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.

Administrative Notice: this will be the last Research Article published on the platform for 2022. We will resume our regular publications in January. Have a wonderful holiday season with your loved ones and a New Year filled with blessings! I’d also like to express a sincere THANK YOU for supporting Signal Sigma! We have a lot more planned for 2023 - stay tuned!

- Andrei

This week features a complete elimination of equities as an asset class from our strategies. SPY closed below our key support level yesterday (382), and as a consequence, the targeting logic will not include equities in any model’s desired allocation. Bonds and cash remain the only asset classes desired by our system.

1. 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.

The US Dollar has continued grinding lower for the past week. After a brief jolt on Friday, UUP is now back at technical support ($28). The main currency pair that will impact the dollar will be the JPY/USD, as the yen has surged on the BoJ’s recent hawkish policy shift. The dollar will be supported by a safe haven bid, including a shift to US Treasuries, but pressure is mounting from competing currencies. The Fed is no longer the only Central Bank that is hiking rates. In fact, as the leader in the tightening cycle, it is also expected they will be the first to cut. This logic calls for strength in the EUR especially in 2023, and maybe even gold. We are keeping an eye on this dynamic.

Upside for UUP is at 29, with good risk-reward. Whatever happens next, weather a bounce or a breakdown, will most likely set the tone for the next couple of months.

We are still trading in an environment where there is a high negative correlation between the USD and every other asset class combined. Lately, we have seen the first signs of a breakdown in this extreme correlation regime. The bounce of the US Dollar has been underwhelming in reaction to the weakness of the other asset classes.

As soon as this correlation regime breaks meaningfully, we will be able to allocate more freely to something other than cash.

Enterprise is sitting tight this week, only targeting bonds for exposure.

For now, the strategy is 100% allocated to cash, avoiding the volatility associated with the latest bear-market rally.

The Enterprise Strategy

Enterprise, our most conservative model, plans to initiate a position in TLT on the next available BUY signal.

Since this model only trades 4 asset class ETFs, we use it to judge overall portfolio positioning.

Treasuries are targeted for allocation via the TLT ETF, at 5.5% of portfolio value. Getting a BUY signal for TLT could occur this week, as the MACD has turned negative. After a period of consolidation, a positive crossover would trigger a trade.

Cash reserves (USD) are currently at maximum - 100% CASH.

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.

Equities are no longer a viable asset class for investment, but it’s still worthwhile to take a look at how different Factors are performing and check for any notable opportunities.

The Momentum factor (MTUM) has taken the lead in terms of both 6-months absolute and excess-to-SPY returns. If equities would be targeted for exposure, the following factors would present viable investment options:

• MTUM (Momentum)

• MDY (Mid-Cap Stocks)

• RSP (Equally-Weighted SPY)

• IVE (Value)

• SLY (Small Caps)

These ETFs stand out to us because they are both relative out-performers (Z-Score Relative above 0, right-low panel) AND are trading below their normalized 50-day Moving Averages (Sigma 50 below 0, left-low panel). If we were to make the case for any one factor, it would be Momentum, as it selects stocks based on price performance, even in the face of adverse market conditions. The resilience of certain stocks in a bear market is certainly something to take note of.

On the flip side, the strength seen in international stocks (EFA, EEM) is only warranted by the dollar’s recent weakness and could be ripe for a pullback. The Dow (DIA) is also vulnerable to a technical pullback, but less so.

Here’s how we stand on the Sectors front:

Selling pressure has gathered steam for the sector ETFs as well. Last week, only 2 of these ETFs were trading below their respective 50-day Moving Averages. This week, 7 sectors are trading below the normalized 50-day MA. Communications (XLC) look oversold yet again on the Sigma Score panel (lower-left), while Real Estate (XLRE), Consumer Discretionary (XLY) and Tech (XLK) are leading to the downside by Z-Score deviation (right-lower panel).

If equities were targeted for exposure, we would find good opportunities in the following ETFs:

• XLE (Energy)

• XLF (Financials)

The usual reasoning applies here as well: these sector ETFs are both relative out-performers according to their Z-Score AND are trading below their 50-day Moving Averages. Industrials (XLI) and Healthcare (XLV) seem prone to a technical pullback, as they are the only ones enjoying strength in this market pullback.

The weakness shown by Real Estate, Consumer Discretionary and Communications seems warranted at this point. This is not an opportunity to buy the dip in these areas.

Taking all of these into account, Nostromo will apply the same allocation logic as Enterprise. It will not select any equity ETFs for allocation due to SPY’s break below support. Instead, it will attempt to buy bonds (TLT) on the next signal.

The Nostromo Strategy

Nostromo, our tactical allocation model is starting the week with 100 % cash positioning.

The strategy will perform identically to Enterprise this week, with very similar targeting and the same signal logic.

Treasuries are targeted for allocation via the TLT ETF, at 5.5% of portfolio value.

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, our focus for stock selection will be the Buy-the-Dip Opportunities Screener. With the market feeling the heat of selling pressure, it’s time to see if there are any unwarranted bargains on the market. As a reminder, here are the screener’s rules:

• Regression Trend is Positive; the stock is trending up, on a 2 year historical window

• Sigma 50 < 0; currently, the stock is trading below the level where it’s normally been trading relative to its 50-day Moving Average

• Z-Relative > 0; the stock is outperforming its benchmark ETF

We have set the Pietroski F-Score to a minimum of 6 (to select quality fundamentals) and the same Factor correlations as determined in the previous section (MTUM, MDY, RSP, SLY, IVE). Operating Leverage Mean was set to a minimum of 1. We compared the Gross Margin 2 Year Average (column A) with the latest figure for Gross Margin (column B), to select only companies that are currently growing their gross margin (column C), despite inflation pressures.

Here are the results:

Companies worthy of further investigation (try to see their financial metrics through the lens of our new Fundamentals Explorer, in beta): NDAQ, NXST, INSW, BCOR, IRM, WTS, AVD.

At current levels, Horizon will liquidate the 10-stock portfolio at today’s close. This model is the most aggressive and has no need for any other confirming signals. It will take it’s allocation framework from Enterprise and Nostromo meaning the only remaining position will be TLT.

Horizon Strategy

Horizon is entering this week’s rebalance holding a 10-stock portfolio that will be liquidated at today’s close.

Horizon is an aggressive, momentum based strategy, that aims to follow the best performing stocks only if equities are a viable investment option in terms of asset allocation.

Since SPY closed lower than our measured support level, this strategy will only keep the position in bonds (TLT).

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.

Overall, we find that conditions are starting to degrade and creep into oversold territory. We are not there yet, but selling pressure can clearly be felt. We are monitoring the internals for the top 1000 stocks by trading volume to assess the health of the Market v.s. SPY.

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

The number of stocks trading above the key moving averages still points to a constructive environment. As selling pressure mounts on the whole market (SPY’s Sigma Score is at -0.99), individual issues are faring better (the average stock has a Sigma Score of -0.4). The divergence in these scores, as well as a chart that seems to be turning up, despite recent pressure, keeps us optimistic on the structure of the market from this perspective.

Bullish Signal in Market Internals Z-Score

Another bullish divergence can be observed in the average Z-Score of a stock in the market versus the Z-Score of the SPY itself (the Z-Score measures how many standard deviations a certain reading is above or below a computed trend).

While the SPY’s Z-Score readings have been grinding lower and lower since the start of the year, the average stock is faring much better. The divergence in Z-Scores starting in the middle of June is obvious on the chart. Put simply, the average stock has been doing much better than the SPY itself. Again, an undeniably bullish development below the surface. This divergence is persisting this week as well, as the current uptrend is facing some serious headwinds, now sitting on some sort of technical support, at the previous “top”.

Bearish signal in Average Dollar Transaction Volume and Volatility

There is no let-up in the volatility experienced this year. It’s clear that the current trading environment is a whole other beast that what investors experienced in the near past. In order to be profitable, we need to adapt and make use of this volatility to our advantage.

In terms of transaction volumes, the current medium-term trend is unchanged: volumes are trending lower, as the Fed is removing liquidity from the financial system. The surge in volume experienced last week has done little to reverse this trend. It only serves as confirmation that lower prices overall agree with both buyers and sellers. Not a good omen for the direction of the market overall. We’d like to see normalized volatility and high transaction volumes in order to get more constructive here.

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.

First of all, we will take an average of CASH position sizing from all of our models. This will come down to roughly 98%, with a minimum and maximum of 95% and 100% respectively. It’s pretty clear that our models are cautioning us against taking any unwarranted risk at this point.

The Market Environment view is still defensive this week. The broad market appears to be breaking below our designated range. If we get some confirmation of this breakdown (a failed rally at 382-385 will do just fine), then we will add to our Short equity exposure.

The Sigma Portfolio is currently allocated 9% Long, 21% Short equity exposure.

We’d like to use any rally above 382 to close some of our long positions as well. Here are the remaining longs and their correlations:

According to the Correlation Screener above, the Sigma Portfolio contains positions primarily correlated with the Value Factor (IVE) and Mid-Caps (MDY), factors which we have identified as opportunities in the previous section.

Andrei Sota