Portfolio Rebalance / April 4
Following the Signal Sigma Process
Tuesday is the day when all of our strategies rebalance their asset class holding weights. The approach to this article follows the step by step process described here.
We are trading in a holiday shortened week, with little notable earnings or releases. For the most part, conditions are similar to those we reviewed last week, with some notable changes in portfolio targeting.
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.
Equities have accelerated towards technical channel highs and continue to be investible; Gold remains highly overbought and historically deviated to the upside; Treasuries have also advanced nicely; Commodities have rebounded to “investible” status again, courtesy of oil’s bounce on OPEC’s production cut
The US Dollar has now become extremely oversold in the medium term, but there is little in the sense of technical support near the current price. Further dollar weakness could continue until UUP hits the lower trend-line at $27.00.
We are constantly checking for a break in the current negative correlation regime between the US Dollar (white) and every other asset class, combined (orange). While the overall environment is still highly inversely correlated, we would have expected to see the dollar trade lower, given the rise in multiple asset classes (the white arrow marks strictly a chart-based expectation of where the dollar should have traded in this situation). The fact that it’s trading at a higher level could mark a shift in the current correlation regime.
For the moment, however, it is still an environment where the Dollar is trading against “everything else”, symptomatic of a bear market.
Enterprise has reduced allocation to treasuries on a MACD SELL signal last week. TLT has been in a holding pattern for some time, between $100-$110.
The Enterprise Strategy
Enterprise, our most conservative model, is entering the week 15% long Treasuries, and 85% in CASH.
Since this model only trades 4 asset class ETFs, we use it to judge overall portfolio positioning.
Equities are targeted for exposure at 48% of portfolio value (similar to last week), via SPY ETF. The position will be filled when SPY triggers a BUY signal without violating M-Trend support (now at $390).
The model’s treasury allocation is underweight for the time being, and is meant to be increased on the next available BUY signal (from 15% currently to 41%).
At 85% Cash is still the dominant position for this model by far.
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).
QQQ (Nasdaq) and EFA (Developed Foreign Markets) have continued their astonishing runs this past week, but they are starting to reach the limits of how far they can rise before “gravity” sets in. Deviations from moving averages (Sigma Score, left panel) work like rubber bands - there’s only so much they can stretch before “snapping back”. IVW (Growth Factor ETF) is also highly extended short term, but less overbought on a longer term basis.
RSP (Equally Weighted SPY) and SLY (Small Caps) catch our eye for being relatively oversold and having a lot of potential to “catch up” and accumulate the flows that are bound to come out of QQQ and EFA.
By using our proven selection criteria (Z-Relative > 0, while Sigma 50 < 0), the following factors would make good investment candidates for a technical play:
EEM (Emerging Markets)
The rest of the factors have transitioned to various stages of consolidation.
Charts Emphasis:
The Equally-Weighted S&P500 (RSP) is looking like a strong relative performance rebound contender. Nasdaq (QQQ) has reached relative performance levels more commonly associated with reversions in relative performance. EFA is breaking out of its trading channel, but is highly overbought.
Here’s how we stand on the Sectors front:
Like in the factors category, we have included the last 3 weeks of tables as well.
The Financial sector (XLF) along with rate sensitive Real Estate (XLRE) and Utilities (XLU) remain under pressure this week. They also stand out as under-performers on a longer term basis as well.
Defensives like Healthcare (XLV) and Consumer Staples (XLP) are faring better, and are starting to look like they are rebounding.
Tech (XLK) and Communications (XLC) are egregiously overbought at this stage and a pullback would be a good opportunity to increase exposure.
There are no sectors that fit our selection criteria for a technical play at this point. It has to be said that the overall picture seems to be improving in terms of breadth. However, when tech starts to deflate, our best bet for a rotation play remain Healthcare and Consumer Staples, possibly even Energy.
Charts Emphasis:
Nice technical rebound for Financials (XLF) although the sector is far off its recent highs despite the positive performance. The relative performance chart tells us it’s still a “dead cat bounce” situation. Healthcare (XLV) still struggling against SPY in this risk-on environment. Tech (XLK) pausing atop a huge upside deviation.
Taking all of these into account, Nostromo will select the single performing factor for allocation, and go all-in: EEM. EFA will be sold on the next available signal.
On the bonds side, MBB is slated for reduction, while TLT is preferred for exposure.
The Nostromo Strategy
Nostromo, our tactical allocation model, has successfully allocated to equity risk exposure via 2 Foreign Market ETFs.
The strategy maintains its 53% stocks position using EEM (Emerging Markets ETF) and EFA (Developed Foreign Markets ETF).
The EEM position is slated for a doubling on the next BUY signal, while EFA will be closed.
On the treasuries side, Nostromo plans to allocate towards TLT (Long-Term Treasuries) on the next BUY signal. If the opportunity presents itself , it shall sell MBB.
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
This week, we would like to screen for short opportunities. We shall tweak one of our pre-existing screeners, to try and get some ideas for hedging. The main thesis for a short position in this day and age would be eroding gross margins, coupled with bloated inventory and weak sales growth.
We shall start by selecting our Margin Growth Screener.
We shall then choose “Declining” from the "Margin Expansion” menu, so that only companies with deteriorating margins show up.
We shall limit the Pietroski F-Score to 5 (maximum), so that quality companies don’t make it into the screener.
We shall select “Interest Coverage” on a column, and set it at maximum 3, so that only companies that are struggling to pay interest on debt will show up.
We shall set Sales Growth to a maximum of 5%, ensuring sluggish growth.
We shall set “Inventory Turnover” to a maximum of 7 (below average sales / inventory).
We can order the list according to “Beta to SPY” or any other factor that we’d like to avoid.
The screener outputs some resounding names: Nvidia, Peloton, CoinBase, Kodak, Intel, Micron, Sonos, Bed Bath & Beyond.
We can use the Fundamental Explorer instrument to take a deep dive into their financials. Then, use the Valuation Wizard to generate a Price Target, and see the target on a chart using Technical Analysis. If interesting, we will look for opportunities to short these companies into their earnings call.
The Horizon Strategy
Horizon has rebalanced positions to target this week. Equity allocation has remained the same, but treasuries allocation has increased to 40%.
This model has performed poorly as of late. It’s equity curve is more related to the Momentum Factor ETF than SPY. Momentum has lagged the broader market, and has reached previous-low levels.
As an aggressive equity exposure model, Horizon has got trapped in repeated “bear-market rallies”. Eventually, those will end sooner or later and this model will start performing closer to its historical metrics.
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.
Studying the market environment from a moving average point of view reveals some bearish underpinnings. We’ve highlighted the moments when over 800 stocks are trading above their 20-DMAs using purple rectangles. These seemed to align more with tops in the market, rather than buying opportunities. Furthermore, the difference between SPY’s Sigma Score and the broad market’s is very large (1.73 for SPY vs 0.28 for the average stock). This signals that SPY has gotten well ahead of itself here.
There is also a bearish “head-and-shoulders” technical formation taking shape in the number of stocks trading above their 200-DMAs. While the market is pushing higher, and nearing its most recent peak, it is not supported by underlying technicals. Most stocks are not following SPY’s performance, and a narrowing market is not good news for the bulls.
Bearish Signal in Stocks trading above their 200-day Moving Averages
The market is no longer oversold. It is not yet overbought either, like in previous topping processes.
Neutral Signal in Stocks Overbought / Oversold
In terms of Z-Score divergence, the bearish difference noted in the first panel persists. At 0.7 Z-Score, SPY is well ahead of the average stock (0.18). This is representative of a narrow market, reliant on the performance of a couple of stocks.
Bearish Signal in Market Internals Z-Score
Dollar Transaction Volume has remained below average, as the surge of liquidity following the banking crisis has subsided. Transaction volumes are fine for the moment, but we wouldn’t want to see this indicator much lower in the near future. It would signal the rally has lost steam. With the Easter holiday coming up, it’s understandable trading volumes will be lighter for now. Volatility has given us a welcome respite lately, and that is a bullish development.
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.
Nostromo and Horizon agree on overall equities exposure. All models have a certain weighting towards treasuries and cash.
To start, we will take an average of CASH position sizing from all of our models. This will come down to 44%, with a wide 85% - 5% allowed. Equity exposure stands at 35% on average, while on the treasury side models average 20%. The average allocation makes a lot of sense at the moment, and we would lean on taking on more risk in both stocks and bonds. We’d underweight cash at the current juncture, given the dollar’s poor performance.
There are no immediate trades that need to be executed in the Sigma Portfolio right now. We will monitor market developments and keep you apprised.
I wish you a wonderful Easter Holiday, along with your loved ones and family!