Portfolio Rebalance / April 12
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 have delayed the publishing of this week’s Portfolio Rebalance article to account and provide commentary for the latest inflation data.
Headline Inflation came in at 5.5%, below the 5.6% expected. Core Inflation was recorded at 5.6%, right on expectations. The market initially reacted positively to the data, but a rally petered out throughout the day. Our guess is that investors are looking through lower than expected inflation into what this means for the upcoming Earnings Season: weak consumer demand, lower guidance than expected. It may also underscore the fact that investors realize that a Fed pivot would not be bullish for equities.
Our strategies have no meaningful changes this week, as the market has not done anything particularly interesting. Aside from supply / demand, positioning and short-term algorithms, there have been no notable events to influence investors.
Yet the act of reviewing portfolios weekly is a discipline we follow closely, even if the process does not appear particularly exciting.
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.
In the only notable change from last week, Gold has finally formed an Up-Trend; its highly deviated posture still keeps the shiny metal un-investible for now
The US Dollar is languishing near the lower trend-line. It is no longer Oversold, and has managed to hold this key level of support. We suspect the next move will have outsized volatility, with odds slightly favoring a decline.
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. We have drawn out a short term technical channel (grey dotted lines), with an identical slope. If this trend is set to continue, it would finally break the inverse correlation regime.
Enterprise has an identical allocation target to last week and has not traded in the meantime.
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 (identical 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).
This week, it seems all factors have recovered to levels associated with a healthy bull market. QQQ (Nasdaq) and EFA (Developed Foreign Markets) are still longer term overbought, but their short term extensions have subsided. We shall take this as a healthy development, but they are still prone to profit-taking.
RSP (Equally Weighted SPY), SLY (Small Caps) and MDY (Mid Caps) are the only factors still trading below their 50-Day Moving Averages, due to thier exposure to bank stocks.
By using our proven selection criteria (Z-Relative > 0, while Sigma 50 < 0), no factors are set up for a technical trade.
Charts Emphasis:
Nasdaq (QQQ) in absolute terms, at the top of its technical channel.
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.
Sectors are showing a healthy disposition, with Communications (XLC) and Tech (XLK) still overbought and Financials (XLF) heavily oversold. Healthcare is also short-term overbought. We could be setting up for a rotation trade in the next period, as money could flow from Tech (XLK) and Communications (XLC) toward Basic Materials (XLB), Industrials (XLI) and Consumer Discretionary (XLY).
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.
Charts Emphasis:
Healthcare has bounced versus SPY, but there is still a lot of room for technical improvement. Technology (XLK) is showing the limits of extensions above the mean, as “gravity” is starting to play its part.
Nostromo will revert to targeting a standard stocks / bonds portfolio comprised of SPY and TLT ETFs. It is looking to close the EFA and EEM positions, as they have done their jobs in terms of outperformance for now.
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).
Both equity positions are slated to be closed on their respective SELL signals. Instead, SPY will be bought on a BUY signal, even if the EEM and EFA positions will not close.
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 a different type of quality companies. Those that display both good momentum trends, and are able to increase key metrics like Free Cash Flow and Dividends.
We shall start from the Dividend Growth Screener and apply the following extra rules:
Dividends are Rising
Piotroski F-Score > 5 (higher quality)
Operating Leverage Mean > 1 (solid business model)
6mo returns and 1yr returns > 0 (basic momentum requirement)
FCF Growth % > 0 (sustainable dividends)
While the output is pretty large (66 stocks), there are several tickers that stand out: AVGO, ADI, GWW, KLAC, MCHP, NXPI, R.
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. We might uncover some potential candidates for our portfolio!
The Horizon Strategy
Horizon has rebalanced positions to target this week. Both Equity and Treasury allocation has remained the same as last week.
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 touched 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.
This week, we are noting the same divergence between SPY’s Sigma Score (1.33) and the Broad Market’s (0.27). While less extreme than last week, this still tells us the index is ahead of itself and we are trading in a narrow market. The good news is that despite SPY’s stagnation in terms of price, more stocks are trading above their 200-DMAs than last week (573 vs 555).
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 still 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. This is an indicator that works best at market extremes, and we are not in either situation right now.
Neutral Signal in Stocks Overbought / Oversold
In terms of Z-Score divergence, the bearish difference noted in the first panel persists, at levels lower than last week. At 0.69 Z-Score, SPY is well ahead of the average stock (0.2). This is representative of a narrow market, reliant on the performance of a couple of stocks.
The same “head and shoulders” formation can be witnessed in the lower panel, for the average stock’s Z-Score.
Bearish Signal in Market Internals Z-Score
Dollar Transaction Volume has declined to below average. Realized Volatility has also taken a dive, to the peaceful levels recorded in late-stage bull markets. For the moment, we’ll interpret this data as neutral. We’d like to see higher transaction volume to support a further equity market rally (low volume in a rally is bearish).
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%. There is no change this week, and as a consequence, we are also looking for the next catalyst to shake up allocations. If the inflation report was not “it”, then surely Q1 Earnings Season will give us plenty to consider, model and trade. For now, we are content with our exposure.
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. As poker players would put it, our move is “check”.