Portfolio Rebalance / October 16
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.
During the past week, major asset markets have had broadly positive developments. Some commentators are questioning why the equity market is doing so well, while the 10-year yield is back above 4%. And to answer that question we turn to an indicator we’ve discussed in today’s daily briefing: the Citigroup Economic Surprise Index.
Basically, analysts make projections, and reality either confirms or disappoints those projections. The Citi Economic Surprise Index measures whether economic data performs better or worse than Wall Street estimates. When this index rises, economic data performs better than expected. Conversely, when it falls, it is worse than expected. While the index fell during the summer months, it has now rebounded along with yields as the economy proves to be much more resilient than previously expected.
To be clear, for the year ahead, the most important variable is weather the economy will experience a recession or not, as the outcome for the equity market is radically different. With every passing month that disproves the bears, we should see the main indices rise.
Along with Q3 earnings, the next major catalyst on the horizon are the US Elections. Lately, across all betting markets, Donald Trump has taken a healthy lead, from a previously near 50-50 race. As we’ve previously said in our Presidential Election Preview article, the markets are first and foremost looking for an uncontestable win and a peaceful transition of power. As long as the democratic election process is completed successfully, without too many allegations of voter fraud, we expect either candidate’s clear win to be a bullish catalyst — and that seems to be the direction that things are going in at the moment.
The S&P 500 is up +1.6% since the deadlock was broken, on October 5’th.
Given these generally bullish underpinnings, as well as the start of the seasonally strong period (mid-October through late April), we’ll start our usual portfolio rebalancing process.
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 remains in a bullish trend on all timeframes. Although the benchmark equity ETF is overbought in the medium term, technical support sits close by, at $568 and dips can be bought.
Commodities (DBC) hit the top trendline of the trading channel and immediately retraced as oil prices suffered extreme volatility (+14% then -8.6% in less than a month). For the moment, commodities are trading above the M-Trend level, which differentiates between investible or non-investible assets in a down-trend. For commodity bulls, this marks a decent entry point.
Gold (GLD) — the best performing major asset class of 2024 year-to-date — continues to be technically well supported, with barely any dip to be had. We would be looking to add gold to our portfolio again on a decent dip, at around $238 (R1).
TLT pulled off a strong reversal after hitting deep oversold conditions, and reclaimed its 200-day moving average. We are already at the maximum allocation for this asset class right now, but investors wishing to gain exposure to bonds have a good entry point at current levels. There have been multiple catalysts for the large drop in bond prices, most notably a supply/demand imbalance starting condition (when treasuries were very overbought in mid-September) and mildly stronger than expected inflation. At the moment, most of the risk has been priced out, so upside is much more probable.
Enterprise, our core investment strategy, has kept its allocation steady during the past couple of weeks, with equities providing strong returns atlevels of at least 70% portfolio NAV. Today’s closing of the treasury position is “just a trade” profiting from the latest bounce in the asset class. However, by next Wednesday, the position will be reopened.
Stocks exposure via SPY is maintained at 70%.
Bonds exposure (IEF) goes to 0% at today’s close.
The position in GLD remains at around 2.8% today.
Commodities (DBC) make up about 1.26% of portfolio exposure.
Since this model only trades 4 ETFs, we use it to judge overall portfolio positioning. Enterprise shows a balanced but risk-friendly approach, with cash levels now increasing due to the sale of treasuries (27.4%).
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).
What sticks out in today’s leaderboard is the high degree of uniformity among most Factor ETFs, with absolutely no extreme deviation present in either the short or long term. 6 month and 1 year returns are both positive for all factors (great +), and all domestic ETFs are trading above all of the key moving averages.
Emerging Markets (EEM) have retraced to more normal technical levels, following China’s lack of stimulus details. We previously stated that economic “gravity” will pull these stocks lower eventually, and that seems to be the dynamic for now. Patience is required here, but this may be an entry point in the making.
While there’s no screaming BUY among factor ETFs at the moment, we do like the high beta plays here (QQQ, MTUM, IVW), since they will most likely provide outsized returns in a continuing bull market.
Among more granular Factor Returns, companies which heavily invest in new technologies have continued to dominate short term returns, up to the 6-month mark. A high R&D to Gross Profit ratio is associated with companies with high growth potential. The market has also rewarded these companies with high returns.
In the longer term (1 year and 2 year marks), there are no clear winning factors at the moment. The market has rewarded a mix of quality companies with traditional metrics like the Quick Ratio, Earnings Yield or Piotroski F-Score, but a clear pattern eludes our analysis.
Here’s how we stand from a Sectors standpoint:
We have included 3 former tables from previous articles, for your convenience.
Among Sector ETFs, there is a bit more dispersion than on the Factors side. First of all, defensive sectors like Real Estate (XLRE), Staples (XLP) and Healthcare (XLV) are struggling under continued selling pressure and record a negative medium-term-trend. This is actually bullish for the rest of the market, as a “true” risk-on rally can’t have leadership from consumer staples stocks like Colgate-Palmolive (CL).
That being said, the aforementioned Sectors and CL itself are very buyable on this pullback.
On the other hand, sectors like Financials (XLF), Industrials (XLI) and Utilities (XLU) are extended both in the short and longer term. Utility companies are no longer viewed as safe dividend payers, but as third-degree beneficiaries of the A.I. boom.
Energy (XLE) is an interesting outlier in the sense that it’s trading very close to its key moving averages, and it’s very close to a neutral Z-Score on an absolute and relative basis. In our view, Energy exposure is useful to hedge high growth areas of a portfolio, as higher oil prices normally result in higher yields. Higher yields, in turn, put pressure on valuation multiples — especially relevant for expensive companies.
Nostromo, our quirky tactical allocation model, has around 30% equity exposure via the Healthcare ETF (XLV). The entire rationale for that investment was dip-buying. So far, no exit rules have triggered, so the position is maintained.
The strategy will also initiate a position in both TLT and SPY whenever a BUY signal is detected.
Until then, the model’s exposure profile will remain discrete, with XLV being a less volatile position.
3. Individual Stock Selection
Millennium Alpha, our star stock picking system has smashed +40% returns year-to-date. There are numerous winners in the portfolio, not only limited to NVIDIA (NVDA) and Meta Platforms (META), but secondary picks like Comfort Systems USA (FIX), IES Holdings (IESC) and Arista Networks (ANET) have also done very well.
The portfolio is primarily correlated to the Momentum Factor ETF (MTUM), and a mix of Tech (XLK) and Industrials (XLI) on the sectors side. The next portfolio refresh (when new positions are introduced and some positions are removed) is scheduled to occur next Tuesday.
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.
From a moving averages perspective, the market looks very resilient and not overbought. These are the type of internal conditions that foster continued positive (if unspectacular) developments for most stocks.
Bullish Signal in Stocks trading above their 200-day Moving Averages
As a contrarian indicator, sentiment works best near extremes. The current reading (64/100) signals “Greed”.
As is the case with moving averages above, sentiment is indeed positive, but not “Exuberant” by any means. In order to have bull markets that conquer fresh all time highs regularly, a certain degree of optimism is required. There have been sufficient pullbacks recently that unbridled euphoria is not yet present. Investors are still somewhat cautious of elevated valuations and market prices. Hence, sentiment is fine for now.
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.
Last week, we wrote:
Since early August, the broad market and large caps have been running neck and neck. There is almost no differentiation in performance at the moment, but we suspect the broad market may get the advantage in the next stage — in other words, the Z-Score Divergence will trend toward the lower part of the graph again. “A rising tide that lifts all boats” is bullish.
Not much has changed this week, with both measures at very similar levels. This is bullish.
Bullish Signal in Market Internals Z-Score
Dollar Transaction Volume has dived yet again, as the rally has not enticed investors to transact. This is a bearish development, as the assumption is that a lack of liquidity is a driver of volatility, implying lower prices.
Another way of interpreting the data is that buyers and sellers will transact at higher than average volume levels once prices come down. We’ll leave this indicator in the bearish camp for now.
Bearish 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.
All things considered, a healthy dose of risk allocation makes sense at the moment. Our primary strategy (Enterprise) maintains 70% equity exposure and the stock picking Millennium Alpha has done very well due to bullish market internals. There is nothing currently that has us worried and we don’t see any signs of too much exuberance either.
Our portfolio allocation is currently leveraged to the tune of 10% portfolio value (that’s resulting in a negative cash position). The opportunity in the bond market is too good to pass up, and our stock allocation is fine as it is.
Automated Strategies and Market Outlooks
The Sigma Portfolio (Live)
We will make a single adjustment to our stock portfolio, taking profits in Exxon Mobil (XOM) and buying the dip in Colgate-Palmolive (CL). The overall allocation remains unchanged.
Executing the following orders at market close:
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 $21.227 by risking $12.144 if our targets are correct. The risk-reward equation is good, nearing the 2-1 ratio that we’re looking for.
Factors exposure is primarily allocated toward Momentum (MTUM), Growth Stocks (IVW) and the Nasdaq (QQQ).