Portfolio Rebalance / October 24
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.
Asset markets have stalled in the past week, with the U.S. Dollar consolidating in an atypical way. One would expect the dollar to rise given the swoon in other asset classes, but that has not exactly been the case.
Our strategies are acting accordingly, and shutting down risk exposure, in classic “trend following” fashion. Our models are not well suited to trade range-bound markets, and we’ve had plenty of those in the past year.
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 has risen further, along with bonds - the only asset classes to rise on the week;
SPY in an awkward technical spot, closing below the 200-DMA for 2 consecutive days. Technicals might not be as relevant, however, as the bulk of market moving data will come in today’s after-hours session. It’s up to MSFT and GOOG to “save the day” and offer some fundamental support to a technical bounce from here. The “Oversold” condition (supportive of a bounce) doesn’t do much for the benchmark ETF in this scenario. It’s all up to earnings.
Commodities haven’t quite breached $25.60 resistance at the S1 level. Several levels of support remain just below, and DBC appears to be in the midst of a trend-change (to negative). The supply-demand balance in commodities remain highly contested. That’s a fancy way of saying they could go either way, but upside is favored for now.
Buying interest in Gold continues this week. GLD has broken to the upside, above R1 resistance at $182. While overbought and due for some consolidation, the bullion ETF has good odds of eventually reaching our target of $186.
The U.S. Dollar (UUP ETF) has consolidated in the past couple of weeks. It has broken through the 20-DMA support, which has been holding for the past 3 months. If support breaks at $29.5 on UUP, our target to the downside becomes $29. This move should coincide with various other markets rallying.
Long dated treasuries (TLT) continue to trade below our stop level and are not investible.
Enterprise, our core investment strategy continues to reduce risk exposure.
Enterprise is selling all available asset classes today, most notably reducing the position in equities.
SPY is reduced to 39% of portfolio value (the allowed minimum). Commodities and Gold are only slightly adjusted.
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 sits at approximately 55% of portfolio holdings and is now the dominant asset class.
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 remain stuck in negative Medium-Term Trends for the 6’th consecutive week in a row. We don’t have accurate statistics for this observation, but it’s certainly unprecedented since the writing of this newsletter. Such oversold conditions typically precede reversal patterns in the broad market.
On a short term basis, the iShares Russell 2000 ETF (IWM) is very oversold and deviated to the downside. As we’ve noted before, this ETF garners our special consideration do to it being more representative of the “average stock”. If we were to use the Russell 2000 instead of the S&P 500 to gauge the health of the overall market, a stop-loss would continue to be issued. IWM needs to recover and trade above $170 in order to signal a rebound in the equity market.
Furthermore, on a 200 days history (starting from Jan 6, near the start of the year), no factor except Nasdaq (QQQ) and Growth Stocks (IVW) has positive returns. This is 2023 in a nutshell so far - only a handful of companies included in 2 risk-on ETFs are actually performing.
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, the 3 outperforming ETFs represent notable opportunities:
Momentum Factor ETF (MTUM)
Nasdaq (QQQ)
Growth Stocks (IVW)
Here’s how we stand on the Sectors front:
We have included 3 former weeks of tables as well, for your convenience.
In a similar set-up to Factors, all sectors are forming negative Medium-Trem Trends this week. This is the 4’th week in a row of all-negative trends, and we suspect this is the precursor to a trend reversal and bottoming process.
In the short term, Staples (XLP), Transports (XTN), Basic Materials (XLB), Real Estate (XLRE) and Utilities (XLU) are all unusually deviated to the downside. The only sectors holding up are Communications (XLC), Tech (XLK) and Energy (XLE). There are no short-term overbought sectors
In the longer term, the only sector that looks overbought is Communications (XLC). There are several highly oversold sectors, however: Utilities (XLU), Staples (XLP), Basic Materials (XLB) and even Healthcare (XLV) and Industrials (XLI) are all lagging at this point. On a 1 year history, only Communications (XLC) and Tech (XLK) have managed to outperform the SPY. All other sectors have under-performed badly.
For a tactical play, our system would select Consumer Discretionary (XLY) and Tech (XLK). These sectors are outperforming on a relative-to-SPY basis and are also trading below their respective 50-DMAs, representing a buying opportunity.
Nostromo, our tactical allocation model, is looking to deleverage from its equity exposure by selling down all of its factor ETF exposure.
Right now, Nasdaq (QQQ) is making up 50% of the portfolio, and the position will be closed on the next WR% SELL signal. The same treatment will befell Growth Stocks (IVW) and Momentum Factor ETF (MTUM), which are occupying 16% of the portfolio each.
Nostromo’s bonds position comes from a combination of TIPs with IEI (3-7 year treasuries) and HYG (corporate bonds).
Nostromo is marginally leveraged, with a -7% cash position.
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.
Currently, just 334/1000 stocks that we track for the broad market are trading above their 200-Daily Moving Averages. The established range that goes back to November 2022 has been broken. No bueno.
Bearish Signal in Stocks trading above their 200-day Moving Averages
As a contrarian indicator, sentiment works best near extremes. Right now, sentiment is extremely negative, with over 600/1000 stocks oversold. This is just above the 2 standard deviation measure in the last 2 years. Previous instances of “Extreme Fear” sentiment have been great places to add exposure, in expectation of a reversal. Still, it’s useful to note that the current score of this indicator is 22/100. It has reached 10/100 previously, so conditions can get worse in the short term.
Bullish Signal in Sentiment
The comparison of Z-Scores reveals a divergence between SPY and the broad market that’s slowly starting to close. Small and mid-caps stocks need to stop falling first. At this juncture, the indicator is only telling us that large and mega-cap stocks are leading, absorbing liquidity from the rest of the market.
Neutral Signal in Market Internals Z-Score
Dollar transaction volume is slowly creeping up toward the recent average. Added liquidity is a net positive. However, rising volume on falling prices is not such great news for the bulls, as high transaction volume confirms that the prevailing price is accurate.
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.
Our average system exposure is now 66.3%, due to Horizon’s reduction in equity exposure. Again, this is the expected behavior of trend-following models. It’s our job as human investors to view the actions of these strategies as an answer to the question “what would a computer do?”.
And the answer in this case is that an outperforming computerized model would sell in a bout of “Extreme Fear” sentiment. This is also how many professional managers and hedge funds operate. The only “glitch in the matrix” is that we may not be in an environment where “trend following” does so well. Instead “range trading” has been the name of the active management game for a while now.
“Range Trading” implies buying at relative lows, and selling at relative highs. Right now, equities are trading at a relative low point.
There is no immediate need to take drastic actions now, but we will rebalance 2 positions, without modifying the overall risk exposure of the portfolio.
Automated Strategies
The Sigma Portfolio (Live)
Today’s drop in Fair Issac (FICO) presents us with a buying opportunity. But in order to not change the overall make-up of the portfolio, we’ll sell MTUM to make room for the extra shares. FICO is correlated to MTUM primarily, so that’s why we’re making this replacement.
We will execute the following orders for the Sigma Portfolio at the close:
SELL 2% MTUM (Reduce Position Size by 25%)
BUY 2% FICO (Add 2% of Portfolio to 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.
