I have some personal news to share with my readers - as of today, I am officially recognized as a Registered Investment Adviser, in the European area. This is a momentous achievement for me, as an individual with no formal training in the field of finance.

- Andrei

Following the Signal Sigma Process

The approach to this article follows the step by step process described here.

This week, we are resuming our main newsletter, entitled “Portfolio Rebalance”. We’ll go over the recent trades executed by our strategies, their positioning, and various metrics from the platform’s instruments.

As you may have noticed, our 3 active strategies (Enterprise, Nostromo and Horizon) have tilted their general allocation toward Gold and other related positions (Silver, Miners and such). This is due to the fact that the main risk analysis engine (the program responsible for selecting 2 complementary asset classes) has determined that Gold is more attractive than stocks from a risk-reward perspective. Given that all major asset classes trade against the U.S. Dollar at the end of the day, what would be the fundamental thesis underpinning a more serious allocation to precious metals and does it make sense?

We’ll discuss below.

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.

The US Dollar has bounced from the isolated S1 resistance level ($28.51 on UUP), and is prone to re-test the lower trend-line. More support can be found just below, at $27.34 (S2 level), a level which is likely to be hit soon, if weakness continues. While the Dollar is clearly not overbought at present, the fact that it has tested resistance and failed at the S2 level is telling in terms of limited upside currently.

We are constantly checking for a break in the current negative correlation regime between the US Dollar (white) and every other asset class, combined (orange).

In the medium term, the correlation is starting to trend positive. Despite the short term inverse moves between the two equity curves, there is a clear channel forming in the same direction, with identical slope. This - to us - signals that the previous regime is nearing its end, which is bullish for investors of all stripes.

Enterprise has ditched CASH (now holding a negative balance) and is instead holding an exceedingly large position in physical Gold. This used to be allocated to Stocks, but due to SPY’s extreme upside deviations, the risk-reward is not deemed favorable. The thesis behind optimism for equities relies on Central Bank support (easing of rates, restart of QE, economic weakness). Yes, weakness in the face of accelerating deflation - which will essentially spurr the printing of money. Traditionally, Gold and precious metals have been beneficiaries of such actions, moreso that stocks. See the post financial crisis monster rally in bullion (150% between 2009 and 2011). Current prices are a smidge below that peak, with Gold not being able to hedge inflation accordingly in subsequent years.

There is definitely a fundamental case to be made here, that aligns with holding stocks and gold heading into an economic slowdown.

The Enterprise Strategy

Enterprise, our most conservative model, is now 104% long physical Gold, and 20% long Treasuries.

Since this model only trades 4 asset class ETFs, we use it to judge overall portfolio positioning.

The model has initiated the position in GLD as the yellow metal formed a technical “bottom” and had good prospects for a bounce. The order was triggered on July 07. However, it is already looking to take some profits, in the short term, on any technical signal.

The model’s treasury allocation is looking to be increased by about 30%. Bonds are also great beneficiaries in an economic slowdown. They benefit from perceived safety, as well as value appreciation when rates eventually go lower.

Cash allocation is at negative 24%, which means the strategy is employing leverage. This is one way of compensating for when the model is not fully allocated to either asset class.

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 weeks from when we last published this article format in order to help you compare developments (click on the arrows or thumbnails to cycle through the tables).

Our first observation is that all Factor ETFs with the exception of Foreign Developed Markets (EFA) are in a medium-term uptrend. However, the only factors to have outperformed the SPY in the last 6 months are Nasdaq (QQQ) and Growth (IVW). All of the other factors have underperformed.

Growth Stocks (IVW) and the Nasdaq (QQQ) continue to see outsized deviations, but in the short-term, it’s Mid-Caps (MDY), Value Stocks (IVE) and the Equally Weighted S&P500 (RSP) that are standing out as overbought. What’s interesting is that on a longer term horizon, these factors (along with the DOW) are seeing the worst relative performance.

This is the ideal set-up for a rotation from previous winners (Growth, Tech, Large Caps) to the broad market (RSP, MDY, IVE).

There are no immediate technical opportunities of note.

Here’s how we stand on the Sectors front:

We have included the last 3 weeks of tables as well, for your convenience.

We find that in short term, Industrials (XLI), Consumer Discretionary (XLY) and Transports (XTN) show the highest deviations by a wide margin. Transports are especially prone to a correction here, not only due to the technical upside deviation, but fundamentally as well (weak guidance very likely this season). Tech (XLK) is also showing the highest longer term deviation from all of the sectors, but in the short term it has pulled back somewhat - an entirely expected move.

The clear underperformers remain Energy (XLE), Staples (XLP), Utilities (XLU) and Healthcare (XLV). The latter 3 sectors due to their defensive nature, and the former one due to a fantastic performance in the past 2 years, which is now starting to fizzle (or normalize).

There are no immediate technical opportunities of note.

The Nostromo Strategy

Nostromo, our tactical allocation model, is borrowing Enterprise’s overall positioning and putting a little “spin” on it. Since Nostromo can select up to 40 granular ETFs, it can better isolate outperforming ideas. In terms of precious metals allocation, the model will pick physical silver, silver miners, and 2 varieties of gold miners (GDX, and GDXJ). SIL and GDX are yet to trigger the right BUY signals, so they receive no allocation just yet.

On the treasuries side, Nostromo is holding a 19% position in TLT and is looking to replace this with a higher yielding (and more risky) LQD - Investment Grade Corporate Bonds.

The strategy still holds 26% in cash at the moment.

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.

3. Individual Stock Selection

This week, we’ll run a screener based on margin expansion. Margins (the ability of companies to pass on costs to their clients) will be one of the hottest topics discussed on earnings calls this season. Let’s see which companies have seen their margins increase. We’ll set the “Trend” column to “Margin Expansion”, then set the “Trend” to “Rising” in order to create the base screener.

Then, we’ll like to also see which of these companies has managed to increase sales, so we’ll create a “Sales Growth” comparison on columns A, B and C and only allow positive sales growth. We’ll set the Operating Leverage to 1 and the Pietroski F-Score to 6 in order to only pick the greatest business models.

Here’s the screener set-up:

The combined equity curve looks promising, indeed! There is some noise in the upper and lower trend lines due to certain price irregularities (illiquid stocks must have made their way in the screener), but overall the selection of stocks is most closely correlated with the Industrials (XLI), Energy (XLE) and Basic Materials (XLB) sectors.

We can use the Fundamental Explorer instrument to take a deep dive into their financials. Then, use the Valuation Wizard to generate a Price Target, and see the target on a chart using Technical Analysis. We might uncover some potential candidates for our portfolio!

The Millennium Strategy

This week, we will spotlight Millennium Alpha, our top smart-beta model. There are some eye-popping gains that certain stocks have delivered (AVGO at 57% and GWW at 20%), but what we’re really interested is finding out the broad investment themes of this portfolio.

As can be seen in the upper part of the visual, more than half of holdings are correlated with Industrials (XLI). In terms of factors, the majority of positions are very similar to Mid-Caps (MDY). There’s little sign of Tech (XLK, QQQ, IVW), which comes as a surprise given the good performance.

Albemarle Corp (ALB) is one of the Sigma Portfolio positions, purely by “coincidence”.

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 has improved in the recent month, with the average Sigma Score for many stocks catching up to SPY to a certain extent (0.76 vs 1.49). The overall number of stocks trading above their 20-day moving averages is aligned with previous market tops, which is unsurprising. When looking at the 200-day moving averages, we find that we are close to a breakout. While slightly negative in the short term, we view the improved participation as bullish for the time being.

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

Sentiment is a contrarian indicator and works best near extremes. We are indeed at an extreme juncture right now, with a record number of overbought issues. Hence, this is an ideal point to reduce exposure into. It is simply a matter of time until we swing the other way around and find more pessimism than warranted. This indicator is clearly bearish.

Bearish Signal in Sentiment

In terms of Z-Score divergence, the bearish difference is near extremes.

Z-Scores for the broad market have improved somewhat lately (which is great) - but the performance differential to SPY is huge. A lack of participation from the majority of issues is very challenging at the moment, since the situation can also resolve itself with SPY “catching down” to the rest of the market.

Bearish Signal in Market Internals Z-Score

Dollar Transaction Volume has surged on the initial stage of the rally, then plunged off a cliff. This kind of volume cannot support a further advance, as liquidity is simply lacking. Long VIX traders will point out that volatility is primed to surge sooner rather than later.

Our view tends to agree with this statement, given the nature of liquidity. The next spike in transaction volume is likely to come from a “down-move”.

Bearish signal in Average Dollar Transaction Volume and Volatility

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’re at a very interesting juncture. Many broad market indicators that we follow are distinctly bearish. Yet the longer term technical picture has become undeniably bullish. Combine that with the fact that our models are "hiding” in precious metals and our only thinking here is that we need to play it safe. Our industry metrics are flashing warning signs, and we’ll be looking at Delta’s earnings call to see if we have it right. If their guidance is soft, we may see plenty of downside for Consumer Discretionary stocks, and high-risk bets in general. Having these bets unwind would not be at all surprising.

If you haven’t watched the transport’s space, Delta’s parabolic run is one for the history books:

Automated Strategies

The Sigma Portfolio (Live)

In The Sigma Portfolio, we have reduced equity risk, and added Gold-related exposure, as suggested by our models. We won’t go “All-In” on the yellow metal, at least not yet.

There could be a very attractive entry point for equities in the near future, and it’s worth keeping some powder dry at the moment. Meanwhile, our 40% bonds exposure, which is split between short and long term bonds is generating income, while also providing theoretical upside.

There is little to adjust at the moment, absent a pullback in equities. At that point, we will apply the tried and tested technique of “buying-the-dip”.