Portfolio Rebalance / 30 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 markets pushing valuations and prices ever higher, we need to start asking ourselves if the time has come to apply the brakes to risk exposure. Our systems are unbothered by the recent rally (of course they are - trend following strategies are made to capture upside in rallies) - but there does come a time when fundamental limits are stretched beyond reasonable levels.
We are approaching such a level as we speak. In this article, we’ll go through the process step by step and attempt to understand where capital will rotate and how we can position our portfolios in order to capture the most upside.
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 and Commodities are seeing a bit of a revival due to the jump in Oil
SPY continues to trade near all time highs and receives a high deviation warning from our asset allocation instrument. That happens when the distance from the channel median trend-line is above 1.5 standard deviations. In order to better fit the price action to the fundamentals, we need to adjust SPY’s chart for our optimistic Growth Acceleration Scenario, with a $508 median Price Target and 12% CAGR. Even using these rosy assumptions, technical upside sits at $498, which is now just +1.36% away from the last close. Support sits at $468, -4.73% to the downside, near the R2 technical level and the 50-DMA.
Momentum continues to favor the bulls, as the MACD signal shows no signs of turning negative at the moment;
Commodities have bounced timidly, with the rally in Oil driving strength in the otherwise broad based DBC ETF. Natural gas has collapsed again to early December levels, not being able to sustain any kind of breakout. There’s much work to do here until we can get more constructive on commodities, but so far the 20-DMA looks to be providing support for DBC.
It’s worthwhile noting that Commodities and Equities had enjoyed a positive correlation up to early October. Then, everything changed, and now we are in a negative correlation regime between the two asset classes. The only plausible explanation pertains to inflation expectations and its drivers. Normally the equity market should not celebrate low commodity prices, as these usually signal lackluster demand for goods and weak global growth. But when the Fed pivots based on the premise that inflation is contained, low commodity prices suddenly become a net positive. We are watching for any potential reversal in this space.
Gold has been faring surprisingly well recently, especially given the bump higher in interest rates. So far GLD has been able to maintain a series of higher lows, in a rally that started in early October. So far so good, for the yellow metal.
TLT is trading slightly below all key moving averages and below the S2 Resistance level at $96. It’s safe to say that overhead resistance is significant, while technical downside ($86) could imply a large drawdown if inflation resurfaces. Long term treasuries need to consolidate at these levels and not break down further in order to gain enough traction and momentum to build on previous gains.
Enterprise (our core investment strategy) is slightly increasing risk exposure today. The model is marginally adding to its equities position, going from 70% to 73% in SPY. Gold gets a bump as well on account of its positive performance. Treasuries are adjusted lower by 3%, as their performance has been lackluster lately.
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 1.75%.
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 present weakness, as the trend in China (FXI) has not materially improved, despite a “dead-cat-bounce”. The trend there is clearly negative. Foreign Developed Markets (EFA) are performing fine, but not particularly exciting.
Domestic-focused ETFs are all trading strongly in the short term, with notable extensions in the Dow Jones Industrial Average (DIA), Growth Stocks (IVW) and an incredible surge in the Momentum Factor ETF (MTUM). MTUM is now at an almost 3 standard deviation distance away from its median trend-line, a measure which is hardly sustainable without a consolidation longer term.
The top 5 stocks most correlated with MTUM ETF are all tech related at this point.
Longer term, and given the kind of stocks that are highly correlated with MTUM, it comes as no surprise to see Nasdaq (QQQ) and Growth Stocks (IVW) highly extended as well. Value Stocks (IVE) are the worst relative performer of the group.
Among more granular Factor Returns, we see a resurgence in expensive stocks during the last week. A high valuation (Price to Sales) and high R&D spend relative to revenues is working out great at the 3 month and 1 week performance duration.
Ranking shown for P/Sales
On longer timeframes, companies that had a higher spend on R&D relative to Gross Profits have consistently performed better.
Ranking shown for Piotroski R&D / Gross Profit
Operating margin is showing an interesting pattern: good at the 2 year performance, low at the 3 and 6 month terms, stellar at 1 month and 2 weeks while dismal in the latest week. This could be a basis for a “buy the dip” tactical trade setup for the medium term.
Ranking shown for Operating Margin
Overall, it is apparent that the market is moving toward supporting high growth companies again, with R&D budgets to spend.
Here’s how we stand on the Sectors front:
We have included 3 former tables from previous articles, for your convenience.
Sector performance is starting to turn. We are now getting 4 sectors with medium term trends that just crossed over to negative. Consumer Discretionary (XLY), Basic Materials (XLB) and Utilities (XLU) join Energy (XLE) in its momentum slump.
Communications (XLC), Financials (XLF) and Tech (XLK) are highly overbought shorter term. Dividend paying Utilities remain under pressure, as the sector remains unexciting in a stock market looking for growth.
Longer term, Energy (XLE) remains grossly oversold, while Tech (XLK), Financials (XLF) and Communications (XLC) provide leadership and positive relative-to-SPY performance.
We’ve been monitoring Small Caps (IWM) for a breakout since the start of the year. We’ve had one failed attempt in late December, and now IWM looks to be gunning for new highs yet again, with extra support from the successful test of the 50-DMA support.
IWM has been trading range-bound for almost 2 years and has underperformed SPY dramatically during this time. Bears have had a major valid concern for the past year - namely the horrible breadth of the market, with only a handful of names rallying. A technical breakout in IWM would signal that the tide is turning, and it’s starting to “lift all boats”.
Nostromo, our tactical allocation model, is doing its “tactical” thing and closing out the position in SPY bought last week for a quick 1.2% profit.
The strategy is also waiting for a valid buy signal for TLT in order to initiate a position in treasuries. While this model usually trades multiple ETFs, for now it is content holding / targeting only SPY and TLT.
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 - has notched another high-watermark, along with the market recently.
We have expanded the use of its Ranking Logic so that you can now get a stock’s overall ranking, as well as the ranking within its own economic sector, specific industry AND peer group all within the same place: the Single Instrument Chart. This is proving to be an awesome quality of life improvement for quickly gauging a stock’s performance using a machine’s perspective.
Using the Ranking System itself has yielded excellent results recently as well. Virtually all of our latest picks have been selected by using this instrument. Valero Energy Corporation has been a no-brainer partial replacement for XOM given its ranking.
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 number of stocks trading above key moving averages has advanced recently and is situated at healthy levels. Still, it’s obvious the S&P 500 is trending higher, while the breadth of the broad market is kind of flat, creating a minor bearish divergence.
Neutral Signal in Stocks trading above their 200-day Moving Averages
As a contrarian indicator, sentiment works best near extremes. We are currently experiencing regular levels of “Greed”.
The market is not yet overbought and euphoric enough as to trigger a true SELL signal - there’s still upside left on this indicator. We are, of course, far and away from any reading suggesting buying on fear. Eventually a correction will arrive, and a better entry point shall present itself in order to raise exposure meaningfully.
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 defining investment themes of 2024. The trend that began last year with the dominance of “the Magnificent 7” looks to be continuing for now. Mega cap stocks are simply outperforming the broad market to an unusual extent - the switch occurred sometime in March 2023 and the investing landscape has refused to budge. Narrow leadership is not healthy for the stock market.
Bearish Signal in Market Internals Z-Score
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.
Our models have dialed down risk exposure this week - an understandable move considering markets trading at all time highs and less favorable risk-reward setups.
We are running our live portfolio near standard benchmark allocation. There is no particular reason to be either aggressive or too defensive for the moment, as the market has done “nothing wrong”.
Automated Strategies and Market Outlooks
The Sigma Portfolio (Live)
This week we have no trades planned. The next major step in our strategy includes a bout of profit taking and rotation to other sectors / factors.
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 $9.425 by risking $8.111 if our targets are correct. This risk-reward is not great, as it’s almost equally balanced and only slightly better than taking our money to a blackjack table. But that’s what happens when markets rise - the risk-reward gets worse. Profit taking in NVDA, QQQ and GWW is coming.
We have been enjoying a strong correlation to the factors that have performed best, BUT that also leaves us open to a nasty rotation trade. We need to perform that rotation ahead of the market, in order to avoid getting punished.
We’ll be looking to rotate out of Tech (XLK) and Consumer Discretionary (XLY) in favor of Energy (XLE), Staples (XLP) and Healthcare (XLV) - a clearly defensive move.
If you have any questions, please contact us using your favorite channel. Have a great week everyone, and happy investing!
Andrei Sota