Portfolio Rebalance / 17 January
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 a sluggish start to the New Year and pervasive overvaluation across various asset classes, it comes as no surprise to see parts of the market start to come under selling pressure. This is true for basically all risk assets, leaving the U.S. Dollar as the sole beneficiary.
Our systems have reigned back bullish bets for quite some time, and we’ve run our portfolio on the defensive side starting in mid-December, by taking profits in extended positions. So when is the time to become buyers again?
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 remain investible this week; Commodities have utterly failed to recover;
The equity market has proven to be rather resilient lately. SPY has stopped just shy of historical all-time-highs, as it is struggling to meaningfully breach overhead resistance. Our assumptions that produce the chart below are more conservative than the average Wall Street analyst estimates - a Price Target of $470 at the midpoint and 7% compound annual growth rate.
Given the lukewarm reception to Q4’s earning reports so far, this scenario appears to be the most realistic. It suggests upside is still limited, while downside is more likely but well contained in the short term. Even in the face of a 3-4% correction, the bullish bias of the market is undeniable, and “buying the dip” should work out fine as long as supports hold.
The benchmark SPY ETF remains on a SELL signal for now, as the MACD continues to trend lower after experiencing a negative crossover from a very high reading in late December
Commodities are now trading below our technical stop level, at $23.4 on DBC. This level is generated when the asset is trading in a downtrend, and aims to protect a portfolio from negative performance that is more likely to happen given this type of setup. Commodities would need to rally meaningfully in order to become investible again, but weakness in Nat Gas (UNG) and a pervasive consolidation in oil (despite conflict in the middle east and the re-filling of the SPR) are keeping the index in check. A substantially improved growth outlook would be the key catalyst here.
After the bullish run which has occured recently, Gold has consolidated in a tight range over the past week. An increase in yields is not bullish for the non-yielding metal and is primarily responsible for pushing prices lower. Support should come in at $187, and if that fails, downside is at $179. Upside sits at $191.
TLT has broken below the recent consolidation range, and should find support at the 50-DMA, near $94. As the enthusiasm about Fed rate cuts had been fully priced in at the start of the year, bonds are taking a breather as officials start pushing back against these assumptions. The market is still pricing in 6 rate cuts for 2024, while FOMC voters suggest 3 cuts are in order. The adjustment translates into selling pressure for all bond maturities if officials have it their way. Although it seems unlikely at the moment, we could see TLT trade back toward $86 if support cannot hold.
Enterprise (our core investment strategy) maintains the same allocation as last week: 70% equities, 25% treasuries and 2.8% gold. Commodities have been excluded from the portfolio as DBC is deemed uninvestable.
This model has been maintaining a healthy exposure to the equity market, remaining in “risk on” mode. Since the market has not broken its bullish bias, the strategy has no reason to become more defensive here.
There are no orders sent for execution today.
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%.
Note: at the start of every year, we reset the simulation start time of the strategy displayed on the website. When the reset is performed, slight changes might occur in the Trade History. This does not result in any meaningful performance differential over the long term.
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).
All equity factors are enjoying a positive medium term trend, but we suspect this alignment is closer to breaking than not. In any case, it does indicate a topping process rather than a real buying opportunity (that would be when the crossover from negative to positive occurs).
In the short term many factors (7/10) are trading below their respective 20-Day moving averages, in what can be described as a negative breadth situation. SPY is still trading above the 20-DMA as of this writing, along with Growth Stocks (IVW), Momentum Factor ETF (MTUM) and Nasdaq (QQQ). MTUM appears especially overbought in the short term, trading at high deviations above all key averages:
Emerging Markets (EEM) are lagging badly and trading below ALL key averages.
Longer term, all factors are generating some positive absolute performance, but in relative terms, only MTUM, IVW and QQQ are outperforming the SPY.
The recently launched Factor Returns Dashboard allows a different take on which factors are most correlated with high returns on different time periods.
In the short term periods, companies with a high Price to Sales ratio have enjoyed the best returns, but have taken a beating in the very last week (44 is the lowest possible rank). We might be witnessing a turning point in the performance of expensive stocks.
In the last trading week, the market has been rewarding high quality companies (Piotroski F-Score) with high margins and dividend payouts.
Ranking shown for P/Sales
Longer term, Earnings + FCF Yield as well as Margins dominate the rankings. As the economy has gone through an inflationary period, it makes sense that the companies with the most pricing power have come out on top.
Ranking shown for Earnings Yield
Gross Profit Margin reigns supreme among factors on all timeframes, indicating that investors are fretting about the effects of inflation and rewarding companies that can achieve high pricing power.
Ranking shown for Gross Profit Margin
Here’s how we stand on the Sectors front:
We have included 3 former tables from previous articles, for your convenience.
All sectors with the sole exception of Energy (XLE) are enjoying momentum tailwinds and positive medium term trends. As noted in the Factors section, at this stage, this is more of a topping process sign than a “buying opportunity” signal.
Healthcare (XLV) remains the sole sector in short term overbought territory. Financials (XLF) used to be up there as well, but constituent companies did not manage to report good enough earnings. The entire sector has pulled back as a consequence.
Longer term, it’s Energy (XLE) which stands out as grossly oversold, on an absolute and relative basis. The stock of one of the most influential energy companies, Exxon Mobil Corp (XOM), is technically barely able to hold critical support. If support does manage to hold and the stock turns up, it would constitute a buying opportunity in our book, since XOM is trading at a similar price to June 2022.
The iShares Russell 2000 ETF (IWM), representative of small caps and the broad market is a factor we are closely watching for a variety of reasons. After the incredible run-up in late December, a breakout has proven elusive above $201 (R1 Resistance). IWM is now retracing toward support at $186 (S1), with downside at $175, near the trading range lows. If downside is reached, it would be the 9’th “swing” from the upside of the range to the lower part, frustrating a lot of traders in between.
The commentary for Nostromo is unchanged from last week:
Nostromo has completely exited the market after getting a sell signal for SPY in late December.
Our tactical allocation model has been performing poorly as of late, unable to generate any meaningful outperformance and “outflanked” at every turn during the past year. Nostromo “zigged” when it should have “zagged”.
It’s something we need to accept in working with any stock market strategy. Nothing works 100% of the time.
On the equity side, Nostromo is targeting SPY for allocation on a positive BUY signal. For treasuries, the strategy aims to buy TLT, also on the next BUY signal. In the meantime, cash is the only holding of this model.
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. IF.
3. Individual Stock Selection
With the Momentum factor (MTUM) doing very well recently, let’s explore what stocks our own Millennium Momentum model is holding.
Surprisingly, the portfolio’s most notable correlations are Energy (XLE) and Staples (XLP) on the sectors side and iShares Russell 2000 ETF (IWM) along with the Dow Jones Industrial Average (DIA) on the factors side. No QQQ or XLK to speak of, in terms of correlations.
For us, Phillips 66 (PSX) and Huntington Ingalls Industries (HII) are the standout positions in this portfolio, being quality names in their respective industries.
Recently, we’ve introduced an awesome Ranking Instrument that allows you to go in depth and customize the logic that selects stocks for the Millennium portfolios. Using this tool, you can apply our extremely powerful process to a subset of the stock universe that meets your investment criteria.
For example, let’s say we’re only interested in generating investment ideas for energy companies (and prepare for a tactical allocation in case XLE manages to bounce convincingly). We’d open the page and select “ENERGY & TRANSPORTATION” from the Economic Sector selection box, then choose the Industries we are interested in.
The result is a ranking like the one you see in the table below, containing the top Energy stocks (according to Millennium Momentum). What’s more, you can also tinker with the ranking system and easily get a custom selection. If you send a screenshot of your setup over to us, we will also backtest the selection process for you. A video explaining how this works is coming soon!
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.
Moving averages are starting to crest and turn lower. Already the number of stocks trading above their 20-DMA’s has receded from 870 to 364 now, and for the 200-DMA the trend is similar. There is a very clear range forming in the broad market that apparently can’t easily be broken out of, topping out at around 777 stocks for the 200-DMA. Breadth is not bad, but it’s not inspiring either. The market looks like it’s starting a consolidation / correction pattern.
Neutral Signal in Stocks trading above their 200-day Moving Averages
As a contrarian indicator, sentiment works best near extremes. We have now officially entered “Neutral” territory, with stocks being neither overbought nor oversold.
We would be inclined to add to our equity risk exposure once this indicator reaches our target of just above 40 (now 58/100). It should be noted that sentiment took a bigger hit than expected recently. The selling pressure feels “worse than it actually is”.
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).
This is one of the investment themes that will define 2024. Will small and mid caps finally outperform? For now, the trend is flatlining. Investors still overwhelmingly favor large caps due to their better odds of weathering an economic downturn in 2024.
Bearish Signal in Market Internals Z-Score
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.
We are still maintaining a defensive posture in the Sigma Portfolio when it comes to equity risk exposure. Stocks like Microsoft and NVIDIA allow us to maintain some healthy fundamental upside, while Exxon Mobil and Range Resources close up the rear and “hedge” against a sudden rise in commodity prices. Nevertheless, we are in no hurry to overweight equities versus benchmark at this juncture (54% now, vs 60% in benchmark).
On the treasuries side, there is one adjustment to be made, however.
Our models are 76% allocated to risk overall, similar to last week.
Automated Strategies and Market Outlooks
The Sigma Portfolio (Live)
This week, we would like to opportunistically add to our position in TLT, benefiting from the recent drawdown. In order to maintain the same overall allocation to bonds, we will sell SHY proportionately. The overall effect of this transaction is lengthening our bond portfolio duration (SHY effective duration is 1.8 years, while TLT is 16.5 years). Executing the following orders in the Sigma Portfolio at today’s close:
SELL 3% SHY (Sell 20% of Position Size)
BUY 3% TLT (Add 3% to existing Position)
We have also updated all stop targets in 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.
In total, we stand to gain $12.288 by risking $6.242 if our targets are correct. This is a fair risk-reward profile, only attainable by careful position selection and increased stop targets. XOM has our attention as it has violated a stop level, but we’ll give it the benefit of the doubt for now, since Energy is highly oversold.
Correlations to Factors and Sectors can be found on the next tabs:
Correlations look balanced at the moment, there are no glaring issues that need to be addressed.
If you have any questions, please contact us using your favorite channel. Have a great week everyone, and happy investing!
Andrei Sota