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.

Note: The Sigma Portfolio Tracker has a new home in the pre-release version of our new app! Go to Portfolio > The Sigma Portfolio to access it. We will stop updating the Google Sheets version as of today.

Since the last time we have performed a full portfolio rebalance, several important market events have occured, most notably in the bond market. December 18th was the key date, when the Federal Reserve began suggesting a “pause” to interest rate reductions, given the still too hot inflation readings. This “pause” was not well received by most asset classes, especially treasuries. Over the past month, only Gold managed to eke out a small gain, while everything else lost. TLT’s -9% drop sticks out like a sore thumb since the 1 month loss goes way above the expected volatility for the period (which is around 4%).

While money flows have been flowing into equities from households, hedge funds and professionals have been aggressively selling. Anecdotal evidence suggests that retail investors were taking on leveraged positions by the middle of December, as speculation on the future US administration’s plans became rampant.

Unfortunately, many of these levered plays have turned to losses. We can look to the crypto market to identify extreme risk appetite and subsequent results. After the Fed’s announcement on December 18’th, $1.7 billion in crypto was liquidated in a single day, blowing up hundreds of thousands of accounts. Yesterday, there was another notable liquidation event where over $206 million in crypto positions were liquidated within an hour as Bitcoin's price fell below $100,000. This event liquidated positions of more than 129,900 traders in the last 24 hours.

Equity markets have struggled to make gains in these circumstances, and two attempts to recover have so far proven to be “traps”. Technically, SPY is quickly being squeezed into a declining wedge pattern, where a break below recent lows spells big trouble.

While institutional selling pressure is not always a “be all, end all” indicator, it suggests there could be more to the recent market weakness than a temporary pause. The recent selling of U.S. equities by hedge funds over the past sessions has been the strongest in more than seven months. While valuations have been historically high for many months, this is the first time we see significant selling in hedge fund positioning. Note that valuations still remain elevated from multiple perspectives.

SPY’s current drawdown is just -3.16%, so there is “plenty of room” for further corrective action. Part of that correction can unfold as a consequence of a change in Earnings Growth expectations. This is logical, as the only reason 2023 and 2024 were great market years was analyst’s projections for continued growth (not actual results - as the expanding P/E ratio proves). If that growth projection were to reverse for any reason… investors could be in for a rough start to 2025.

Yesterday’s JOLTS number was certainly interesting. Job Openings came in higher than expected at 8.1 million, but the hires and quits rates point to trouble beneath the surface. The hiring rate is now the lowest in over ten years. Furthermore, the quits rate continues to decline. Quits are voluntary job separations and are a good indicator of employee confidence. When quits are high, employees are more confident in the labor market and their ability to find a new, higher-paying job. Based on the quits rate, employees are not very confident today. The tweet and chart below from Heather Long prove a great point:

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 traded poorly since mid-December and with the exception of the recent lows, there’s not a lot of technical support separating the benchmark equity ETF from a 200-DMA retracement. This won’t likely happen without a fundamental catalyst (like increasingly hot inflation or poor corporate earnings / guidance).

Commodities (DBC) have tanked way below our stop-loss level, so their inclusion in portfolios is ruled out for the time being. The main culprit for the weak performance has been oil (USO), though the recent spike is notable, as is oil’s overall up-trend. Nat Gas (UNG) is also on the cusp of a technical breakout.

Gold (GLD) has been a winning addition in our portfolio since the mid-November correction, but Gold miners (GDX) have lagged far behind. The solid demand for bullion has kept a lid on further corrective action, and Gold has undergone a period of consolidation. The ratio of Gold Miners to Gold is very extended to the downside and could be a nice set-up for GDX (at least relative to Gold).

TLT’s dismal performance disqualifies the entire asset class from inclusion in our portfolios. A technical recovery above $89.6 is required first, although needless to say, treasuries are extremely oversold.

Enterprise, our core investment strategy, doesn’t have many options when it comes to it’s allocation, since it only trades 4 ETFs. It can basically select between stocks and gold. Given the limited options, the decision here is to “buy the dip” - the statistically correct answer.

Stocks exposure via SPY has been increased to 84% this week from 42% last week.

Bonds exposure (IEF) continues to be 0%.

The position in GLD remains small, at about 3%.

Commodities (DBC) are excluded from the portfolio.

Since this model only trades 4 ETFs, we use it to judge overall portfolio positioning. Enterprise is now almost fully risk-on, betting on a recovery in equity markets. We have a feeling that this positioning reflects “the lesser of all evils”, as cash is still viewed as suboptimal in portfolios.

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’ll use the new Time Machine feature in Signal Sigma V2 to compare the same metrics between the most recent close and December 18, the last notable inflection point (click the arrows to cycle the dates).

Emerging Markets (EEM) stand out as the most oversold factor on a short term basis. Along with Foreign Developed Markets (EFA), these ETFs are the only ones trading below all key moving averages. No factor is overbought in the short term.

On a longer timeframe, Foreign Developed Markets (EFA) and Value Stocks (IVE) stand out as the major losers and factors to avoid. A positive Relative Z-Score is now rare, with only the Dow Jones Industrial Average (DIA), iShares Russell 2000 ETF (IWM), Growth Stocks (IVW) and Mid-Caps (MDY) managing to record one. These are the factors we would steer towards at the moment.

Momentum is generally weak across the board, with only one factor (EFA) showing positive MACD signals on both weekly and daily timeframes. The median Overbought/Oversold score, measured by the Stochastic Oscillator, stands at just 16.6, which is below the threshold of 20 that classifies an asset as "Oversold."

It’s interesting to see that there are some recovering technical trends following the selloff on December 18, so the comparison between timeframes is encouraging.

Here’s how we stand from a Sectors standpoint:

Same as with the Factors analysis, we’ve generated the graphics using Signal Sigma V2 and the Time Machine to compare metrics at the close of the two dates (Jan 7 / Dec 18).

Basic Materials (XLB) continues to be exceedingly oversold on a short term basis, followed closely by defensives Staples (XLP), Real Estate (XLRE) and Healthcare (XLV). Notably, Utilities (XLU) are holding their own and are not part of the "oversold defensives” theme.

Longer term deviations are also suggesting that Basic Materials (XLB) are oversold enough to elicit a bounce (too bad XLB is in violation of a technical stop, otherwise it would have made for an interesting addition).

Warranting some optimism are sectors which manage to maintain a positive Relative Z-Score even under selling pressure: Consumer Discretionary (XLY), Transports (XTN), Utilities (XLU) and Financials (XLF).

6 out of 12 sectors ETFs are oversold at the moment, but note the technical recovery when compared to December 18. Our picks for a tactical allocation are the sectors highlighted above as relative outperformers during this drawdown:

• Consumer Discretionary (XLY)

• Transports (XTN)

• Utilities (XLU)

• Financials (XLF)

3. Individual Stock Selection

Millennium Alpha has taken a -10% hit to its immediate performance, as momentum stocks were hammered, even before Powell’s December 18 speech. Despite this, the strategy is still outperforming on a 3-month lookback window, and seems to be recovering as of late.

This week, only minor adjustments have been made to position sizes, but next week, a full refresh is scheduled.

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.

Market breadth remains healthy only from a 200-DMA perspective. Otherwise, a lot of damage has been done. The pattern that we are seeing is consistent with a profit taking / consolidation move for now.

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

As a contrarian indicator, sentiment works best near extremes.

The recent drop in sentiment is puzzling when balanced with the fact that the S&P 500 is not even in a -4% drawdown at the moment. While the index level drop is absolutely normal, seeing sentiment so close to “Extreme Fear” so fast tells us that a lot of positioning had been speculative recently.

Before calling this indicator “Bullish”, we would wait for an official “Extreme Fear” reading, which we don’t yet have. For now, we’ll label this as “Slightly Bullish”.

Slightly Bullish 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), equally weighted.

Since August 2024, market capitalization hasn’t really been a decisive factor in performance. Small, mid and large caps have moved more or less in lock-step. iShares Russell 2000 ETF (IWM), for instance, has outperformed the median 6 month return of the top 10 influential stocks in the S&P 500. This indicator is not useful at the moment, and we’ll rank it as “Neutral”.

Neutral Signal in Market Internals Z-Score

Dollar Transaction Volume had initially dropped off a cliff following the sell-off on December 18. If volume had stayed subdued while selling pressure was still prevalent, the dynamic would have been positive, since volume confirms price. In this case, rising volume is a confirmation of lower prices, which is not exactly bullish.
For now, this indicator is neutral, as it is still below average.

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 need to do some cleaning up in our portfolio by sticking to the rules that have kept us out of trouble in all of these years (the Sigma Portfolio is older than suggested on this website). First of all we’ll get rid of some laggards, then decide on additions.

Overall, the vibe is not negative enough to elicit outright selling and exposure reduction on our part. This still looks like a buy-the-dip opportunity. However, it’s not a “bet the ranch” kind of opportunity, but rather a “if the portfolio is below target allocation, buying now makes sense” kind of deal.

As our allocation target for equities is 60%, we are already above target to begin with. Notably, our Enterprise strategy has increased exposure this week, leading to us also looking to increase exposure opportunistically. However, we will do this in a more “constrained” manner, and not take on excess levels of risk.

Automated Strategies and Market Outlooks

The Sigma Portfolio (Live)

To sum up, here are the orders for the next market close:

• SELL 100% of IESC (Close Position)

• SELL 100% of CL (Close Position)

• SELL 100% of RF (Close Position)

• BUY 5% MA (Initiate a 5% Position)

• BUY 5% BK (Initiate a 5% Position)

• SELL 2% of GLD (Reduce Position by 2%)

• BUY 2% GDX (Increase Position by 2%)

• SELL 3% of AMD (Reduce Position by 3%)

• BUY 2% FTNT (Increase Position by 2%)

• SELL 7% of TLT (Reduce Position by 7%)

• BUY 2% FICO (Increase Position by 2%)

All of these trades will be executed at the next market close (Friday, January 10).

The Sigma Portfolio Tracker is available in the new version of the app under Portfolios > The Sigma Portfolio.

In total, we stand to gain $21.524 by risking $9.020 if our targets are correct. The risk-reward equation nets out at +$12.503, or 11% of our total NAV, which is a great ratio.

Factors and Sector exposure will be added to the Portfolio soon!

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

Andrei Sota