Portfolio Rebalance / November 07
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.
After a spectacular rebound last week, all asset classes are now deemed as investible according to our systems. The USD has been volatile but almost flat on the month, and last Friday’s employment report signalled rather “bad news” that the market chose to interpret cheerfully.
The economy added 150k jobs in October versus a consensus estimate of 180k, a rather underwhelming outcome. Compared to the 297k jobs added in September, the latest data points to a sharp decline. Under the surface it was the private payroll growth of 99k which came in significantly below expectations of 158k, which investors found disappointing (and reassuring) at the same time.
Reassuring because the Fed is clearly aware that employment growth has slowed significantly. This bodes well as far as inflationary pressures are concerned. The Fed is now much less likely to raise rates further, despite any claim to the contrary. In turn, yields contracted sharply, sending the dollar lower and bonds higher. Lower yields imply higher stock valuation, hence the rally in equities.
A stalling economy is a problem for stocks if conditions persist more than a couple of quarters, however. So far, we’ve seen bonds trade in lockstep with stocks to a certain extent. In a recessionary scenario, we expect this correlation to break down and become highly inverse (stocks down, bonds up). Quite tellingly, a lot of prominent investors (Stanley Druckenmiller, Bill Gross, Bill Ackman) have voiced strong support for bonds as an asset class.
Our own Enterprise strategy is rebalancing and buying bonds at this stage, and we are following in the Sigma Portfolio as well.
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 asset classes are now investible;
SPY is doing what we expected it to do: consolidate in a relatively tight range; support remains at $431, while immediate upside is capped at $439, at the channel trend-line; longer term, the next resistance level remains $449.
The MACD signal has turned sharply positive, offering support in the near term;
Commodities are trading directionless at the moment, but some levels are starting to form. Support remains near $24, at the 200-DMA, while upside is capped at S1 Resistance, near $25.5. We’d like to see DBC break in either direction in order to better predict the next move.
Following the outsized gains realized after war broke out in the Middle East, Gold has surged right up to our R2 resistance level at $186. Since then, the advance has stalled, and we sniff a fine profit taking opportunity if Gold moves below support at $183.
The U.S. Dollar (UUP ETF) has traded sideways recently and is now testing support at the M-Trend level, near $29.6; the dollar is almost flat on the month, making the recent downturn look more like a consolidation than a true breakdown. Support is holding for now, putting bulls of all stripes in an awkward position.
Long dated treasuries (TLT) have cleared our STOP-LOSS level of $84.72 and have now become investible. Near term resistance is at $98, which seems like a far-away price target for the time being. We’ll see how this ages in the next couple of weeks, as new supply will enter the market in force; this week’s auctions include a $48 billion 3-yr note tender on Tuesday, followed by the $40 billion 10-yr note auction on Wednesday and the $24 billion 30-yr bond auction on Thursday.
Enterprise, our core investment strategy, is again doing a pretty dramatic reshuffling. This time, bonds are included.
After exiting positions in bonds and stocks, Enterprise had navigated most of last week holding only cash. We have entirely dismissed the move in our own portfolio, since the chance for a continued rally in equities was much higher than visiting new lows, at least for the time being.
Enterprise will initiate positions in both key asset classes at today’s close. SPY will be bought at 56% of portfolio weight and IEF will constitute 31%. Commodities and Gold are left almost untouched, and are simply rebalanced to 2% and 4.8% respectively.
Since this model only trades 4 asset class ETFs, we use it to judge overall portfolio positioning. The largest holdings remain equities, at 56% of portfolio weight (where minimum is 40%).
Cash will represent 7.6% of portfolio weight once the orders are executed. Overall, this allocation makes much more sense to us.
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 are in negative Medium-Term Trends for the 8’th consecutive week in a row. However, at least one medium-term trend is bound to revert into positive territory, as the market rebounds.
On a short term basis, there are no outstanding observations, save for the excellent performance of Momentum Factor ETF (MTUM), which was identified as a likely candidate for outperformance in previous editions of this newsletter.
Small caps (IWM) have a much more healthy technical set-up now than they did last week, with prices that suggest they are again investible.
On a longer term horizon, Nasdaq (QQQ) and Growth Stocks (IVW) are getting extended to the upside, though not alarmingly so. Mid-Caps (MDY) and the Equally Weighted S&P500 (RSP) are continuing to underperform on a relative basis.
There are no tactical opportunities for allocation at the moment.
Here’s how we stand on the Sectors front:
We have included 3 former weeks of tables as well, for your convenience.
The medium-term trend direction has finally shifted for one of the sectors, namely Utilities (XLU). All of the other sectors are still trend-negative, but we’re seeing less inter-sectors correlation, as opposed to the situation with Factors.
In the short term, Transports (XTN) look oversold, while Tech (XLK) leads. Neither sector is extremely deviated to one side or another, but we have to note that the recovery has been uneven.
In the longer term, Tech (XLK) and Communications (XLC) are trading in overbought territory again, while Staples (XLP) languishes as a relative-to-SPY under-performer.
As a tactical allocation, we find value in Consumer Discretionary (XLY), which has been kind of missing from the rally so far. It is the only relative-to-SPY outperforming sector, that’s also trading below its 50-DMA, putting it in a strong position to rally.
Nostromo, our tactical allocation model, will be taking profits on its Momentum Factor ETF (MTUM) position at today’s close. This will bring its overall risk exposure down to 62%
The strategy is also looking to close its remaining equity positions in Nasdaq (QQQ) and Emerging Markets (EEM), in favor of buying Consumer Discretionary (XLY). Of course, it is waiting for the right trade signals to trigger before issuing these orders.
Nostromo’s 24% 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) and some LQD (iShares iBoxx $ Inv Grade Corporate Bond ETF).
Nostromo is no longer leveraged, leaving up to 14% portfolio value as dry powder (cash).
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. 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.
456/1000 stocks we track are trading above their 200-day moving averages, vs ~350 last week. We are now back to trading in the range established since November 2022, which is certainly good news for the bulls. As long as more than 400 stocks trade above the 200-DMA, the market is “fine”.
Bullish Signal in Stocks trading above their 200-day Moving Averages
As a contrarian indicator, sentiment works best near extremes. The recent bounce has taken the market from “Extreme Greed” to “Neutral” in a couple of quick sessions. Right now, the market is in neutral territory, and our sentiment indicator brings no added value.
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). In this “bounce” episode, we can see the divergence rising again, as the market is buoyed by mega cap stocks. We would like to see the broad rally just as much (if not more) than the SPY, in order to give the green light from a breadth perspective. Nevertheless, the divergence is on its way to normalizing since the peak in summer.
Neutral Signal in Market Internals Z-Score
Dollar Transaction Volume has been creeping up since early October. Right now, volume is neutral, despite the heightened volatility. We would like to see higher than average volume confirm the reflexive rally, and offer better liquidity in support of a push to 1-year highs.
Neutral Signal in Average Dollar Transaction Volume and Volatility
4. 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.
With many market signals in a neutral disposition on the equity side, it’s time to consider our allocation to alternative asset classes. For now, Gold has been doing the heavy lifting for us, with a 15% portfolio weight. As the consolidation in the yellow metal looks to turn into a breakdown, we are in a position to take profits here, and bring GLD to its standard 5% weight.
In its place, we will be adding to our TLT position, which has minimal downside at this point.
Automated Strategies
The Sigma Portfolio (Live)
In order to better align our portfolio with the Enterprise strategy and considering our outlook for the next 6 months, we are executing the following orders at the close:
BUY 5% TLT (Add 5% to Position)
SELL 10% GLD (Close 66% of Position)
We are inclined to add even more long-term bonds exposure on a confirmed breakout. For now, this remains just a trade. We’d like to see the USD break down lower before committing more aggressively to bonds.