Portfolio Rebalance / November 05
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.
With all eyes on the U.S. Election today, algos are choosing to play it safe and err on projecting higher volatility ahead. Indicators like the VVIX are unusually high for a market just a couple of percentage points away from all time highs:
Options activity as of yesterday’s close is pointing to bearish outcomes, with put buying dominant from institutions (data and interpretation from nextSignals.com):
Yet despite short term de-risking (which is natural ahead of a key event), history shows that no matter who wins - the market will do fine in the coming year. Goldman Sachs has recently released a list of odds and associated price movements, according to the final outcome:
Trump w/ Republican Sweep = 25% probability; S&P +3%
Trump w/ Divided Government = 30% probability; S&P +1.5%
Harris w/ Democratic Sweep = 5% probability; S&P -3%
Harris w/ Divided Government = 40% probability; S&P -1.5%
Betting markets are currently assigning the win to Donald Trump, following some wild swings in the last couple of days…
…and even the market’s favorite “inverse prophet” is corroborating Trump’s win.
In conclusion, if events play out as Goldman and betting markets expect, we could see an equity market rally into the end of the year. This would be the case especially if voting (and counting) go smoothly, without claims of fraud and civil unrest.
Let’s see how our process plays out this week…
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.
All major asset classes are investible this week.
SPY has maintained support at the 50-DMA, although it’s hardly relevant in today’s setting. We agree with volatility traders in the sense that both upside and downside can be exacerbated in the next couple of days. The market could swing to $610 at best (R1, +7.2%), and $526 at worst (-7.55%).
Commodities (DBC) have seen some wild swings in September and October, primarily due to the influence of oil markets and geopolitical concerns. The overarching fundamental theme has been China’s stimulus programme and the subsequent fizzling out of growth expectations. Currently, DBC is trading above key support at $22.3, and looks to be setting a new technical base. The price action is encouraging here, with the first level of resistance at $23.14.
Gold (GLD) continues to be the best performing asset class of 2024 by far. The rally has been primarily fueled by Central Bank buying (particularly China and Russia), with “new money” in the form of retail inflows pushing GLD to all-time-highs. A retracement to support can always happen, but we argue that any dip would be a buying opportunity for bullion.
TLT just triggered a MACD BUY signal, as it appears to have found a technical bottom just above our stop-loss level of $91. The benchmark government bonds ETF is highly oversold in the medium term, but appears to be forming “higher lows”. All in all, this is a great entry point into the asset class, for investors who are light on treasuries exposure. Clearing $93 to the upside would cement a technical rebound.
Enterprise, our core investment strategy is trading in a risk-off fashion ahead of the U.S. Elections. All core positions are reduced, and cash is increased.
Stocks exposure via SPY is being reduced from 70% last week to 39% today.
Bonds exposure (IEF) is goes from 25% last week to 20.8% today.
The position in GLD is being increased to 4.6% after formerly being closed.
Commodities (DBC) are also being set to 2% at today’s close, from 0% previously.
Since this model only trades 4 ETFs, we use it to judge overall portfolio positioning. Enterprise is clearly de-risking today, following the same trend found with institutional algorithmic models.
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).
In today’s Factors leaderboard, the ETFs that have not recorded 6 month returns higher than 8% have flipped to a negative medium term trend (MDY notable exception). In terms of market breadth, this paints a “neutral” image in the near term. Also, all domestic ETFs are recording positive 6-month and 1-year absolute returns — a bullish stat.
Foreign Developed Markets (EFA) is lagging in the short term, with technicals nearing a key support level in the form of the 200-DMA and S1. EFA has by far the worst momentum out of all the factor ETFs that we track.
There are only 2 factors recording excess returns over SPY in the past 6 months, and those are the Nasdaq (QQQ) and Growth Stocks (IVW). Out of the two, QQQ is the better buy, due to its lower relative Z-Score.
Should the markets dip significantly after the election, our buy-the-dip picks would be Momentum Factor ETF (MTUM) and iShares Russell 2000 ETF (IWM), both leading in terms of 200-day returns.
Among more granular Factor Returns, there seems to be a shift in near term factors which are high-performing. The top factors at the 1 and 2 week marks are low ranking at the 1 month mark and longer. Gross Profit Margin is one of these factors, most likely rising along with fears of increased inflation. Companies with higher gross margins are generally better insulated against a resurgence in inflation.
In the longer term (1 year and 2 year marks), as well as the very short term (1 and 2 weeks), the Piotroski F-Score is making a comeback, with a major dip in between (note the low ranking between 1-6 months). This may be a good time to pick up quality companies on the relative cheap.
Here’s how we stand from a Sectors standpoint:
We have included 3 former tables from previous articles, for your convenience.
Among Sectors, 6 out of 12 ETFs are now trading in a negative medium term trend, reflecting a level of fragility in terms of market breadth. However, with the exception of Energy (XLE - a “different beast” altogether since it tends to track commodities), all ETFs are posting positive 6-month and 1-year absolute returns.
Healthcare (XLV) stands out as oversold in the near term, but close to “flat” when looking at longer term deviations.
Utilities (XLU) have dropped precipitously from all-time-highs, most likely as profit-taking kicked in. There are several levels of support that our system has identified, and the price action proves that there are limits to any rally. Now, the “force of gravity” is kicking in and we will be closely watching for a reversal here.
With that being said, there are currently no Sectors excessively overbought or oversold, and no tactical allocation opportunities. Defensives (XLP, XLRE, XLV and XLU) are clearly under pressure and unable to trade above their 20 or 50 DMA’s, which is a net positive for the rest of the market, rotation-wise.
(We wouldn’t want to have a rally led by defensives.)
Nostromo, our quirky tactical allocation model, is doubling up its existing position in bonds and buying TLT at today’s close. This system is all-in on bonds and cash ahead of the Elections.
The interesting part here is that Nostromo is not even targeting equities for future exposure (Target Amount column for SPY is 0 - the current negative position is an “artefact” from previous positioning, not a meaningful short position).
With 63% in cash, this strategy is primed for volatility ahead.
3. Individual Stock Selection
Millennium Alpha and all of our stock picking systems are encountering a technical issue, so we can’t rely on their trading for the day. Our data provider failed to update the pricing for all of the stocks in the investible universe.
This will be fixed by tomorrow.
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 trading above their respective 20 and 50-DMAs has gradually declined during the last bout of profit taking. This is not too concerning as long as a healthy part of the market holds the 200-DMA, as is the case right now. What we are seeing is normal consolidation in a resilient market.
Bullish Signal in Stocks trading above their 200-day Moving Averages
As a contrarian indicator, sentiment works best near extremes. The current reading (49/100) is simply… “Neutral”.
It’s as if market sentiment is mirroring the election odds to a certain extent. Prudence is the name of the game, with portfolios somewhat hedged going into the event.
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.
Small caps have been more resilient lately in front of selling pressure, compared to mega caps and especially chipmakers. Domestic resilience is generally a bullish signal, as it implies a strong economy ahead (smaller, domestic companies are more economically sensitive than transnational mega-corporations).
Bullish Signal in Market Internals Z-Score
Dollar Transaction Volume is suffering from the same bug that’s hitting Millennium Alpha. We can’t rely on this indicator today.
N/A 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.
Let’s not mince words. While our systems are selling risk assets and opting for higher cash allocations, our job is to observe their behavior and validate their investing decisions. Enterprise has no notion that elections are happening for example. Also, Enterprise has no idea what each investor’s risk tolerance and investing horizon is.
It’s worth repeating that when we analyze the output of trading systems, we take it as “what a computer would do” and not “what I should do as in investor’.
We believe the betting markets are right. At the time of this writing, voter turnout is both higher than projected and higher than in previous years. This usually happens when the population is unhappy with the status quo. This implies a win for Trump, which is bullish for stocks and risk assets more broadly. So we’re not selling today.
We may be wrong, but in that event the downside to our positions is relatively limited. In other words, we can afford the risks we are currently taking.
Automated Strategies and Market Outlooks
The Sigma Portfolio (Live)
*The Sigma Portfolio display is suffering from the same technical issue previously identified in Millennium and Dollar Transaction Volume.
Click here to access our own tracker for the Sigma Portfolio and review how each position contributes to the overall exposure profile.
In total, we stand to gain $23.585 by risking $11.888 if our targets are correct. The risk-reward equation is favorable at the moment, with a nearly 2-1 ratio.