Portfolio Rebalance / May 23
Following the Signal Sigma Process
Tuesday is the day when all of our strategies rebalance their asset class holding weights. The approach to this article follows the step by step process described here.
After roughly 45 days of price consolidation, the equity market has finally broken out. We explore whether the current rally is sustainable from a broad market perspective and the way our automated strategies choose to position around this shift in technical paradigm. The latest headlines revolve around yet another debt ceiling stalemate, despite the fact that Congress has raised this 78 times since 1960.
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.
Equities and Treasuries continue to be investible, despite what looks like an over-extension in equities; Commodities have failed to rebound and are trading firmly below the lower channel trend-line. Gold has offered up a potential buying opportunity for those looking to gain exposure on the dip.
The US Dollar continues to look overbought and is struggling against its S1 resistance level ($28.38 on UUP). The asset classes that saw continued weakness on the dollar’s latest rally have been commodities (including Gold) and treasuries. Equities have performed unbothered.
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 some of room to rise in the short-term, with the combined asset classes almost reaching the bottom of this short-term channel.
Enterprise has initiated a significant position in risk assets, and it’s currently looking to DOUBLE it.
The Enterprise Strategy
Enterprise, our most conservative model, is entering the week 15% long Treasuries, and 48% in Equities.
Since this model only trades 4 asset class ETFs, we use it to judge overall portfolio positioning.
The model has bought SPY on the breakout last week, when target allocation was at 48%. The last rebalance sees the strategy aim for a much higher exposure, if another BUY signal occurs (this is unlikely).
The model’s treasury allocation is also poised to more than double. In the case of TLT, a BUY signal is much more likely to trigger.
Cash allocation is set at 36%, with the position poised to go negative if both stocks and bonds get BUY signals.
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).
Small Caps (SLY), Mid-Caps (MDY), Momentum Factor ETF (MTUM) and the Equally Weighted S&P500 (RSP) remain under pressure, with the DOW (DIA) joining the under-performance party. The performance differential to SPY is maintained this week as well, despite the rally that has lifted all stocks to a certain extent.
Nasdaq (QQQ), Foreign Developed Markets (EFA) and Growth Stocks (IVW) have been the main beneficiaries of the last period. Extensions are now reaching egregious levels, practically screaming for a rotation trade. It’s very rare to see a factor trade at 3+ Total Z-Score and 2 Sigma Score, like is the case for QQQ.
If it’s got anything to do with A.I. no one wants to sell it.
Finally, there is no Factor that fits our selection model for a Technical play at this point. We would need something of a pullback first. Also, it’s notable that 6/10 factors are signaling a Negative Medium-Term trend.
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), Financials (XLF), Utilities (XLU) and Real Estate (XLRE) have been underperforming for one year, after being on a tear in the previous period. Their performance has caught up with SPY at this point. Utilities and Energy look especially oversold, while Financials have moderated performance somewhat.
Driving the market higher has been a 2-sector job: Tech (XLK) and Communications (XLC). Both have registered explosive relative performance. When plotted against the laggards, we still notice they are barely catching up and closing the performance gap from 2 years ago.
Notably, there are now 5 sectors with both 6 and 12 months positive absolute returns! XLC and XLK are joined by XLY, XLI and XLP as ETFs that satisfy this basic momentum requirement. This is a positive development in terms of market breadth.
Finally, there is no Sector that fits our selection model for a Technical play at this point.
The Nostromo Strategy
Nostromo, our tactical allocation model, has initiated a position in SPY last week, on the breakout. Since no other sector or factor ETF qualified for inclusion, the model defaulted to the benchmark equity ETF.
Should SPY trigger another valid BUY signal (unlikely), the model will raise allocation further.
On the treasuries side, Nostromo plans to allocate towards LQD on the next BUY signal.
The strategy still has 52% cash at this point.
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 Momentum + Quality Screener and attempt to find small or mid-cap stocks that have outperformed their benchmark ETFs. We are not interested in looking for tech or growth stocks at this point, however, so we will exclude these sectors from the scan. Here are the rules:
Exclude QQQ, IVW and EFA correlation;
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
MACD Trend is Positive; medium term momentum is trending up
Some really interesting stocks in this very filtered screener, but no bargains! HLIT could be a BUY at better levels, as well as HSY and MRK.
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, and added to equity exposure aggressively. After all, the model is adept at squeezing bears out of positions, despite the fact that recently this has not turned out so well in terms of returns.
As seen in the second screenshot, our momentum strategy is leaning towards heavy exposure to Energy and Industrials on the sectors side and Mid-Caps and Momentum on the factors side. Technology is creeping in however, courtesy of the RMBS position, that has QQQ and XLK top correlations.
On the treasuries allocation, Horizon has switched exposure to LQD.
Horizon is leveraged at the moment, with a negative 45% cash exposure.
This model has performed poorly as of late. It’s equity curve is more related to the Momentum Factor ETF than SPY. Momentum has lagged the broader market, and has 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 not amazing this week. The broad market is holding up well when accounting for all moving averages, but the Sigma Score difference is very high. This means that SPY is much more deviated above its moving averages than any regular stock.
Neutral Signal in Stocks trading above their 200-day Moving Averages
Our Sentiment indicator has fluctuated all over the “Neutral” zone in recent weeks. We see no change at the moment, as the broad market is not by any means “euphoric”. This could be interpreted as bullish (not everyone is on board for the rally), but we are best served when this indicator is at extremes.
Neutral Signal in Sentiment
In terms of Z-Score divergence, the bearish difference persists.
The same “head and shoulders” formation can be witnessed in the lower panel, for the average stock’s Z-Score. It is not showing any signs of a breakout or breakdown currently, rather it 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 stayed above the “Danger Zone” (red dotted line). We would be concerned if a rally in prices would lead to more muted volumes, signaling exhaustion from the bulls. But as it is, average volume is there, and it’s pushing the market up slowly, in a low-volatility fashion.
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.
Our strategies suggest it is time to lower cash allocations and start taking on more meaningful risk. In fact, every automated model now has more allocation to equities than the Sigma Portfolio. Horizon even has gone full leverage mode and is 45% short cash.
To start, we will take an average of CASH position sizing from all of our models. This will come down to 17%, with a 52% to (45)% range. Equity exposure stands at 66% on average, while on the treasury side models average 18%.
Automated Strategies
The Sigma Portfolio (Live)
In The Sigma Portfolio, we plan to gradually take on more risk, and buy “dips”. We will work our way to 60-70% equity allocation as long as support holds in the broad market.
Today’s rebalance order will remove some Tech exposure, in favor of our Basic Materials and Energy positions. It will also raise our overall equity allocation to 44%.
SELL 50% MSFT (Take Profit)
BUY 2% XOM (Add 2% to Position)
BUY 1% ALB (Add 1% to Position)