool. There is a viable case to be made here that equities are way overbought. Nostromo is the only strategy to have almost zero drawdown during the Covid-19 crash in 2020.

3. Individual Stock Selection

Our flagship stock picking model - Millennium Alpha - is going from strength to strength, logging another all-time-high close. META was the driver of the model’s latest surge, but it’s not like other stock picks are not performing. United Rentals Inc (URI) and WW Grainger Inc (GWW) are prime examples of lesser known companies that have returned almost as much as NVDA for example.

We’ll use the system’s Ranking Logic to screen for our rotation candidates in a very specific way. From the Economic Sector, we’ll remove “Technology”, and from the Factor Correlation we’ll select IWM and IVE (small caps and value). A shortlist gets conveniently generated.

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.

The bearish divergence we have noted as of last week has only grown larger by the time of this writing. This is now an officially bearish internal metric for the market, as most stocks are still trading in a range and not breaking out.

Neutral Signal in Stocks trading above their 200-day Moving Averages

As a contrarian indicator, sentiment works best near extremes. We are currently experiencing neutral levels of sentiment, contrary to what many commentators might suggest.

Quite simply, most portfolios are not doing as well as you’d think just by looking at index-level performance.

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).

Leadership provided by mega caps in the past week is evident, pushing the Z-Score divergence to 2-std high levels. That’s in the 98th percentile of measurements in the past 2 years, reflecting an insatiable appetite from investors to park their money in highly liquid stocks.

Bearish Signal in Market Internals Z-Score

Despite the creaky picture painted by all of the other breadth indicators, dollar transaction volume is telling a different story. Volume is simply surging along with the latest advance. Higher than average volume on higher prices is bullish, since volume tends to confirm price direction.

Bullish 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.

Now comes the hard part: what do we make of all of this, and how do we translate all of the different metrics into actionable investing insights?

On the one hand, we’ve got an average 81% system exposure coming from our automated models, indicating that holding cash is probably not the best call right now. The market’s sentiment is rather neutral, with plenty of “walls of worry” to scale.

Breadth is bad, but volume is surging. Parts of the market that are doing great are pushing valuation extremes, but the ones which are reasonably valued are trading poorly. This is an environment ripe for a rotation trade, where we don’t want to necessarily reduce equity exposure, but adjust it really well instead.

Automated Strategies and Market Outlooks

The Sigma Portfolio (Live)

First of all, we need to recognize that recent economic data came in hot and did not confirm our long bonds thesis. It did feel like we got rug-pulled in TLT. Given TLT’s technically challenging backdrop for we’ll follow the example set by Enterprise and reduce treasuries in favor of equities:

• SELL 5% TLT (Reduce Position by 5% to 20% of NAV)

Next off, we’ll rebalance ETF exposure to favor value versus high growth:

• SELL 100% QQQ (Close Position)

• SELL 3% MTUM (Take Profits, Reduce Position by 3% to 3% on NAV)

• BUY 7% IVE (Initiate a 7% Position)

Then, we will proceed to take profits in NVDA:

• SELL NVDA (Reduce Position by 3% to 2% on NAV)

We’ll add this 3% to PRGS (much more defensive tech stock):

• BUY PRGS (Add 3% to existing position)

Findally, we’ll initiate Global Payments Inc GPN with 3%:

• BUY 3% GPN (Initiate 3% Position)

This is how our Asset Class allocation will change after the execution of these orders:

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 $13.211 by risking $6.964 if our targets are correct. This is a much improved risk-reward than what we registered last week (which was basically a crap-shoot). Note that plenty of positions are still prone to profit taking (marked green).

The factor exposure profile is now much improved, with lowered correlation to QQQ and IVW, and higher for IVE and RSP (aka more defensive and balanced).

On the sector side, Financials (XLF) exposure is still a bit too high, but that’s by design.

If you have any questions, please contact us using your favorite channel. Have a great week everyone, and happy investing!

Andrei Sota