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.

Last week, we took a risk-on approach to our portfolio management by extending the duration of our bonds holdings, while also increasing equity allocation risk. The composition of our stock portfolio also tilted risk on, with the selection of higher beta stocks.

Earlier today, the main economic data point of the week has been released - the April Inflation readings are out and they came in right as economists predicted: YoY headline inflation came in at 3.4% and core inflation was reported at 3.6%.

However, it was the “miss” in Retail Sales that the market is celebrating. Retail sales in the US were unchanged month-over-month in April 2024, following a downwardly revised 0.6% gain in March and defying market forecasts of a 0.4% rise, suggesting consumer spending has slightly eased.

Understandably, Consumer Discretionary (XLY correlated stocks) are not responding to well to this report. But all that matters in the short term are interest rates, and those are moving lower. With lower rates, every long term asset benefits (TLT, QQQ, XLK, growth stocks in general). Small caps are also outperforming due to their sensitivity to lower rates.

All in all, it seems like our plans are coming to fruition. For now, there are only slight adjustments to be made to our portfolio, since we’ve already moved to target weights last week in anticipation of a rally.

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.

SPY remains bullishly poised, assuming our 1-year Price Target of $545 and 14% CAGR slope of the trading channel. We will update our fundamental assumptions at the end of the month in order to keep this analysis useful. Immediate term upside and downside are almost equally distant as of yesterday’s close. The benchmark ETF is overbought (95/100), but that is the usual reading during bull markets.

Commodities (DBC) have consolidated just below the S2 resistance level at $23.6, but have maintained 50-DMA support. A rally in commodities would technically be possible, but we need to understand which component would push DBC to our rally target.

Could oil (USO) provide this push? Momentum does not appear to favor oil at the moment, with a 200-DMA retracement in the process of occurring.

What about agricultural commodities (DBA)? It looks like the same 200-DMA retracement is in the works there as well.

What about Nat Gas (UNG)? We have a winner! And this is also why UNG is in our portfolio - the risk / reward is impressive, even though it’s only based on technicals.

Gold (GLD) is another commodity that has taken a breather recently. The consolidation in gold has maintained bullion at an elevated level, however. We’ll be looking for a better entry point further down the line, as prices are still highly extended.

Long term treasuries (TLT) are currently breaking above S2 resistance at $90.7, after today’s inflation reading. We’ve had similar breakouts previously, which have systematically failed to maintain upside above the 200-DMA, now at $92.4. Sooner or later, this pattern is bound to change. But the real question is how will equities react to a surge in bonds and why would interest rates fall?

Enterprise, our core investment strategy, maintains a similar allocation to last week, with minimal adjustments for now.

In terms of equity risk exposure, SPY is maintained at around 67%.

Bonds exposure (IEF) stays at 20.8%.

The position in GLD is maintained at 4.98%.

The position in DBC is also maintained at 2%.

Cash stays at 7%.

Since this model only trades 4 ETFs, we use it to judge overall portfolio positioning. The strategy’s risk profile is balanced, almost in line with its 60-40 benchmark. We agree with the model’s positioning.

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 (EEM) is the factor technically breaking out after a long period of under-performance to SPY (-17% one year relative underperformance, more exactly). All of the other factors are still trading in a negative medium term trend, a disposition we would expect to see change soon.

In the short term, only Mid-Caps (MDY) look slightly extended. The fact that all factor ETFs are trading above all key averages is a bullish market breadth signal.

Longer term, the Momentum Factor ETF (MTUM) has almost fully recovered after the April slump in absolute terms and is back to overbought. But on a relative-to-SPY basis, there’s hardly been any bounce. Same goes for QQQ relative-to-SPY, which is reaching very interesting levels:

Among more granular Factor Returns, we find an unusual metric dominating short term correlations: the Debt Ratio. The Debt Ratio measures the extent of a company’s leverage (total debt / total assets). The higher this value, the more risk on the balance sheet. Why would the market reward such companies?

There’s only one possible explanation: investors see lower interest rates on the horizon.

Across all timeframes, last week’s top performing factor (Current Ratio) has taken a dive in the short term. This is a metric correlated to high returns in the longer term, so the recent pullback can be considered a buying opportunity.

Here’s how we stand on the Sectors front:

We have included 3 former tables from previous articles, for your convenience.

The rally in Utilities (XLU) is all that stands out from this week’s leaderboard in sectors ETFs. Short term, the deviations are extreme, but the relative-to-SPY performance of XLU in the last year is a staggering -20%. In other words, despite being highly overbought in the immediate term, Utilities are simply playing catch up. There is also the added realisation that Utility companies are net beneficiaries of the A.I. boom - all those data centers that are planned to be built / upgraded also demand added power delivery.

Staples (XLP) are also near term extended, but nowhere close to Utilities. Among defensive, dividend paying sectors, Real Estate (XLRE) is surprisingly missing out on gains.

With the exception of Energy (XLE), all sectors are trading above key moving averages, a testament to positive market breadth.

Nostromo has maintained a similar exposure to last week, but is now slightly less leveraged, with -10% negative cash balance.

Absent significant volatility, this model will neither sell nor buy. It’s trading system waits for the appropriate signal to enter and exit positions. For now, the market appears to be in “continuation” mode, not “reversal”. Nostromo is likely to remain allocated to equity risk for a while.

While underperforming in real life, this quirky model has its uses as a decision support tool. It’s also illustrative to understand why underperformance can also stem from under-allocation and “waiting for the right time”. If that time never comes, the opportunity cost is hard to make up.

3. Individual Stock Selection

Millennium Alpha has rebounded strongly from the slump in late April and is now close to its high watermark. The portfolio is very well diversified in terms of sector correlation: Tech (XLK), Industrials (XLI), Communications (XLC) and Healthcare (XLV) exposure dominates, but these are remarkably well balanced.

On the factors side, most positions are highly correlated with the Momentum Factor ETF (MTUM), which is expected since Alpha is a trend-following model at its core.

As per usual, you can tweak this system using your own inputs if you wish.

The stock picks that we have arrived at for the Sigma Portfolio a while ago (URI, SNA and MCO) have all outperformed in the interim. This proves the versatility of the system as an investment idea generation device.

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 above their 20 and 50 day moving averages has continued to rebound. We would like to see the >20 and >50 DMA numbers hold up in a pullback scenario as well. For now, breadth is solid.

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

As a contrarian indicator, sentiment works best near extremes. The correction episode has not managed to push sentiment toward “Extreme Fear”, as we would have hoped for.

Right now, sentiment is greedy, which is neither great, nor terrible.

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), equally weighted.

The Z-Score divergence has performed remarkable in the “bounce-back” of the last couple of weeks. It has stayed in a similar range, as both SPY and the broad market have recovered in tandem. This is bullish for breadth, as the tide “lifts all boats” not just a couple of mega caps.

Bullish Signal in Market Internals Z-Score

Dollar Transaction Volume has fallen off a cliff as stocks surged. This is not what bulls want to see. Any healthy advance in prices should be accompanied by reasonably high transaction volume. This is not the case today. We’ll keep a close eye on this indicator in the next couple of days, as the trend is troubling.

Bearish Signal in Dollar Transaction Volume

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.

Automated models are strongly allocated to risk at this juncture.

The seeds that we have planted in the last couple of weeks are starting to sprout, and right now is not the time to be making major adjustments in our portfolio. We’d still like to see a slight pullback in equity markets and dispel that worrying signal coming from Dollar Transaction Volume as support should hold. We are already allocated near our target (60% stocks, 40% bonds), and the months ahead should have a positive return bias.

However, overweighting our targets need a certain element of “opportunity” which is missing right now, with markets near all-time highs.

Automated Strategies and Market Outlooks

The Sigma Portfolio (Live)

Summing up: no trading for today. We'll wait for a better opportunity to deploy our remaining dry powder, with plenty of risk already present in our holdings.

Click here to access our own tracker for the Sigma Portfolio and understand how the positions contribute to the overall exposure profile. We’ve been adding to risk as well as tech and momentum exposure with the latest trades.

In total, we stand to gain $15.053 by risking $11.033 if our targets are correct. The risk-reward ratio has declined, as stocks surged.

In terms of Factor correlations, exposure is well balanced. There is a strong correlation to mid and small cap stocks, but growth and Nasdaq-related stocks are not overlooked either.

On the sectors side, Tech (XLK), Industrials (XLI) and Consumer Discretionary (XLY) correlation dominates. Utilities (XLU) are the least correlated with our holdings, something we may look into once the rally in utilities takes a breather.

If you have any questions, please contact us using your favorite channel. Have a great week everyone, and happy investing!

Andrei Sota