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. 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.
After 6 straight weeks of advance, the equity market has lost some of its momentum and is experiencing a period of consolidation. With the election rapidly approaching, we are not surprised to see the market take a break after its torrid advance. Investors can’t really complain, as the Year-to-Date performance of the S&P 500 is undoubtedly one of the best, as the graph below illustrates:
Additionally, Sentimentrader shows why investors seem so confident despite the coming elections and the possibility of a contested outcome -- the market hasn’t posted 2 days of consecutive decline for about 30 sessions:
It has rarely gone this long without at least small consecutive losses. The current streak ranks among the best since 1928. It’s even better on the Nasdaq, and similar streaks preceded one-year gains 100% of the time.
The bond market doesn’t seem to be too excited about inflation prospects, but at least 10-year yields above 4% imply confidence in the economy to a reasonable degree. As stated previously, our chief concern going into 2025 is not the resurgence of inflation, but a recessionary outcome for the U.S. economy.
Two major catalysts are now in play:
The looming U.S. Elections, to be held on Tuesday, November 5
Q3 Earnings Season, with Apple, Google, AMD, Meta Platforms, Eli Lilly, and Amazon.com set to report next week
With this understanding of the investment backdrop, we are starting our usual 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 a medium and longer timeframe. With the MACD signal crossing over to negative, short term gains may be harder to find. We may see more corrective action heading into the election and a more negative market bias overall, especially as some of the most important earnings get released next week.
However, any correction should be contained at the 50-DMA, now at $565.
Commodities (DBC) have bounced from our technical stop-loss level ($22.3, M-Trend) and trade directionless. The asset class remains broadly investible, neither overbought, nor oversold -- but volatile. For the time being, we would follow the old Wall Street adage: “If in doubt, stay out.”
Gold (GLD) — the best performing major asset class of 2024 year-to-date — is pushing upside deviations to their technical limits. This is truly remarkable for a $15 trillion asset class that generates 0% yield and zero earnings. While the fundamentals underpinning gold’s rally appear to be related to inflation hedging and strategic Central Bank buying, technicals continue to remain supportive of rising gold prices.
The closest support level rises to $240, and we would be buyers around that price.
TLT is struggling to gain traction in what can only be described as “bipolar market action”. After previously being extremely overbought in anticipation of Fed rate cuts (mid-September) the supply/demand dynamics for treasuries have completely reversed. With 10 year yields well above 4%, we believe investors are overestimating future economic growth.
As a consequence, TLT (and longer term bonds in general) are providing investors an excellent entry point at the moment. In addition, bonds would make the perfect complement for a stock portfolio from current prices, as an economic slowdown would boost bond prices.
Enterprise, our core investment strategy, has kept its allocation steady during the past couple of weeks, and continues to do so today. The strategy has previously traded bonds with great success and has mostly avoided the recent slump.
Stocks exposure via SPY is maintained at 70%.
Bonds exposure (IEF) is now back to 25%, from 0% last week.
The position in GLD has been closed for now, on a profit-taking signal. Gold will return in the portfolio next week.
Commodities (DBC) make up about 1.26% of portfolio exposure - same as last week.
Since this model only trades 4 ETFs, we use it to judge overall portfolio positioning. Enterprise shows a balanced but risk-friendly approach, with equities making up a large part of the allocation.
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).
In today’s Factors leaderboard, domestic ETFs are handling selling pressure reasonably well, with a couple of names unable to hold above the 20-DMA (DIA, IWM, MDY, QQQ and RSP). As shown in the left bar chart, these 20-DMA breaks (yellow negative segments) are small and not particularly significant.
However, the two international markets ETFs that we track (EFA and EEM) are showing comparatively large downside deviations. Foreign Developed Markets (EFA) have even registered a negative medium-term trend, the only ETF in the leaderboard to do so.
Overall, the breadth of the market remains bullish, as all 10 Factor ETFs are showing both a positive 6-month absolute return, as well as a positive 1-year absolute return — a clear sign of healthy momentum.
Longer term, it’s the Nasdaq (QQQ) which appears most oversold, especially on a relative-to-SPY basis. We’ll bring up our favorite relative chart again, to better illustrate the case for investment in the Tech-heavy Nasdaq. Basically, there has been almost no performance differential compared to SPY since June 2023, a highly unusual disposition in a bull market.
Other than Nasdaq (QQQ), we cannot identify other tactical opportunities at the moment. In case the correction / consolidation process gets more serious, we would look to invest in the most resilient Factors (high relative Z-Score). However, let’s not anticipate that outcome for now, and let the market run its course.
Among more granular Factor Returns, companies returning capital to shareholders via a high dividend yield have outperformed, up to the 6 month timeframe. Most likely, this is due to the massive rally in Utilities (XLU), now the best performing sector over the last 2 quarters. Utility companies are usually preferred by investors for their stable and relatively generous dividends, explaining the factor correlation that we see below.
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, we can technically distinguish between 3 groups of companies:
Using this distinction makes sense for the moment, as an allocation to each sector would achieve different purposes, with little overlap or correlation. Energy (XLE) is the only ETF registering a negative 6 month return.
The traditionally defensive sectors are all registering a negative medium term trend, as they have come under selling pressure along with treasuries. Since they sometimes trade as bond proxies due to their high and stable dividends, this technical trend makes sense.
Utilities (XLU) is the only “defensive” sector that is now overbought on both a short and long term horizon. Consider that on a 200-day basis, Utilities stocks have outperformed Tech stocks (XLK) by a considerable margin. We believe that both are a play on the same AI theme, with power-hungry data centers requiring vast amounts of investment in electricity transport infrastructure.
Financials (XLF) are another overbought sector both in the short and longer term, and this can be justified by higher yields which allow banks to enjoy better margins on their loans. However, if yields go much higher, lending activity can be negatively impacted, so a bet on XLF is a bet on yields staying “reasonable”.
Tech (XLK) also looks reasonably priced at the moment, one of the rare instances where such companies are not highly deviated from their usual trading patterns.
For tactical allocation purposes, we would buy the dip on Healthcare (XLV) and Staples (XLP), given the right BUY signal. Both ETFs have compelling technical setups, which have proven profitable in the past.
Nostromo, our quirky tactical allocation model, has sold out of Healthcare (XLV) . It is also buying a position in Mortgage Backed Securities (MBS) at the close today.
Successful “Tactical Allocation” seeks to maximize short and medium term imbalances between supply and demand. in this sense, Consumer Staples (XLP) is targeted for dip-buying, on the appropriate signal.
The strategy is also looking for BUY signals in the bonds space, where an ETF such as TIP is preferred to TLT.
Until these signals are triggered on the targeted positions, Nostromo will stay mostly in cash, following a great 6-month run.
3. Individual Stock Selection
Millennium Alpha, our star stock picking system has just refreshed its portfolio. In this month’s rotation, the following positions have been closed:
Replacing them, our system has selected and bought positions in:
Overall, the portfolio is mainly correlated with the Momentum Factor ETF (MTUM), as well as Growth Stocks (IVW) on the Factors side. From a Sectors perspective, Tech (XLK) and Industrials (XLI) correlation predominates.
The Year-to-Date live trading performance of this model is staggering, now standing at around 43%.
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.
Resilient. That’s the word that best describes the market breadth so far in 2024. All levels are healthy and indicative of a bull market with regular patterns of retracement followed by a rally.
Bullish Signal in Stocks trading above their 200-day Moving Averages
As a contrarian indicator, sentiment works best near extremes. The current reading (55/100) is distinctly “Neutral”.
It’s always curious to get a “Neutral” reading with markets so close to all-time-highs, yet here we are! We believe this is an accurate representation of sentiment among both retail and professional investors. At current levels, this indicator simply tells us that exuberance is missing, but nothing else of 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), equally weighted.
This metric has mostly flatlined since early August, as most companies in the market have started moving in lockstep (at least in terms of deviations). We believe that the overall trend depends on the future direction of yields. Lower yields will favor small caps, which are more economically sensitive. Conversely, higher yields will hurt mega caps less, as they have much better access to borrowing markets and more advantageous debt deals.
It looks like the market is undecided as to the direction of yields if strictly judging from this metric.
Neutral Signal in Market Internals Z-Score
Dollar Transaction Volume has returned to the recent average, as prices dipped. This is indicative of investors in an apprehensive mood and uncomfortable chasing stocks higher in size.
This also aligns with our previous observation that markets are not euphoric. It is also notable that volume jumps back to normal as soon as prices decline just enough -- in other words, investors are waiting for slight discounts in order to resume transacting.
Neutral 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.
We will continue to tweak exposure in our portfolio today, taking into account the changes in Millennium Alpha. There is no change to the overall allocation, as the market has not evolved meaningfully from last week.
Automated Strategies and Market Outlooks
The Sigma Portfolio (Live)
We will make the following adjustments to the Sigma Portfolio at today’s close.:
SELL 100% HALO (Close Position)
SELL 100% EME (Close Position)
BUY 3% NFLX (Initiate a 3% Position)
BUY 3% FICO (Initiate a 3% Position)
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 $24.119 by risking $10.160 if our targets are correct. The risk-reward equation has improved, as the market declined.
Factors exposure is primarily allocated toward Momentum (MTUM), Growth Stocks (IVW) and the Nasdaq (QQQ).