Portfolio Rebalance / September 27
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.
The recent market action puts the focus again on the difference between trend-following strategies and mean-reversion models. Typically, trend-following strategies tend to buy perceived breakouts. Conversely, mean-reversion models would sell an asset once it reaches the same “breakout” point, and bet on a reversal instead.
Most models on this platform are trend-following systems. They are designed to detect an emerging bull market and stick to it. This kind of behavior is well suited for cycles where a clear trend can form. They will fail in a range-trading environment, where assets have no particular direction. This is the price we are paying for a certain amount of outperformance, and it’s this area where human decision making becomes important.
This week, the pullback in most asset classes puts our systems to a test. Some models are deleveraging, while we are choosing to stay the course and slowly add to our risk exposure. Let’s explore…
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.
For the first time in a couple of months, not all asset classes are investible; US Treasuries falling to new lows get flagged by our system as “Not Investible”;
SPY categorically breached $431 support and is now facing the prospect of a large liquidity gap. The next logical level of support resides in the $418-$420 area, near the 200-DMA, some 1.65% lower. The benchmark ETF is highly oversold in the medium term (2/100).
Commodities have held up well during the recent risk-assets decline, holding M-Trend support at $25 on DBC. This kind of resilience is encouraging for the sector.
Gold has triggered a shallow sell signal today and has not managed to hold intermediate support. It’s now facing a retest, at $174 (on GLD). Longer term we like the asset class, and if you prefer “mean-reversion” positioning, this constitutes a good entry point as long as support holds.
Contrary to our expectations, the US Dollar has surged higher and broke through technical resistance yet again. The two attempts at moderating momentum (see lower MACD panel) have been “fake-outs”. The Dollar is poised to challenge all-time highs. In what is becoming quite a concern, UUP has barely crossed the midpoint of its technical channel, meaning that it is not overbought longer term. In the short and medium, however, the dollar is extremely overbought.
Long dated treasuries have broken support established at previous oversold levels (October ‘22 at $92.4). This is the reason that our trend following system is flagging TLT as uninvestable for the moment.
Yielding 4.84%, we think longer dated treasuries are extremely mispriced. The bond market is signaling that growth will magically revert to previous cycle highs, contradicting a decades long trend that points lower. Sure, the economy has experienced above trend growth due to artificial Covid-related stimulus. If you believe (like we do) that this was an exception, and not “the new normal”, then bonds offer the best risk-reward setup of all the asset classes.
It’s just that our system would like to see TLT a bit more well bid, first.
Enterprise, our core strategy is up for a refresh. It is meant to be an “all weather portfolio” that is easy to copy and manage. Right now, it’s not achieving these goals, so we’ve begun a fine-tuning process.
We have removed leverage and lowered volatility in order to make the strategy real-life investible. We won’t cover it in today’s newsletter, but it will see a resumption next week.
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 are again registering a negative Medium-Term Trend. This is the second week in a row we are noticing this. For the moment, this indicates some caution is warranted, but this kind of alignment is more often than not associated with bottoming processes.
On a short term basis, all factors except QQQ and IVW (containing growth oriented companies) are trading below ALL key moving averages. We see another bottoming signal in this alignment.
Nasdaq (QQQ) and Growth Stocks (IVW) are joined by the Momentum Factor ETF (MTUM) as relative-to-SPY out performers. The Equally Weighted S&P500 (RSP) continues to be a laggard both in terms of relative as well as absolute performance.
Our system will chose the following ETFs for a tactical allocation, due to their short-term oversold nature (trading below the 50-DMA), while simultaneously outperforming on a longer term basis:
Nasdaq (QQQ)
Growth Stocks (IVW)
Momentum Factor ETF (MTUM)
We share the MTUM vs SPY chart below, in order to see how the relative performance looks like:
Here’s how we stand on the Sectors front:
We have included 3 former weeks of tables as well, for your convenience.
Most sectors have come under significant pressure. With the exception on Energy (XLE), all sectors are forming a negative Medium-Trem Trend.
In the short term, declines in Staples (XLP) and in Real Estate (XLRE) are dragging the two interest rate sensitive sectors to extreme lows. Utilities (XLU), Transports (XTN) and Industrials (XLI) are not far off in terms of being short term oversold.
In the longer term, the only sector that looks overbought is Communications (XLC). Along with Tech (XLK) and Consumer Discretionary (XLY), Communications are relative-to-SPY outperforming sectors. Utilities (XLU) and Staples (XLP) are oversold to a wide margin due to their sensitivity to interest rates (basically, investors buy utilities and consumer staples stocks for their dividend). If you are bullish on treasuries, you should be bullish on XLU and XLP as well.
Communications (XLC), Tech (XLK) and Consumer Discretionary (XLY) are the sectors that our system would select for a tactical play. These ETFs have pulled back below their 50-DMAs while simultaneously outperforming SPY on a longer term relative basis.
Nostromo, our tactical allocation model, is deleveraging a bit this week.
While still maintaining an aggressive posture, it has sold its position in Gold. It is aiming to sell all of the remaining precious metals ETFs on their corresponding SELL signals.
It is looking to diversify its equity part of the portfolio into the 3 factor ETFs identified in the section above: QQQ, IVW and MTUM. To this end, it is looking for another sell signal on QQQ, so the positions would become balanced.
On the treasuries part, Nostromo is looking to rebalance portfolio holdings, again following trade signals. It is looking to add MBB and LQD, while reducing TIPand HYG.
Nostromo holds a negative -86% 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.
3. Individual Stock Selection
The inclusion of Momentum Factor ETF (MTUM) in Nostromo’s selection list has intrigued us. So we set out to build a screener based on stocks who’s MTUM correlation is higher than 0.5. Here’s the screener setup and results:
MTUM Correlation > 0.5
Pietroski F-Score >= 6
Margin Expansion: Rising
Operating Leverage > 1
Interestingly, the list (that outputs 28 stocks), already contains some Sigma Portfolio positions - NOW, EXP, FICO.
Combined chart of all screened stocks.
Notably, this group of stocks is just coming off all-time highs, which is encouraging from a technical point of view. MCD warrants some additional attention, as it is the only Staples (XLP) - correlated stock on the list. And XLP is highly oversold.
We can study their financials using the Fundamentals Explorer, and model their Price Target / EPS Growth Rate using the Valuation Wizard.
Unsurprisingly, this week we’ll spotlight Millennium Momentum. This strategy is benchmarked to MTUM ETF, and has outperformed nicely in the last couple of months, seemingly immune to current headwinds. It has also beaten its benchmark by a wide margin in the past year.
Its current drawdown (on a 1 year period) is just -1.5%. Most of the portfolio is correlated with Energy (XLE) and Financials (XLF). NVDA also has its place in the portfolio composition.
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.
Moving averages are “holding support”, if we look at the number of stocks trading above their 200-DMAs. SPY’s Sigma Score is now lower than that of the average stock. This is bullish to the extent that we consider the market oversold enough to elicit a bounce. And it’s also bullish, as long as the number of stocks above the 200-DMA is not below 403 (the yellow dotted line).
Bullish Signal in Stocks trading above their 200-day Moving Averages
As a contrarian indicator, sentiment works best near extremes. Highly oversold conditions could prop up the market at this stage - we have now entered the “BUY ZONE” in terms of sentiment, as many oversold indicators have reached extremes. Previously, this kind of setup has proven itself to be an excellent buying opportunity and tends to last between a couple of days and a maximum of 2 weeks;
Bullish Signal in Sentiment
We are seeing definite proof that Z-Scores are starting to align between the S&P 500 (weighted toward large caps) and the broad market index (1000 companies, equally weighted); the Z-Score divergence has reversed trend and is now headed toward 0, as the previous performance of the mega caps is reverting; ironically, this makes smaller cap companies better at weathering the current storm.
Neutral Signal in Market Internals Z-Score
Transaction volume was anemic in the past couple of days, despite the headline-grabbing decline. Lower volume on lower prices is bullish.
Bullish 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 has come back down from > 200% to 138%. This is more in line with our preference as well. With asset markets trading in “Extreme Fear”, and most breadth indicators turning bullish, now is a good time to start picking off names from our buy list. We are adding to risk exposure at this juncture.
Automated Strategies
The Sigma Portfolio (Live)
In The Sigma Portfolio, we are initiating a 2% in MCD, a position with a very favourable risk-reward setup.
The goal is to raise our equity risk exposure gradually on this pullback up to 80%. We will keep adding to positions every day (or so), if the market holds support.
Executing the following trade at the market close:
BUY 2% MCD (Initiate 2% 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.
