Portfolio Rebalance / February 21
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.
With markets experiencing a slowdown in momentum, part of our rotation thesis is playing out as expected. It was a matter of time before profit taking hit this year’s winners: momentum, mega cap, growth, tech & semiconductor stocks. This does not only encompass the “Magnificent 7", but all sorts of risk assets which have done amazingly well since the start of the year.
As infrequent traders, our only recourse to mitigate losses in these types of environments is to be adequately positioned ahead of profit taking events (as opposed to reacting intra-day with little chance to outsmart the specialized day-trading algos). That is why we have begun to initiate a rotation process 2 weeks ago: closed our positions in NVDA, QQQ, MTUM, in favor of Value Stocks (IVE) and more cash. This week, the process continues, as we head into a seasonally unfavorable period.
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 no longer carry a high deviation warning; Treasuries and Gold remain investible as well; Commodities are not gaining any traction, but have held to recent lows;
SPY’s advance has stalled at the High Trend-Line, with short term momentum turning negative. The benchmark ETF offers limited immediate reward, while profit-taking risk is substantial. Reminder: we are due to publish a new quarterly Bottom - Up Valuation and Market Outlook at the end of this month, which may impact the CAGR slope and Price Target of our charts.
The MACD signal has decidedly crossed negative, signaling weakness in the short-term; longer term, it is the high level from which this signal is triggering that would be a cause for concern (note the similar set-up in late August 2023, where the crossover occured from a similar high reading)
Commodities aren’t gaining any traction in the current environment. Oil has been making some headway recently, but other hard assets have not followed (Nat Gas - UNG - a huge under-performer, and copper also trading uninspiring). The agricultural commodities (DBA) side has also held up well, despite significant volatility.
Gold has bounced from its decidedly oversold condition last week. Analysis by Aakash Doshi, head of commodities research at Citibank, points to three catalysts that could significantly propel the price of gold to $3000 by 2025:
“The most likely wildcard path to $3,000/oz gold is a rapid acceleration of an existing but slow-moving trend: de-dollarization across Emerging Markets central banks that in turn leads to a crisis of confidence in the U.S. dollar,”
Another trigger that could drive gold to $3,000 would be a “deep global recession” that could spur the U.S. Federal Reserve to cut rates rapidly. “That means the brakes have been cut, not to 3%, but to 1% or lower – that will take us to $3,000,”
Stagflation — an increasing inflation rate, slowing economic growth, and rising unemployment — could be another trigger, though Doshi said there’s a “very low probability” of such a scenario.
All in all, solid support exists at around $181, which would make for a great entry point in GLD.
TLT remains oversold and below established resistance levels, as there is no notable catalyst to influence bonds in the immediate term. With the Conference Board’s latest LEI update, a recession is no longer their base case scenario and points to sustained levels of growth / inflation in the economy. Many investors were betting on bonds as a “hedge” against an economic downturn that would force the Fed to aggressively cut rates. So far, that prospect has been pushed farther and farther into the future, keeping selling pressure on treasuries.
Enterprise, our core investment strategy, is maintaining allocation this week. The adjustments that are being made to position sizes are minute and only represent 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” at the moment, riding the bullish wave in equities.
Cash exposure stands at 3.46% 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).
The bounce in Emerging Markets (EEM) and Foreign Developed Markets (EFA) continues this week, especially since leadership offered by Momentum (MTUM), Nasdaq (QQQ) and Growth Stocks (IVW) is weakening.
In the short term, Momentum Factor ETF (MTUM) remains highly extended and prone to a continued pullback, while Nasdaq (QQQ) is currently trading below its 20-DMA, in a first break of minor support.
Longer term, it’s the Momentum Factor (MTUM) and Growth Stocks (IVW) which are the most highly deviated and overbought, similar to last week. Small caps continue to be relative under-performers, caving under the same selling pressure as larger cap companies. All of the other factors are trading within normal ranges, save for Value Stocks (IVE), the relative under-performer of the group. Note that IVE has held up much better than IWM during the last days of selling.
Among more granular Factor Returns, R&D has been the name of the game when it comes to the short time horizon. The higher the spend on research compared to sales figures, the better a stock has performed in the near term.
Ranking shown for R&D / Revenue
On longer timeframes, a quality metric like the Pietroski F-Score continues to work well, holding the top spot at the 2 year mark.
Ranking shown for Pietroski F-Score
Assets Growth continues to be the overall best factor that correlates with high returns over any time period.
Ranking shown for Assets Growth
Here’s how we stand on the Sectors front:
We have included 3 former tables from previous articles, for your convenience.
In the short term, Healthcare (XLV) and Financials (XLF) look quite extended, while Utilities (XLU) have re-captured its 20-DMA. Tech (XLK) has broken below its 20-DMA, while all of the other sectors are trading balanced. Consumer Discretionary (XLY) has generated a positive medium term crossover since last week, in a notable performance improvement.
Longer term, Energy (XLE) looks like the underdog of the pack, being extended to the downside both on a relative and absolute scale. Meanwhile, sectors like Healthcare (XLV), Financials (XLF) and Communications (XLC) would be candidates for profit taking.
As a tactical allocation opportunity, Real Estate (XLRE) stand out due to the ETF trading below its 50-DMA, while outperforming SPY on a relative basis.
Nostromo, our tactical allocation model, is only holding treasuries, via TLT. Real Estate (XLRE) is targeted for exposure on the next available BUY signal, as this is the only sector both trading below its 50-DMA and outperforming SPY on a relative basis.
On the treasuries side, HYG would be preferred to TLT, due to the same dynamic. These ETFs will be traded in and out of as their respective signals trigger.
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
Millennium Alpha, our flagship stock picking model is refreshing its portfolio today. Positions like QLYS, ANET, NBIX, LPG and MCD will be closed, and the strategy will replace them with names like Tapestry Inc (TPR), Allison Transmission Holdings Inc (ALSN), Applied Materials Inc (AMAT) and Ralph Lauren (RL) among others. The positions in this portfolio will persist for one month and each subsequent rebalance will only be used to bring positions to target weights.
The model has now caught up to its benchmark on a 1-year time horizon, the only major period where it had been lagging.
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.
While the bearish divergence in market breadth persists, another observation has caught our eye: despite the downturn in the S&P 500, we have not recorded an increased number of stocks trading below their 50-DMAs and 200-DMAs. This is a sign of resilience in the broad market, so we’ll upgrade this reading to neutral.
Neutral Signal in Stocks trading above their 200-day Moving Averages
As a contrarian indicator, sentiment works best near extremes. Right now, we are experiencing a “Neutral” reading in sentiment, as some fear has been creeping in to the market, related to a potential sell-off on profit taking. Broadly elevated levels in equities have also spooked potential buyers, but we are a long way from any measure of “Fear”.
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, but it has taken a dive lately. This is due to the fact that selling has disproportionately affected mega cap companies. However, there is still a long way to go before restoring balance to this otherwise very concentrated market.
Bearish Signal in Market Internals Z-Score
Dollar transaction volume has steadily increased during these 3 days of decline. Rising volume on lower prices is bearish, as selling interest is confirmed by a higher than average dollar transaction value.
Bearish 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.
Against a backdrop of deteriorating breadth measures and general loss of momentum in the market, we will follow through with our plan for profit taking. Drugmaker Eli Lilly and Co. (LLY) has already exceeded our lofty targets, and requires some adjustment. We are watching developments in stocks like Palo Alto Networks (PANW, -27.55%) and its peers (FTNT, DDOG and SNOW to a certain extent). An opportunity might be opening up in the space, but we’ll need to wait for the dust to settle before attempting to initiate positions.
Automated Strategies and Market Outlooks
The Sigma Portfolio (Live)
Our portfolio headed into this period of softness on a defensive note and carrying 9% in cash. While it’s not time to become overly defensive just yet, we do want to make sure that we book profits in positions which have already exceeded expected returns. On the ETF side, the rotation also continues, as we let the market dictate trade flow. Right now, we are seeing confirmed softness in Momentum and resilience in value and foreign markets.
The orders for execution today reflect our thinking:
SELL 50% LLY (Reduce Position by 50% to 3% of NAV)
SELL 100% MTUM (Close Position)
BUY 3% EFA (Initiate 3% Position)
This is how the asset allocation will look like after the orders 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 $12.706 by risking $5.802 if our targets are correct. This is a better risk-reward proposition than last week. Next up for profit taking are GWW and the rest of LLY.
The factor exposure profile has now been balanced so that value stocks, mid caps and foreign names are favored in comparison to tech and growth names.