Portfolio Rebalance / July 19
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.
The past week, our automated models have performed well, generating a significant performance “tail” (yes, sudden performance spikes also count as tail events in terms of returns distribution - our goal is to have more right tails than left in order to outperform). Also, as discussed previously, Gold has seen a significant correlation to the S&P 500 and has benefitted from the same basic drivers - namely a plunging U.S. Dollar.
Bonds (the other major asset class we have selected) and commodities have also performed well, since the depreciating value of cash lifts “everything else”. This week, the same general allocation is more or less maintained, with a bit less risk on the table. Let’s start by taking a look at the major asset classes and their “investible” status.
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.
According to our analysis, all major asset classes are technically investible at this point. However, the risk-reward set-up for each varies dramatically.
Equities tend to steal the limelight in a rally, and that’s what we are getting now. With analysts eyeing an all-time-high close in the S&P 500 by year-end, no wonder FOMO is the main sentiment on investor’s minds. While technically strong, the rally in equities takes SPY to more than 2 standard deviations above it’s trend-line. This kind of deviation, coupled with “Extreme Greed” sentiment, makes equities seem “expensive” at the moment. At the very least we can say that a better entry point can be found in the next 3-6 months. Today’s deviation is almost the euphoric sentiment inverse of October’s bear market lows.
At the other end of the spectrum, the most “hated” major asset class right now are clearly treasuries. The view on yields is that they will remain “higher for longer”, with the Fed hiking rates again in July. Technically, TLT has consolidated in a reasonably narrow range since early December. There have been a couple attempts at a breakout, but nothing has stuck. Consider the fact that if the current trend is maintained, TLT will generate a -21.53% CAGR. That is a hypothetical loss of over 20% per year in an investor’s portfolio.
The rise in yields associated with such a drop would not be sustainable, so we chalk up this scenario as purely hypothetical. It follows that sooner or later, treasuries will technically “break out”, by virtue of not going any lower. For now selling pressure remains, but a BUY signal has been triggered on TLT for what it’s worth. Our assumption is that when bonds finally do catch a bid, the movement will be brutal.
The U.S. Dollar has taken a beating lately, which was quite well telegraphed technically last week. Fundamentally, the reason for the USD’s weakness is the view that the Fed will be done increasing rates after the July meeting, while other Central Banks (notably the ECB will keep hiking). Now, the U.S. Dollar is oversold and nearing a major support level ($27.37 on UUP - S2). We have adjusted the chart below to reflect a 5% CAGR, which is far more realistic than the “natural” 8% slope formed by the pure price action.
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. Last week’s abrupt fall in the dollar, however, has violated our assumed trend channel, and puts the inverse correlation back in play. The issue we have with a strong negative correlation is that it implies an investor can either hold CASH or anything else basically. It’s an environment typical of bear markets rather than healthy, trending markets. We’ll take these developments as a warning sign for now, and see how events transpire.
Last week we explained why an allocation to Gold instead of Equities makes sense for Enterprise (similar drivers, better risk-reward for Gold). This week, our core strategy doesn’t change a lot.
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 is adjusting exposure to bonds today (buying on a positive MACD crossover), but the trade is not material to overall positioning.
The model’s Gold allocation is looking to be decreased substantially, however. Enterprise will be waiting for the right signal to initiate the trade.
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 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. All factors are also trading above every significant moving average (left panel). 7 / 10 factors are short term overbought, while only 3 (QQQ, IVW, IVE) are longer-term overbought. Only the Equally Weighted S&P500 (RSP) and the Dow Jones Industrial Average ETF (DJA) are relatively oversold, due to their dismal comparative performance.
We have rarely seen such an optimistic factors dashboard.
A rotation should benefit RSP and DJA, given the current set-up, since these ETFs are the only ones not working (see relative to SPY chart below - trending up for the last 2 years, extremely deviated to the downside right now).
There are no immediate technical opportunities of note for Sectors.
Here’s how we stand on the Sectors front:
We have included the last 3 weeks of tables as well, for your convenience.
On the Sectors side, we can notice a slightly different set up than on the Factors dashboard (more variety, including several oversold sectors). Tech (XLK), Consumer Discretionary (XLY) and Transports (XTN) are egregiously overbought both on a short and longer term basis.
Defensives Utilities (XLU), Healthcare (XLV), Staples (XLP) and Energy (XLE) - the winners of 2022 - are now longer term oversold. Putting the price action into proper perspective, this particular mix of sectors (orange equity curve) is still leading SPY (white) by a wide margin since July 2021. The prospect of SPY catching up and closing the gap in terms of performance is not far fetched.
Meanwhile, leadership has been provided by the high-beta, risk-on sectors: Tech (XLK), Consumer Discretionary (XLY), Transports (XTN), Communications (XLC) and Industrials (XLI) - all short term overbought. Notably, these sectors (orange equity curve) have yet to catch up to SPY (white equity curve) in terms of performance.
We are basically seeing a slow rotation from risk-off (and Energy) to risk-on. SPY’s returns are clearly driven more by the risk-on components, especially tech.
There are no immediate technical opportunities of note. In theory, defensives should benefit from eventual profit-taking in Tech and Discretionary. But, as shown above, the longer term flows still favor risk-on sectors.
Conclusion: rather than allocate to defensives because they are relative underperformers, we would be inclined to wait for a “buy-the-dip” opportunity in risk sectors.
The Nostromo Strategy
Nostromo, our tactical allocation model, is more conservatively allocated to precious metals, using an equity ETF to achieve that exposure (GDXJ). The model carries a 51% bonds exposure through Investment Grade Corporates (LQD) and TLT (Long Term Government Bonds).
Nostromo is getting paid to wait for a better moment to use its 25% dry powder reserve.
Allocation is slightly adjusted today in TLT, with the strategy adding 1% to this position on a MACD BUY Signal.
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
For this week’s screener, we’ll account for our previous analysis, as well as Nostromo’s positioning. Also, a factor that has caught our attention are Small Caps - iShares Russell 2000 ETF (IWM), which has achieved a technical break-out (Yellow S1 level).
We have extended the screenshot for good reason. Focus on the right panel, below the chart, that displays stocks which exhibit the highest correlations to the studied ETF - IWM in this case. We’ll zoom in, for convenience:
Notice a pattern? Excepting LADR and UFPI, all of the other stocks that are highly correlated to IWM are related to financial services! Combined with the fact that Nostromo is holding 51% bonds, a tactical allocation in bank stocks should benefit from a rally in IWM, on a breakout. We’ll use the Fundamental Screener to find the stocks with the best risk-reward. Here are the steps for set-up:
Set correlation column to Factors (so factors will appear in the correlation column)
Set Correlated Factor to IWM, so only stocks primarily correlated with IWM will show up
Set column E to “XLF Correlation”, with a minimum of 0.5, so only stocks associated with Financials will make the list
Set column D to “Return on Equity”, with a minimum of 0 (only positive RoE allowed)
Set column C to “Sales Growth %”, with a minimum of 0 (only positive TTM Sales Growth allowed)
Set column B to “Z-Score Relative”, with a maximum of 0 (only under-performing stocks make the list; more likely to “catch up”)
Set column A to “Sharpe Ratio”, with minimum of 0.5 (at least decent risk-reward stock movement)
The screener will output 15 very interesting positions.
Clicking on the “Combined Chart” button will generate an equal weight equity curve from the screened stocks. Looks promising to us.
Clicking on the Company Info button will allow you to explore the fundamentals and technicals of any stock in a snapshot manner. If we have a Price Target, we can set it on the chart using the Technical Analysis Instrument.
The Millennium Strategy
This week, we will spotlight the Millennium Vol Target Smart-Beta portfolio. This is a similar variant to Millennium Alpha, with the benefit of selecting better capitalized stocks, with a maximum beta-to-SPY of 1.2. This is the kind of portfolio composition preferred by hedge funds, that simply chugs along in various market environments.
As can be seen in the upper part of the visual, almost half of holdings are correlated with Industrials (XLI). In terms of factors, almost half of positions are very similar to Mid-Caps (MDY). Tech (XLK) has a 12.5% weighting (2/15 positions), while QQQ is correlated to a single position. Overall, holdings are rather “boring”, and the portfolio on the whole looks quite conservative to us.
Of course, over the last 2 years, this portfolio has clearly outperformed.
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 situation in market breadth is similar to last week. 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, but we didn’t get there quite yet!. 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. In case you needed more confirmation, here it is: the market is overbought, and investor psychology is “Extreme Greed”. 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 picture has deteriorated slightly from last week. The bearish difference is near a record.
Z-Scores for the broad market have improved (which is great) - but SPY has surged more than the average stock. We count this as insufficient participation. 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. Volume has since recovered somewhat, but it’s still unsupportive of a massive advance. The air is getting thinner as the stock market advances.
Our thesis is that the next spike in transaction volume will come on a price move down.
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.
As usual, we’ll be taking a balanced approach. Our systems are pursuing allocation in precious metals and bonds, but we are keen on selecting outperforming stocks as well. There is a clear opportunity forming in the Small-Caps space, especially in economically sensitive financials. These are the only broad category of stocks that have enough risk-reward potential to look attractive, but have realistic assumptions priced in at the moment. Chasing the high-flying tech sector is risky right now, and we’d rather wait for a better entry point down the line.
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, but rather combine the allocation idea with Gold Miners.
There could be a very attractive entry point for risk-on 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.
The breakout in IWM is encouraging for adding exposure to Financials. We’ll execute the following orders at the end of the trading day:
BUY 2% ZION (Add 2% to Existing Position)
BUY 2% BANF (Initiate 2% Position)
Both financial stocks have a high correlation to IWM, per our Correlation Screener.
