Portfolio Rebalance / October 19

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.

Higher yields remain the primary macro driver of the markets, despite recent geopolitical strife. We would argue that if the prospect of a new Middle East war fails to drive investors to the safety of bonds, then nothing really can (except the Fed, of course).

Despite better than expected earnings, the equity market is trading in a sloppy manner, lacking direction, and not really breaking up or down meaningfully. Our conclusion is that institutions are mostly buying the dip and the medium term positive trend shall ultimately prevail.

Our systems are holding exposure steady, but Enterprise has dropped bonds from the allocation altogether. In the Sigma Portfolio, we are also looking for a pop in TLT to sell into.

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 spiked tremendously on safe haven flows, in stark contrast to bonds;*

SPY has lost the $431 level (now turned into a sort of resistance), but it feels like the real technical range that traders are looking to is the Resistance at the 50-DMA, around $438 and Support at the rising 200-DMA ($422). Trend following systems will not be inclined to buy dips below $431, however, so that tailwind to the market is diminished at the moment.

Commodities have bounced at the 200-DMA ($23.89 on DBC) and are now gunning for the S1 level at $25.60. Also, commodities have begun to form an uptrend, from the perspective of the risk-reward channel.

Gold got a huge spike in buying interest on account of safe haven flows and the fact that it was oversold to begin with - a potent combo. GLD bounced hard at $169, broke through a major level of resistance ($177 - S1), and is now challenging previous highs, around $182. It is worth noting that Gold is now overbought.

The U.S. Dollar (UUP ETF) has consolidated in the past couple of weeks. It has maintained 20-DMA support throughout all of the recent advance, and it doesn’t yet look ready to capitulate. Significant upside still exists, to $30.37 (R1).

Long dated treasuries (TLT) violated our stop loss level and have been removed from most strategies. We are still holding a small position in TLT, recognizing the extreme downside deviation that could reverse at any point. In theory, TLT (and long term bonds in general) have the best risk-reward prospects. However, this is becoming a worrying consensus trade. The majority of managers see rates lower in 2023. This is usually not a sign of “the bottom”.

Enterprise, our core investment strategy has dropped bonds from its allocation and rebalanced positions accordingly.

Enterprise, our core allocation model, has sold bonds.

Instead, there is no asset class that can replace treasuries at the moment. Investors could use a money market fund to park the excess reserves at the moment.

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 40% of portfolio holdings.

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 19 Factors

October 12 Factors

October 05 Factors

September 27 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 remain stuck in negative Medium-Term Trends. This is the fifth week in a row we are seeing this kind of predicament. Since various factors are certainly oversold, we would expect this to represent more of a bottoming or consolidation process rather than a foreboding situation.

On a short term basis, the iShares Russell 2000 ETF (IWM) stands out as being rather oversold. The issue is that the bulk of the market is performing in line with this ETF rather than the S&P 500. If we were to use the Russell 2000 instead of the S&P 500 to gauge the health of the overall market, trouble emerges… As of today’s close, IWM has triggered a STOP LOSS.

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:

Sectors October 19

Sectors October 12

Sectors October 05

Sectors September 27

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

As was the case for Factors, all sectors are forming a negative Medium-Trem Trend this week. This is the third week in a row of all-negative trends, and usually signals a bottoming process is in place.

In the short term, Staples (XLP) and Transports (XTN) are showing significant downside extensions. Staples is a sector preferred for its dividend, and suffers alongside the slide in bonds. Transports have been hit by earnings news from J.B. Hunt and United Airlines - both stocks have had rather dramatic post-earnings declines. J.B. Hunt (JBHT) is the fourth largest trucking company and reported third-quarter revenue lower by 18%.

There are no short-term overbought sectors. Energy (XLE) is notable in its resilience and upside bias. Communications (XLC) is also looking strong due to the fact it’s trading above all key averages.

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 deeply oversold, as was the case last week.

For a tactical play, our system would select Consumer Discretionary (XLY) and Tech (XLK). These sectors are outperforming 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 and go all-in on Momentum Stocks.

Right now, Nasdaq (QQQ) is making up 50% of the portfolio, and the position will be closed on the next SELL signal. The same treatment will befell Growth Stocks (IVW), which are only occupying 16% of the portfolio.

Nostromo has also sold off treasury positions one by one, as each has violated a stop-loss level. Today, Nostromo has closed the position in IEI (3-7 Year Treasury Bond ETF).

Nostromo has deleveraged, and is now holding just a -2% negative cash balance.

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 our own Stock Ratings table (third section on the Dashboard). It’s always useful to peek at the collection of stocks that we’ve fundamentally analized. Just recently, Pioneer Natural Resources (PXD) became an acquisition target and trades almost exactly at the Price Target we’ve predicted in September ‘22.

So what other opportunities are there? In our view, some solid picks with substantial upside include McDonald’s Corporation, Netflix, and Progress Software.

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 is “holding support”, but just barely. This indicator is getting dangerously close to a breakdown. Watch the 400 mark - anything below this number in terms of stocks trading below their 200-DMAs and this turns bearish.

Neutral Signal in Stocks trading above their 200-day Moving Averages

As a contrarian indicator, sentiment works best near extremes. The market registered some notable resilience in terms of sentiment, and now trades in “Fear”. Not a bad place to add equity risk exposure if you need it, that’s for sure.

Slightly Bullish Signal in Sentiment

The comparison of Z-Scores reveals a divergence between SPY and the broad market that’s slowly starting to close. This is only positive as long as we don’t see a breakdown in the iShares Russell 2000 ETF (IWM), which is much more representative of “the average stock”.

Otherwise, the market recovery desperately needs a rally in small caps.

Neutral Signal in Market Internals Z-Score

Anemic dollar transaction volume and average volatility indicate there is no great demand for portfolio reshuffling. Since we are going through a consolidation period, lower volume is expected and is otherwise fine (as long as it’s not too low).

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 96.6%, and sentiment looks “Fearful”. We maintain a rather bullish allocation, overall. Treasuries need to be sold in order to conform to the stop-loss, but we’d rather look for another opportunity (maybe a rally?).

With the exception of bonds, our portfolio is at target.

Overall, conditions seem to imply a bit of patience is needed to work off the rebound rally, which was exceedingly sharp. We’ve now swung in the opposite direction, seeing softness across the curve. Treasuries are causing a lot of trouble for equities at the moment, since the risk-free yield they provide is higher than the S&P 500’s own Earnings Yield.

By some measures, owning treasuries pays more than buying a home and renting it out. In the longer term this dynamic is not sustainable, and “something will break”.

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