Portfolio Rebalance / October 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.
This week, bonds have proven they are not the safe haven investors once thought they were. Yields broke out to the upside, and the price of our main bond-tracking ETF (TLT) crashed through the technical level that separates “investible” instruments from those that are “non-investible”. We did have advance warning of this move, as our system flagged bonds as non-investible since last week - yet the actual move was still surprising to witness.
Meanwhile, the US Dollar soared and all risk assets pulled back. We have completed the overhaul of our Enterprise model, which should now be more conservative, as intended. Let’s dig in…
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 with the exception of treasuries are investible; Gold is also very near a STOP-LOSS point, and could fall out of favor by next week;
Despite the recent bounce, SPY remains trapped in its trading range; those that got “sweaty palms” during this drawdown episode (a.k.a. carry too much risk) may consider taking some money off the table at $431 resistance, where the real test of the rebound shall happen. With the index still oversold, there is potential for a sharp relief rally in the short term.
Commodities have failed at both resistance levels during the current advance. DBC is now facing a potential plunge to 22.71, where the current trend-line resides, if the 200-DMA fails to hold support (at 23.88, right next to the close).
Facing the prospects of higher yields is challenging for an asset class that generates no income - like gold. The yellow metal (GLD ETF) has broken through all support levels and is now nearing the STOP-LOSS level of 169.04, at the lower trend-line.
The US Dollar looks to be losing steam in its apparently unstoppable advance. It has given this impression before, according to the MACD signal, yet it never managed to convincingly change trend. There is still upside to $30.29 on UUP - risk assets are not out of the woods, and only a SELL signal accompanied by a break below $29.50 would end the current melt-up.
Long dated treasuries (TLT) are in Stop-Out mode, having failed to hold support at the M-Trend level. No matter how attractive yields look like right now, or how seductively “contrarian” the investment might seem, we can’t hold this position much longer unless it clears $87.1 to the upside.
Enterprise, our core investment strategy has been refreshed. We’ve set leverage at a maximum 100% of portfolio value, tweaked some risk metrics and replaced TLT with IEF (7-10 year bonds). As a result, the model is now taking less risk both in duration and in position size. The strategy is no longer using “trade signals”, and instead rebalances on schedule on the second day of the week.
The sharpe ratio is still above 0.8, which satisfies our goals for an easy to follow “all weather portfolio”.
Enterprise, our core allocation model, has recently sold its entire position in treasuries due to the stop-loss violation.
Since this model only trades 4 asset class ETFs, we use it to judge overall portfolio positioning. The largest holding remain equities, at 55% of portfolio weight (minimum is 40%).
Neither Gold, nor Commodities are judged to be a proper replacement for treasuries at this time, so the system is content to keep a 37.68% position in cash for now.
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). Overall, there is not much change from last week, with factors looking depressed.
All factors are again registering a negative Medium-Term Trend. This is the third week in a row we are in this predicament. This is starting to look more and more like an oversold market finding its bottom.
On a short term basis, all factors except QQQ and IVW (containing growth oriented companies) are trading below ALL key moving averages. We see another bottoming signal in this alignment.
Nasdaq (QQQ) and Growth Stocks (IVW) are joined by the Momentum Factor ETF (MTUM) as relative-to-SPY out performers. The Equally Weighted S&P500 (RSP) continues to be a laggard both in terms of relative as well as absolute performance.
Our system will chose the following ETFs for a tactical allocation, due to their short-term oversold nature (trading below the 50-DMA), while simultaneously outperforming on a longer term basis:
Nasdaq (QQQ)
Growth Stocks (IVW)
Momentum Factor ETF (MTUM)
Here’s how we stand on the Sectors front:
We have included 3 former weeks of tables as well, for your convenience.
All sectors are forming a negative Medium-Trem Trend, including Energy (XLE) this week. This is the first week Energy is joining the rest of the sectors in this trend predicament.
In the short term, Utilities (XLU) and Staples (XLP) are shockingly oversold. Deviations like these below all moving averages are rarely sustainable, and a relief bounce could be expected at any time. That is if interest rates comply. There are no overbought sectors short-term.
In the longer term, the only sector that looks overbought is Communications (XLC). Tech (XLK) and Consumer Discretionary (XLY) are no longer overbought this week. Utilities (XLU), Staples (XLP) and Healthcare (XLV) lead to the downside, with high negative deviations.
Communications (XLC), Tech (XLK) and Consumer Discretionary (XLY) are the sectors that our system would select for a tactical play. These ETFs have pulled back below their 50-DMAs while simultaneously outperforming SPY on a longer term relative basis.
Nostromo, our tactical allocation model, is again looking to deleverage.
Gold (or any other precious metals play) are no longer part of the portfolio. Instead, the strategy is looking to reduce growth oriented ETFs to target allocations, leading an overall move lower in equity risk.
On the treasuries part, Nostromo is looking to rebalance portfolio holdings, again following trade signals. It is looking to add MBB and LQD, while reducing TIP, IEI and HYG.
Nostromo holds a negative -25% cash position, still betting that the USD will reverse course and lift all kinds of risk assets. It is no longer almost 2X leveraged like it was last week.
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.
Millennium portfolios have refreshed holdings this week, and that means that a host of new positions have entered (and exited) the selection. Now might be a good time to review these smart-beta portfolios for your next investment!
Notable position NVDA is still part of the Alpha portfolio, but no longer a position in Momentum. LLY has also exited the Alpha portfolio, which leads us to consider a change in the Sigma Portfolio as well. Overall, Alpha has sunk below its average drawdown for the past 2 years, while shifting the sector exposure more towards Industrials (XLI).
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.
Moving averages are “holding support”, if we look at the number of stocks trading above their 200-DMAs. SPY’s Sigma Score is very close to that of the average stock, signaling the index has reached a similar downside in the short term.. This is bullish to the extent that we consider the market oversold enough to elicit a bounce. And it’s also bullish, as long as the number of stocks above the 200-DMA is not below 403 (the yellow dotted line).
Bullish Signal in Stocks trading above their 200-day Moving Averages
As a contrarian indicator, sentiment works best near extremes. The market first entered “Extreme Fear” sentiment on September 26. Typically, sentiment bottoms in about 2 weeks, which aligns with October’s seasonality. In the month of October, the first two trading weeks tend to bring the worst returns.
Bullish Signal in Sentiment
We are seeing definite proof that Z-Scores are starting to align between the S&P 500 (weighted toward large caps) and the broad market index (1000 companies, equally weighted); the Z-Score divergence has reversed trend and is now headed toward 0, as the previous performance of the mega caps is reverting. In order to align the scores, small caps should “bounce harder” than SPY.
Neutral Signal in Market Internals Z-Score
Transaction volume keeps being anemic. We are not seeing volume spikes associated with the lows in sentiment. Overall, lower volume on lower prices is bullish.
Bullish 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 102%, during this drawdown episode. While not entirely resolved, the automated models are confirming what we already know: we should stick to our plan and keep building positions for the next couple of quarters.
Our objective is to overweight the Sigma Portfolio up to 80% Equity Risk exposure on this drawdown and profit from the seasonally strong period into Q1 2024.
Automated Strategies
The Sigma Portfolio (Live)
In The Sigma Portfolio, we are adding 2% to our position in MCD (McDonald’s Corporation) and initiating GWW (WW Grainger Inc) with a 2% allocation as well. These trades will take us from 71% equity risk exposure to 75% exposure.
Executing the following trade at the market close:
BUY 2% MCD (Add 2% to Position)
BUY 2% GWW (Initiate 2% Position)
Using our Portfolio Tracker, we can determine our exact Sector / Factor exposure for the equities part of the allocation as seen below.
In terms of Factors, our trades favor the growth side of the equity spectrum.
You can access this correlation distribution for your portfolio as well by setting up the Portfolio Tracker.
