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.

With asset markets rebounding to a certain extent this week, one of our models (Enterprise) will be cutting exposure to equities for the time being, waiting for a better entry point next week.

Meanwhile, Nostromo is still maintaining its posture, initiating a 6% position in Growth Stocks (IVW). With these conflicting decisions as our backdrop, we will also shake things up a bit in our own live Sigma Portfolio. We are aiming to reduce generic ETF exposure (QQQ and MTUM positions) in favor of single-stock positions that offer better risk-reward. We will also switch up some discretionary positions in favor of a selection of stocks from our Millennium portfolios.

Keep reading for the full breakdown.

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 has officially departed “deep oversold” conditions, as the 2 day rebound has now instilled some confidence in dip buying activity; the trading range remains wide, with resistance at $431 and support at $409; in order to assess market conditions better, we’ll also need to look at other factors.

Commodities are trading directionless for the moment, and it’s hard to establish clear levels at this juncture. We need to see DBC break either higher or lower in order to confirm a more pronounced trend. Support remains near $24, at the 200-DMA.

Following the outsized gains realized after war broke out in the Middle East, Gold has hit R2 resistance to the T, at $186 and reversed. We expect Gold to continue trading in a tight range, and have set a new stop-level at $183 for our portfolio.

The U.S. Dollar (UUP ETF) has consolidated and has regained upward momentum. Despite its clear overbought condition, the upward technical level at $30.4 is still some ways away from the last close ($30.07). Equity bulls were hoping for a reversal in the Dollar and a retracement to the 200-DMA, near the lower part of the technical channel, a move which would have boosted every other asset class as well. Yet we are not getting any evidence yet of such a reversal, and the fact that UUP maintains its 20-DMA is a concern.

Long dated treasuries (TLT) continue to trade below our stop level and are not investible.

Enterprise, our core investment strategy is making a bold move today, by cutting equity exposure completely at the day’s close. We explain the logic below.

When a BUY signal is detected in Enterprise, an internal counter starts in order to measure the number of days held for each position. If that position does not turn a profit in 25 sessions, a temporary cut is signaled. This is the case with SPY today, and the reasoning behind the full position close.

Basically the time has run out for SPY to perform given the assumptions from last month. This is a temporary pause, as the position will be reinstated again next week and the timer restarted. But until then, the algorithm is hedging against increased volatility by using cash.

The positions in Gold and Commodities remain unaffected, as they are set at the default weights of 5% and 2% respectively of portfolio value.

This is not a trade we would follow today, as the market remains oversold, generally speaking. We’d rather wait for a much better exit opportunity. Nevertheless, until breadth improves, there is an argument for decreasing risk. Maybe not at this extreme rate.

Cash is now the dominant position in this portfolio, at 94% weight.

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).

All factors still remain stuck in negative Medium-Term Trends for the 7’th consecutive week in a row. This is a remarkable stretch of time without a single factor managing to return to a positive trend. The only good part about this is that the market has not exactly “crashed”, and the whole move seems to resemble a “garden variety” correction so far. Remember that a 10% drawdown is normal in any given year.

On a short term basis, the iShares Russell 2000 ETF (IWM) is the most oversold factor, with Mid-Caps (MDY) close behind. These factors are very representative of the broad market, which is not dominated by a handful of mega-cap names. When picking stocks, it’s this pool of instruments that one is likely picking from - making life pretty difficult for the average portfolio manager or discretionary trader (us included).

While the rally in small caps remains elusive for the moment, the Sigma deviations are large enough to elicit a reflexive rally. We need to see IWM above $170 in order to get more excited.

On a longer term horizon, it’s the Equally Weighted S&P500 (RSP) and Mid-Caps (MDY) which are grossly oversold, especially on a relative-to-SPY basis. Nasdaq (QQQ) and Growth Stocks (IVW) are extended to the upside, but no longer truly overbought.

For a tactical allocation, the 3 outperforming ETFs represent notable opportunities:

• Momentum Factor ETF (MTUM)

• Nasdaq (QQQ)

• Growth Stocks (IVW)

Here’s how we stand on the Sectors front:

We have included 3 former weeks of tables as well, for your convenience.

For the 5’th week in a row, all Factors are lining up with negative medium-term trends in a similar fashion to Sectors. However, we can spot more ETFs that are extremely extended to the downside.

In the short term, it’s Transports (XTN) and Healthcare (XLV) which are grossly oversold. Healthcare (XLV) is the real surprise here, since it’s not an obvious candidate for generating underperformance. While Transports (XTN) are highly sensitive to the economic cycle, Healthcare is much less impacted by it - hence the surprise. The chart for XLV is telling of the damage done to the sector.

In the longer term, the only sector that looks overbought is Communications (XLC). Healthcare (XLV), Utilities (XLU) and Staples (XLP) are the ones looking oversold both on a relative and on an absolute basis.

For a tactical play, our system would select Consumer Discretionary (XLY), Tech (XLK) and Communications (XLC). These sectors are outperforming on a relative-to-SPY basis and are also trading below their respective 50-DMAs, representing a buying opportunity.

Using a discretionary lens, we find the pullback in Healthcare (XLV) intriguing and worthy of future investigation.

Nostromo, our tactical allocation model, is looking to deleverage from its equity exposure by selling down some ETF positions. However, the proper signals must first trigger before these sales go through, and they are unlikely to come up in an oversold environment.

The strategy has added a 5% position in Emerging Markets (EEM) yesterday, and will also add 6% in Growth Stocks (IVW) at today’s close.

Nostromo’s bonds position is mostly derived from a combination of TIPs with IEI (3-7 year treasuries) and HYG (corporate bonds). It is also looking to add MBB (Mortgaged Backed Securities).

Nostromo is marginally leveraged, with a -3% cash position.

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. Stock Selection

The drawdown in Healthcare looks intriguing. We’ll run a custom screener and see what stocks might be of interest to us longer term. The parameters for the screener are set as follows:

• we will set the Correlation column to “Benchmark” so that we can select ETF with the highest correlation to each stock

• set the Benchmark to XLV, ensuring that mostly healthcare related stocks make the cut

• set column A to “Z-Relative” and limit it to minimum of 0 - this ensures that only stocks outperforming XLV remain

• set column B to Sharpe Ratio, and limiting this to 0.5, so that better risk-reward performance is selected for

• set column C to “Return on Equity” and sort by this column

AMGN, LLY, GILD, UNH and VRTX look like very solid picks to us. These names can be bought on the dip, as they are outperforming the broad healthcare sector massively. Take a look at their combined chart:

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.

326/1000 stocks we track are trading above their 200-day moving averages. Despite a bounce from even lower levels, we need to see more than 400 stocks trade above the 200-DMA (yellow dotted line) in order to feel good about breadth. Not the case today.

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

As a contrarian indicator, sentiment works best near extremes. While the recent bounce has taken the market from “Extreme Fear” to plain “Fear”, the respite from oversold conditions is welcome. This indicator is still bullish, albeit less so than one week ago.

Bullish Signal in Sentiment

The comparison of Z-Scores reveals the previous chasm between SPY and the broad market is slowly but surely closing. This comes as large caps decline more aggressively than small and mid caps. However, true strength would come from small caps rallying harder than large caps in the future. This is not the case for now.

Neutral Signal in Market Internals Z-Score

Same comments in regard to volume as last week:

Dollar transaction volume is slowly creeping up toward the recent average. Added liquidity is a net positive. However, rising volume on falling prices is not such great news for the bulls, as high transaction volume confirms that the prevailing price is accurate.

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 average system exposure is now 56.5%. This has come down from over 100% in the past couple of weeks, as our models have a “trend following” principle embedded in their foundation. Since we suspect we’re now in the middle of a “range trading” environment, the assumption is that we’ll have to compensate and actually trade against their signals in the near term at least.

Automated Strategies

The Sigma Portfolio (Live)

Let’s review the make-up of the Sigma Portfolio before discussing today’s changes. We have a fully allocated portfolio, with minimal leverage employed. Our Asset Class allocation is:

• 73% Stocks

• 17% Bonds

• 15% Gold

• -5% Cash (leverage)

We do not own any commodities. For the Equities asset class, the breakdown for the 12 positions is as follows (percentages of total portfolio value):

• QQQ - 20%

• MSFT - 8.4% (millennium position)

• MTUM - 6%

• NOW - 5.4% (discretionary position)

• FICO - 5% (millennium position)

• NVDA - 5% (millennium position)

• LLY - 5% (discretionary position)

• XOM - 4% (discretionary position)

• MCD - 4% (discretionary position)

• GWW - 3.45% (millennium position)

• RRC - 2.2% (discretionary position)

• AMD - 1.8% (discretionary position)

In total, we are holding 26% ETF exposure, 22.4% single stocks selected on a discretionary basis, and 24.6% single stocks selected from our automatic systems.

In order to get more aggressive during this drawdown and increase risk, without commiting much more capital, we will start rotating away from the broad ETF exposure to more focused single stock positions. As such, we will cut QQQ to 14% from the current 20%. We will revisit our investment in Progress Software (PRGS), using a nice entry point at ~$50 and offering 18% upside to our $60 Price Target. AMGN is one of the stocks from our screener session earlier that is also found in Millennium Alpha’s portfolio, so we will initiate this position as well.

• SELL 6% QQQ (Reduce Position Size by 30%)

• BUY 3% PRGS (Initiate 3% Position)

• BUY 3% AMGN (Initiate 3% Position)

We would also like to re-initiate our position in EXP, which was stopped out last week. Since then, the stock has risen back up above the stop level.

• BUY 2% EXP

Overall, our equity exposure will rise to 75% from 73% currently. We are broadening our portfolio by adding 3 positions in anticipation of the fact that market breadth will improve, and concentration in the top names will be less intense. We are looking to offload Gold and add treasuries as soon as it’s technically feasible.