Portfolio Rebalance / October 12

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, risk assets have bounced hard against support levels. US inflation rate remained steady at 3.7% in September, against market expectations of a slight decrease to 3.6%. A softer decline in energy prices offset slowing inflationary pressures in other categories. Energy costs fell by 0.5%, while prices increased at softer rates for food (3.7% vs. 4.3%), new vehicles (2.5% vs. 2.9%), apparel (2.3% vs. 3.1%), medical care commodities (4.2% vs. 4.5%), shelter (7.2% vs. 7.3%), and transportation services (9.1% vs. 10.3%).

Core CPI, which excludes volatile food and energy prices, slowed to 4.1%, marking its lowest reading since September 2021. There was an understanding the Fed would not hike interest rates further, given the already tight monetary policy achieved through “jawboning” the market. The decline in yields contributed to improving risk sentiment and a slightly softer dollar.

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; depending on which charting method we use to determine investability (log or non-log), treasuries may also make the cut in investible territory; it all depends on how TLT responds after the CPI release, given the tremendous short position against it.

SPY has reclaimed the $431 level (now support) and is headed into multiple levels of resistance above - notably $440 at the 50-DMA. Some softness may be experienced in the following week or so, given the sharp reflexive rally from oversold conditions.

For investors that have had a much higher risk than desired during the last drawdown episode, now is a good time to rebalance portfolios and re-align exposure to target weights. Translation: if the recent pullback gave you anxiety, now’s the time to sell (not when panic was high).

Commodities have bounced at the 200-DMA ($23.8 on DBC) but subsequently failed at 24.5 resistance level (S3). The way we’ll see a breakout or breakdown from the following range will most likely determine the medium term path for this asset class going forward.

Lower yields boosted Gold, which earns no income. GLD bounced hard off trendline support and the S3 level at $169. However, it is running into technical resistance at $174 (S2).

In almost a mirror image of other asset classes, the US Dollar (UUP ETF) has receded from highly overbought levels. However, it has bounced off its 20-DMA, coinciding with the M-Trend Level (at around $29.5). We do expect a short lived reversal in the dollar and a consolidation / pullback in all other asset classes in the short term.

That being said, there is upside for the dollar here, if support levels hold. The MACD signal is showing some signs of bottoming, which is not ideal for equity market bulls.

Long dated treasuries (TLT) have closed above the technical stop level (calculated on a non-log chart). We need to see TLT close above $86.62 post CPI data to get a slight “all clear” signal and proceed to invest more heavily in long term bonds.

Enterprise, our core investment strategy has re-allocated to bonds in the form of the 10-year duration tracking IEF ETF.

Enterprise, our core allocation model, has bought back into bonds.

The position in IEF has been rebalanced at 31% of the portfolio NAV, with equity risk seeing no modification.

Since this model only trades 4 asset class ETFs, we use it to judge overall portfolio positioning. The largest holding remain equities, at 56% of portfolio weight (minimum is 40%).

Cash is slightly over-represented in the graph above, with the actual weight coming in at 6.69%. This portfolio is nearly fully allocated to something else than the USD.

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.

October 12 Factors

October 05 Factors

September 27 Factors

September 20 Factors

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 yet again registering a negative Medium-Term Trend. This is the fourth week in a row we are seeing this set-up. Of course, given the sharp rally, we would expect medium-term trends to start recovering.

On a short term basis, we are looking at a multi-factor recovery. There are no oversold ETFs and neither are there ones overbought. Nasdaq (QQQ) and Growth Stocks (IVW) are the only factors trading above all important moving averages.

Nasdaq (QQQ) and Growth Stocks (IVW) and the Momentum Factor ETF (MTUM) are still relative-to-SPY out performers. The Equally Weighted S&P500 (RSP) and Mid-Caps (MDY) remain notable relative-to-SPY laggards.

For a tactical allocation, a single ETF makes the cut:

Momentum Factor ETF (MTUM)

Momentum is the only outperforming factor that is still trading below its 50-DMA.

Here’s how we stand on the Sectors front:

Sectors October 12

Sectors October 05

Sectors September 27

Sectors September 20

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

All sectors are forming a negative Medium-Trem Trend this week, similar to the set-up for Factors. This is the second week in a row of all-negative trends, and usually signals a bottoming process is in place.

In the short term, Staples (XLP) are sticking out to the downside like a sore thumb. The moving average deviation is seemingly off the scales. The absolute chart tells the whole story for XLP:

There are no short-term overbought sectors. Notably, Communications (XLC) and Tech (XLK) are trading above all key moving averages, in a testament to their resilience.

In the longer term, the only sector that looks overbought is Communications (XLC). Tech (XLK) is also flirting with the overbought level. Utilities (XLU) and Staples (XLP) are highly deviated to the downside, as their defensive profile does not match investor’s risk appetite. Also, a high correlation with treasuries is not helpful.

For a tactical play, our system would select Consumer Discretionary (XLY). It is an outperforming factor that is still trading below its 50-DMA despite the current rally. Also, the extremely large downside of Staples (XLP) and Utilities (XLU) looks enticing for a contrarian trade.

Nostromo, our tactical allocation model, is looking to deleverage from its equity exposure.

Right now, Nasdaq (QQQ) is making up 50% of the portfolio, and the weight needs to come down, in line with Momentum Factor ETF (MTUM) and Growth Stocks (IVW).

On the treasuries part, Nostromo is looking to rebalance portfolio holdings, again following trade signals. It is looking to LQD, while reducing TIP, IEI and HYG.

Nostromo holds a negative -26% cash position, still betting that the USD will reverse course and lift all kinds of risk assets.

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.

This week, we will feature the Millennium Vol Target Smart Beta Portfolio. This Industrials heavy allocation has outperformed nicely over the last 2 years due to the “volatility targeting” feature. At the factor level, correlations are almost equally split between “mid-market” ETFs like Mid-Caps (MDY), the Equally Weighted S&P500 (RSP) and the Dow Jones Industrial Average (DIA). You would probably expect these factors to under-perform, but the stock selection algorithm works its magic and delivers positive results.

Notable positions include GWW, FICO, and LNG - a very interesting energy pick. This would be on our list for the Sigma Portfolio, if we didn’t already include RRC (Range Resources) as a natural gas play.

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.

In terms of moving averages (especially looking at the number of stocks above the 200-DMA), we find that the broad market has “held support”. At no point in the correction did less than 400 stocks trade below their respective 200 DMAs. This maintains the market in its established range, with plenty of upside.

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 and has promptly rebounded since then. Notice that other powerful rebounds in the past have led to a period of consolidation before another leg up. It seems like we are nearing that consolidation phase right now. The thrust and speed of the rebound is encouraging.

However, the time to benefit from “panic lows” is gone.

Slightly Bullish Signal in Sentiment

SPY is starting to pull up ahead of the equity market yet again. The Z-Score divergence is not as wide as it used to be, but concentration at the top market cap companies is alive and well. This is not ideal, as the market desperately needs improved participation and a broad rally in order to recover convincingly and put bearish arguments to rest.

Neutral Signal in Market Internals Z-Score

Transaction volume keeps being anemic. This is not ideal, given that there was no major interest in profiting from lower prices. We wouldn’t want to be in a situation of “higher prices on lower volume” as that is a bearish indicator.

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 114%, and sentiment is “Neutral”. This is a bullish state for our models, as they are looking for a positive continuation in various asset markets.

Our portfolio is almost at target currently. We may or may not increase the allocation in bonds - it is an open question so far.

Overall, conditions seem to imply a bit of patience is needed to work off the rebound rally, which was very sharp. We expect some sloppy trading ahead, but nothing too concerning. Once Q3 earnings start to come out, stocks should be well supported.

Automated Strategies