Portfolio Rebalance / June 01
Following the Signal Sigma Process
The approach to this article follows the step by step process described here.
This week, our strategies have triggered trades involving both equities and treasuries, all but eliminating cash from their holdings (using leverage by employing a negative cash balance). Swings in the market have been explained by the debt ceiling debate, but underscoring all of the volatility is the Fed’s next interest rate decision, coming up in 2 weeks. Traders have yet to find a clear direction for odds at the next meeting, with bets on a hike or a pause fluctuating wildly. Tech continues to hold up an increasingly weak broad market, and capital is getting concentrated in the highest liquidity names. In the article, we’ll explore the key trends and finish up by explaining our real-life positioning.
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.
While Equities and Treasuries are investible as has been usual for the past months, it’s the pullback in Gold that has our attention. A worthy entry point may be close for the yellow metal. Commodities are reacting to a weak economic outlook and continue to be un-investeble.
The US Dollar has successfully breached its S1 level to the upside. It is now poised to consolidate around current prices and continue its trajectory up until the M-Trend level (blue line, 29.52 on UUP). The dollar’s resiliency is especially relevant given all of the chatter around its demise as a global reserve currency. Its strength will find support when the Treasury starts to replenish its coffers by selling T-bills in exchange for dollars (essentially removing dollars from circulation).
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).
While there is no change in the overall environment just yet, we are noting a prevailing short-term channel that is trending in the same direction. The overall picture reflects a US Dollar with little room to rise in the short-term, with the combined asset classes almost reaching the bottom of this short-term channel. As long as neither group breaks from the short term trend, a positive correlation will eventually develop.
Enterprise has doubled its exposure to stocks, and has adjusted the treasury allocation upward as well.
The Enterprise Strategy
Enterprise, our most conservative model, is now 15% long Treasuries, and 104% long Equities.
Since this model only trades 4 asset class ETFs, we use it to judge overall portfolio positioning.
The model has initiated SPY last week, and doubled the position on a subsequent MACD crossover.
The model’s treasury allocation will be increased today, at the close, reaching 21%. After this order is filled, the model will be at target.
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).
Growth Stocks (IVW) and the Nasdaq (QQQ) continue to outperform this week as well. Both long and short term extensions are well near levels that have previously preceded significant profit taking. Lagging by a wide margin are “mid-market” factors like Small Caps (SLY), Mid-Caps (MDY) and the Equally Weighted S&P500 (RSP). The latter one is historically lagging its market-cap weighted counterpart. A comparison between leaders and laggards can be seen on the chart below, with the current gap equal to November 2021.
On another note, 8 out of 10 factor ETFs are on a medium-term sell signal. This just goes to show that only growth and tech companies have enjoyed the latest rally, leaving the rest of the factors languishing in terms of performance.
Our system finds two technical opportunities, that are not necessarily in either camp. According to our proven selection model, the following ETFs are suitable for a tactical allocation:
Emerging Markets (EEM)
Foreign Developed Markets (EFA)
These ETFs have maintained their relative outperformance to SPY and have also declined from their recent peaks, putting us on watch for entry points.
Here’s how we stand on the Sectors front:
We have included the last 3 weeks of tables as well, for your convenience.
Energy (XLE) is short-term oversold, with Healthcare (XLV), Staples (XLP), Utilities (XLU) and Basic Materials (XLB) trading below all the key moving averages. Tech (XLK) is ridiculously and unsustainably overbought. Communications (XLC) is also extended, but nowhere near as much. It’s not hard to imagine a sizable rotation occurring between these sectors, but it’s anybody’s guess when that will happen.
A leaders vs laggards chart helps us put the price action into perspective. We do need to bear in mind that accounting for the past 2 years, leading sectors are simply “catching up” to the lagards, and have not yet reached a “break-even” point. In other words, the current situation may continue.
There are 3 relative outperforming sectors: Communications (XLC), Tech (XLK), Consumer Discretionary (XLY). Normally, for a tactical trade, we would like to buy these on a dip. No such opportunity exists now.
The Nostromo Strategy
Nostromo, our tactical allocation model, has initiated a position in SPY last week, and doubled it, similar to Enterprise. However, it is now looking to replace the position in SPY with exposure to Emerging Markets (EEM) and Foreign Developed Markets (EFA). Each trade will be taken independent of one another and could result in 0% exposure if SPY gets sold or even more leverage if the two ETFs get BUY signals without selling SPY.
On the treasuries side, Nostromo will buy a 21% position in TLT at the close.
The strategy will become leveraged, ending the day with a negative 25% cash balance. This way, our model compensates for when it held extra cash as a precaution.
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 specifically designed to find stocks correlated to outperforming factors Nasdaq (QQQ) and Growth Stocks (IVW). We’d like to find those stocks that look like breaking out, and we will use a combined chart in addition to the screener. Here are the rules:
Only include QQQ and IVW on the correlation column;
Operating leverage > 1
Negative EBITDA
Pietroski F-Score < 6
Here is the resulting combined equity curve of the screener output:
HUBS and OKTA are definitely names to keep an eye on!
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 Horizon Strategy
Horizon has rebalanced its portfolio to target allocations. It had already been committed to chase the rally, using a portfolio of stocks comprised mostly of Energy and Basic Materials related names. The main factors Horizon is exposed to are Momentum (MTUM) and Mid-Caps (MDY).
There is still very little exposure allocated to Tech (XLK) and Growth in general. The only such position is Rambus Inc (RMBS), a semiconductor company.
This model has performed poorly as of late, reaching a drawdown of 40%. It’s equity curve is more related to the Momentum Factor ETF than SPY. Momentum, Mid Caps and Small Caps have lagged the broader market, and have not recovered properly during the latest run.
As an aggressive equity exposure model, Horizon has got trapped in repeated “bear-market rallies”. Eventually, those will end sooner or later and this model will start performing closer to its historical metrics.
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 very weak in the context of the current advance. Stocks trading above the 200-DMA are holding on to support, however. While SPY is logging new highs, the average stock in the market is simply nowhere near to matching that performance. There is a large difference in Sigma Scores as well. This situation must resolve one way or another eventually.
Neutral Signal in Stocks trading above their 200-day Moving Averages
Bonus chart: the average equity curve of the top 1000 stocks by exchange volume, equally weighted; not showing SPY’s bullishness, but not breaking down either;
Sentiment has drifted in “Fear” territory recently. There are more stocks oversold than there are overbought. It is a strange time for SPY to be printing 1 year highs.
Neutral Signal in Sentiment (leaning Bullish)
In terms of Z-Score divergence, the bearish difference persists.
Z-Scores for the broad market are not showing any signs of a breakout or breakdown currently, rather the measure is trending flat. SPY is clearly forming an uptrend in terms of Z-Score, so we are leaning bearish by this measure.
Neutral Signal in Market Internals Z-Score (leaning bearish)
Dollar Transaction Volume has surged in recent sessions. Dips have been bought, on suppressed volatility. This just shows that there is plenty of liquidity in the market, and current prices are not impeding transactions from occurring.
Bullish 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.
Our strategies have thrown caution to the wind and are fully committed to being invested in equities (primarily), with a healthy dose of treasuries. Leverage is employed, with 25% negative cash. The last time our strategies were in sync this way was back in August 2022. That turned out to be a bear market rally.
There is no reason to average position sizes between portfolios, as they are all the same: 105% equities, 20% treasuries, -25% cash.
Automated Strategies
The Sigma Portfolio (Live)
In The Sigma Portfolio, we have added equity risk recently, and we are initiating two more positions today. We are also increasing our bond duration, by selling short term treasuries in favour of longer term ones. Here are the trades we will execute at the end of the session, bringing the portfolio to a 60-40 stocks / bonds allocation:
SELL 50% SHY (Reduce 50% of Position)
BUY 10% TLT (Add 10% to Position)
BUY 1% RTX (Initiate 1% Position)
BUY 1% ENPH (Initiate 1% Position)