Portfolio Rebalance / February 14
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 release of yesterday’s CPI figures gave the market a good excuse to pull back and possibly start a consolidation process. It’s still very early to draw any conclusion about the near term direction of prices, but one thing is certain - equities were egregiously overbought to begin with, and any downside catalyst would have had an outsized impact.
Some investors have now been reminded that losses happen fast when they do eventually occur, so it does pay to be well positioned in advance. We’ve already begun our rotation trade last week to prepare for exactly this kind of scenario. The theme we are pursuing is similar today as well, as tech got crushed. Unfortunately, small caps are also suffering, being the most economically sensitive of all stocks.
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.
High Deviation Warning for Equities while Treasuries and Gold remain investible; Commodities are still struggling, but have not declined any further from last week
As we noted in our Weekly Preview and Daily Briefings, SPY had virtually no more upside remaining. As we update our Price Target and Growth Rate at the end of this month we’ll come up with updated figures and charts. But for now, we’re working within this framework, which sets $508 as the median Price Target for the end of the year, on a 12% CAGR trading channel slope. A -3% pullback to support would not be at all surprising.
Core Inflation ran hot yesterday (3.9% versus 3.7% expected), giving the Fed no reason to cut faster than they have already announced. Analysts were closely examining Services inflation, deemed by Jerome Powell as the most influential for setting monetary policy going forward. Services inflation was reported at 5.4%, a rate which is uncomfortably high. Motor vehicle insurance had the highest individual figure (insurance calculations have skewed the data before), but rent was also a large contributor to the Services category.
However, we need to bear in mind that shelter costs, representing about 40% of CPI, lag real rent and asking rent prices by over six months; additionally, the BLS uses imputed costs, hedonics, and mathematical smoothing methodologies that clearly skew data. Did your motor vehicle insurance suddenly increase by 20% in January, as the report implies? Probably not…
Among all major categories, Energy had the biggest drag (-4.6%). No surprise then that DBC, the main commodity tracking ETF, is still in a slump. What’s notable, however, is that prices are appearing to form a base around the recent lows, and have not declined further from last week. DBC remains uninvestible, however, due to trading below our stop level. In theory, it could hedge a more meaningful surge in inflation.
Gold has succumbed to selling pressure, as climbing yields have only made the yellow metal look less appealing to hold, since it pays no dividend. The focus for GLD now moves to challenging support at $181.
TLT has continued to struggle below key resistance, and the CPI data release has not made things easier for bond investors. Interest rate traders have dialed back their rate cut expectations from 5 previously, to 4 today.
Enterprise, our core investment strategy, is keeping allocation in line this week. The adjustments that are made to positions sizes are minute and only represent minor tweaks. Equity risk is maintained at a healthy 81% due to the fact that bonds are underperforming and justify limited exposure.
Since this model only trades 4 ETFs, we use it to judge overall portfolio positioning. We can characterize this model as clearly “risk-on”.
Cash exposure has remains at 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 have bounced and triggered a positive medium term trend crossover, due to a sharp bounce in Chinese equities (FXI). This week, markets in China are closed due to the Lunar New Year celebrations, but the FXI and EEM ETFs trade regardless.
As of this writing, the breakout in small caps (IWM) did not manage to hold. Yesterday’s plunge in all risk assets hit small caps the hardest, as they are the most economically sensitive companies and do not benefit in any way from higher interest rates.
Illustrating the “economically sensitive” theme, the most correlated companies to IWM are financials;
Longer term, it’s the Momentum Factor (MTUM) and Growth Stocks (IVW) which are the most highly deviated and overbought. Surprisingly, small caps have also closed the relative performance gap with SPY according to our Z-Score metric (this only means that price momentum is shifting, not that they’ve actually caught up). All of the other factors are trading within normal ranges, save for Value Stocks (IVE), the relative under-performer of the group.
Among more granular Factor Returns, expensive growth stocks are dominating the short term timeframes. Growth stocks often times spend a disproportionate amount on R&D. Companies that have a large R&D budget compared to revenues got rewarded recently (with a swoon at the one month mark).
Ranking shown for R&D / Revenue
On longer timeframes, the same can’t be said for high R&D spending. The longer the timeframe we study, the worse this factor has performed.
Ranking shown for R&D / Revenue
A factor with a surprisingly good track record across all timeframes is high Assets Growth. Ranking above 10 across all historical periods is indeed a rarity! Just to be crystal clear, Assets Growth measures the 1 year Trailing Twelve Months expansion of a company’s total assets recorded on the balance sheet.
Ranking shown for Assets Growth
Conclusion: growth stocks are still favored in the short term.
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) remains, with Utilities (XLU) being the only sector ETF to trade below all 3 key moving averages (due to it being a proxy for other fixed income assets, which are also struggling to gain traction).
Real Estate (XLRE) could have an interesting set-up here - the ETF is trading below its 20 and 50 day moving averages, but has recently closed almost the whole relative performance gap with SPY (in terms of Z-Score at least).
Healthcare (XLV) and Industrials (XLI) are overbought in the very short term, while longer term they are joined by Communications (XLC) and Financials (XLF).
Energy (XLE) continues to be the most unpopular sector, as investors have fled these commodities-reliant investments. Given technical stabilization in DBC, we could see an opportunity forming in Energy names soon.
Nostromo, our tactical allocation model, is only holding treasuries, via TLT. SPY is also targeted for exposure on the next available BUY signal.
This model has only targeted SPY and TLT despite the fact that it can work with a wide range of other ETFs from the equities and bonds asset classes. What this tells us is that relative value opportunities are missing from the market, so the system needs to stick to its benchmark holdings.
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
This week, we are featuring Millennium Vol Target as our stock picking strategy of choice. Seeing as we may be entering a more volatile period in the markets, this defensively oriented model could offer better risk-reward when compared to Alpha. For example, high-beta positions like semiconductor manufacturers Broadcom and NVIDIA are missing from this portfolio. So is META.
Instead, we get a more traditional stock selection, with Energy names Valero Energy and Marathon Petroleum included. In fact, for Vol Target, Industrials and Energy are the sectors with the highest correlation with the overall portfolio.
As with Millennium Alpha, this strategy has also performed admirably on a 2 year time period, reaching a new All-Time-High value at the start of February.
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 in the last weeks has remained stubbornly in place. This is observable when comparing index trends with moving average trends, as well as SPY’s Sigma Score when compared to the average Sigma Score of a broad market stock.
Bearish Signal in Stocks trading above their 200-day Moving Averages
As a contrarian indicator, sentiment works best near extremes. Investor risk appetite took a hit yesterday, pushing our gauge into neutral territory. However, we’re looking for figures of 40 or below, and more oversold stocks than overbought ones. Right now, conditions are not a suggesting buying the dip just yet, but rather waiting for the full move to develop.
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).
The Z-Score divergence is still very high. Mega cap stocks have proven quite resilient to the latest pullback episode. Case in point: IWM fell -4.0% yesterday, and NVDA only declined -0.2%.
Bearish Signal in Market Internals Z-Score
Transaction volume was higher than average, but lower than the peak of last week. We’ll chalk this indicator up in the Neutral camp.
Neutral 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’ve already cut back on tech exposure previously this week by closing our position in NVDA. Last week, we have performed part of our planned rotation, by reducing our overall correlation to QQQ.
We’d rather follow Enterprise’s allocation plan at this juncture. In order to align with that, we’ll need to further reduce TLT from our portfolio, and dial down bonds exposure. It’s not yet time to “buy the dip” in equities, despite yesterday’s plunge.
Automated Strategies and Market Outlooks
The Sigma Portfolio (Live)
We won’t be replacing TLT with any other position yet. Cash holdings will increase to 9% until we get a better understanding of where this pullback episode will ultimately find support (both for stocks and bonds)
SELL 5% TLT (Reduce Position by 5% to 15% of NAV)
This is how the asset allocation will look like after the order gets filled:
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 $12.617 by risking $6.070 if our targets are correct. This is nearing a good risk-reward ratio. Notably, there are some positions which may still warrant taking profits: LLY, GWW, XLV and MTUM.
The factor exposure profile is well balanced and should provide downside support if profit taking hits tech stocks.
On the sector side, we would like to increase Energy (XLE) and Staples (XLP) further, as part of our rotation trade. Most likely these trades will follow next week, once we get a better understanding of PPI data on Friday.
If you have any questions, please contact us using your favorite channel. Have a great week everyone, and happy investing!
Andrei Sota