Portfolio Rebalance / July 26
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 slumped slightly, in line with the overall price action of the market itself. The new week does not bring major changes to allocations, as most markets states that we measure have not changed materially since 7 days ago. As a result, many findings that we covered in last week’s newsletter remain true today. In this article, we review the full investing process and note the nuances in the financial landscape.
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. Commodities are seeing a very nice pickup in performance, bouncing off the lower trend-line;
Equities continue to grind higher, and it’s anybody’s guess exactly when the rally will end (and why); for the moment, every dip is being bought, rather aggressively.
Commodities are challenging the S2 Resistance Level at $24.57, after a very nice rally off the lower trend-line. Look for potential weakness ahead, as DBC is currently overbought. If we get a real breakout here, we would consider adding energy exposure to our Sigma Portfolio.
The U.S. Dollar has bounced from its oversold condition, near the isolated S2 support level. While the ultimate trend for the U.S. Dollar is still uncertain, one thing is certain: bulls would have hoped for a breakdown. The fact that the reserve currency still has bids coming in, and that it’s trading near the lower trend-line reminds us cash is relatively cheap (and everything else is relatively expensive). Note: we have adjusted the chart below to reflect a 5% CAGR, which is far more realistic than the “natural” 7.8% 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. The dollar has violated our assumed trend channel, but promptly bounced back. The combined asset classes are navigating a steady climb, with overall weakness exhibited by treasuries and commodities. In fact, Treasuries are the only asset class to have not rallied recently, on the dollar’s slump.
The fact that the two pairs of assets are trending in the same direction medium term is certainly encouraging, and signaling that the bear market is over, for now.
Enterprise, our core strategy, maintains positioning.
The Enterprise Strategy
Enterprise, our most conservative model, is now 104% long physical Gold, and 20% long Treasuries, unchanged from last week.
Since this model only trades 4 asset class ETFs, we use it to judge overall portfolio positioning.
The model’s treasury allocation is at target.
Gold allocation, on the other hand, is looking to be decreased substantially. Enterprise will be waiting for the right signal to initiate the trade, since Gold has been trading in a tight range recently.
Cash allocation is at negative 25%, 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).
There are no more holdouts when it comes to the medium term trend - ALL factors are now positive! This is not a piece of good news, as the name suggests, since times when factors were all positive usually align with short term market tops.
All factors are also trading above every significant moving average (left panel). 6 / 10 factors are short term overbought, with the notable exception of QQQ, that has pulled back slightly.
Longer term, Nasdaq (QQQ), Growth Stocks (IVW) and Value (IVE) remain overbought. The Dow and the Equally Weighted S&P500 (RSP) are in a highly unusual situation in this regard (right lower panel). They are close to 2 standard deviations overbought on an absolute basis, but near 2 standard deviations oversold on a relative-to-SPY basis.
Last week, we noted:
A rotation should benefit RSP and DIA, given the current set-up, since these ETFs are the only ones not working…
Our prognosis proved prescient, as both ETFs have rallied nicely since last week, and the Dow has even managed a technical breakout. Given their relative oversold nature, we continue to suggest that RSP and DIA will be net beneficiaries of a rotation trade.
There are no immediate technical opportunities of note for Factors, as in the short term, none are oversold.
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 the same positive medium term trend for ALL sectors. We have never witnessed such a perfect alignment across equity sectors and factors, telling of the extent to which the market is overbought overall.
Also, there are no sectors trading below any key moving average. Industrials (XLI), Tech (XLK) and Transports (XTN) are both short and long term overbought. Basic Materials (XLB) and Financials (XLF) join the overbought category only on the short term.
Conversely defensive sectors Utilities (XLU), Healthcare (XLV), Staples (XLP) and Energy (XLE) - the winners of 2022 - are now longer term oversold. Utilities beta-to-SPY has reached a record low of just 0.32, a consequence of not participating in the rally.
Energy (XLE) piqued our interest, since it is meaningfully correlated with the broad commodity complex (DBC), and relatively oversold vs SPY. Indeed, the bounce we noticed in commodities is being reflected in Energy names, with the ETF challenging S1 Resistance @ $85.87 on XLE.
Meanwhile, the equity rally leadership provided by Tech (XLK) has stumbled. There has been no meaningful correction yet, simply a pause in the velocity of rising prices. It remains to be seen if this loss of momentum brings more material downside.
While harder to detect on an absolute price chart, the loss of momentum in XLK is more evident in the MACD signal, which just triggered a SELL;
There are no immediate technical opportunities of note. In theory, defensives should benefit from eventual profit-taking in Tech and Discretionary. That scenario would come to pass only if more fundamental cracks appear in the bullish narrative.
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.
The strategy is looking for an opportune moment to close the position in Gold Miners (GDXJ) and buy the less volatile underlying commodity - Gold itself. On the fixed income side, a similar defensive rotation is targeted, on the right signal: selling LQD in favor of TLT.
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 take a look at one of our presets - the Momentum + Quality Screener. This screener blends proven technical metrics with factors that ensure a solid underlying business. The following settings are pre-set:
Piotroski F Score => 6; this ensures Quality
6 month & 1 Year Absolute Returns > 0; a basic momentum requirement
Sharpe Ratio > 1; very favorable risk-reward
Z-Relative > 0; stock outperforms its benchmark ETF
Just 36 issues make the list:
The combined equity curve looks a bit too good to be true (or overbought, depending on your lens):
We’ll try to find relatively oversold stocks within this group by setting column A to Z-Score and column B to Sigma 50, then charting the results on a scatter plot. These factors identify “buy-the-dip” opportunities, if any:
Turns out there are plenty of stocks worth looking at! We can study their financials using the Fundamentals Explorer, and model their Price Target / EPS Growth Rate using the Valuation Wizard.
The Millennium Strategy
This week, we will spotlight the Millennium Momentum portfolio, sporting a collection of Energy-related names. This strategy has suffered a large drawdown starting early 2021, when the momentum factor started to badly lag the broad market. Since momentum relies on selecting previous “winners”, this strategy undergoes cyclical periods of over and under-performance. It does look like it may be finally showing signs of life and bouncing off its temporary lows.
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 is teasing us with a breakout in stocks above the 200-day moving average. Similar to last week, we’re not quite there yet. The cummulative deviations suggest a short term topping process might be in place.
Neutral Signal in Stocks trading above their 200-day Moving Averages
As a contrarian indicator, sentiment works best near extremes. We are still in “Extreme Greed” territory, but the market appears to be turning. We’ll take this as a bearish development, but the degree to which this indicator can correct suggests considerable downside. The market has been as overbought just 3 other times in the last 2 years.
Bearish Signal in Sentiment
In terms of Z-Score divergence, there is no change from last week. The broad market and SPY have advanced to the same degree.
There is still insufficient participation in the broad market. 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. Furthermore, the “catch-down” event can be bullish (if SPY corrects more than the broad market, or bearish - if the broad market suffers losses larger than SPY, further exacerbating the divergence).
Bearish Signal in Market Internals Z-Score
Dollar Transaction Volume has recovered to the polinomial average (which itself is trending up).
Our thesis was that the next spike in transaction volume will come on a price move down. This hasn’t exactly happened as anticipated - we were not counting on rising volume in the near term. As a consequence, we’ll count this metric as “Neutral”.
Neutral 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.
Last week’s addition in the Financials / Small Caps space has paid nice dividends. We bought ZION ahead of earnings and enjoyed a nice pop of 10% right after the trade.
Keeping an opportunistic and nimble approach remains key at this juncture. Our systems are attempting to de-gross volatility (transitioning from Gold Miners to physical Gold for example), and the overall market seems to be waiting for a risk-off catalyst. Will today’s FOMC decision and conference kick off the summer doldrums?
It’s not for us to say, as our mission is to manage risk, not bet on certain outcomes. We’d prefer to buy dips, rather than chase this rally in equities for the moment.
Automated Strategies
The Sigma Portfolio (Live)
In The Sigma Portfolio, one of our positions has reached a Take Profit target (OMF), so we are reducing that - unfortunate that the moment coincides with an earnings call that has seen the stock drop somewhat. Simultaneously, we are adding 2% to RTX, which also fell after announcing earnings, on an engine coating issue that will impact cash flow in the short term. In our book, this is what a buying opportunity looks like. Similarly, the risk / reward for ENPH is starting to look very attractive, with a lot of negative factors priced in.
Nostromo’s intention to reduce Gold volatility will be expressed as a “take profits” order in GDX.
We are executing the following orders at the close:
SELL 20% OMF (Reduce 20% of Existing Position)
BUY 2% RTX (Add 2% to Existing Position)
BUY 2% ENPH (Add 2% to Existing Position)
SELL 40% GDX (Reduce 40% of Existing Position)
The adjustments will take our overall exposure up to 30% Long equities.