Portfolio Rebalance / February 14
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.
This week highlights the importance of manual oversight when dealing with automated strategies. Enterprise and Nostromo will both aggressively increase their allocation to equities on a very shallow MACD BUY signal. While the signal is technically valid, it bears remembering why we built these strategies in the first place, and how to use them properly in real-life investing:
We didn’t build them so that we could blindly follow them - instead, they give us a proper framework to work with and “see the market through a computer’s eyes”.
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.
This week, all asset classes are investible. SPY, GLD, TLT are currently forming downtrends and may be in the process of forming a technical recovery. DBC is the only major ETF forming an uptrend, that it is barely able to hold.
The US Dollar rally has stalled, as a major resistance level is encountered. This time, we have not adjusted the chart for UUP, to better emphasize where that bounce came from (the natural lower trend-line). Yet the current growth rate sits at 10.9% CAGR, which is unsustainable longer term (it would completely crush foreign currencies and trade). What we are looking for in UUP in order to support the bullish thesis is to NOT surpass the S1 level, currently sitting at the $28.15 mark. If that level is breached, the next resistance line sits way up, at $29.4 - a break would be very bearish for all other asset classes, especially EM stocks.
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). There is no meaningful such break as of yet.
The combined asset classes have pulled back from highs, and apparently seem to be testing the recent breakout. As the dollar bounced from oversold conditions, so did every other asset class retreat from overbought. We are still waiting to see the ultimate conclusion of the move, but so far it seems the dollar’s advance has been limited. Therefore, we suspect there may be limited downside for the combined asset classes, as our analysis suggests the tide is turning (not in favor of the USD). However, this is prone to change, especially given the recent shift in “Fed Pivot” expectations. Watch the US Dollar as it is testing upside resistance.
“We are not out of the woods just yet” when it comes to this bearish market environment, as the US Dollar is still significantly negatively correlated to everything else. This correlation will probably turn positive when Central Banks will get less attention from traders and investors.
Enterprise is buying SPY at the close of the trading session today, using a very shallow MACD BUY signal. MACD crossover expectations:
The theory behind this signal is that it doesn’t let us buy into a bear-market rally immediately. Instead, it forces us to wait for a negative crossover first (signaling a market consolidation process that does not violate stops) and only then, on the next positive crossover can we actually buy. What we got instead was this:
No signaling method is perfect. While using such signals improve the results of a backtest, it’s our job to understand and apply their purpose in real life. It is safe to say this signal’s purpose has not been served with this positive crossover (something similar happened with TLT as well recently). The STOP and PROFIT TAKER settings (reported in the strategy dashboard window) for this trade give us proper insights:
STOP SET AT: 400.21
PROFIT TAKER SET AT: 431.43
Combined with yesterday’s fundamental analysis, the logic for the trade becomes clear. However, at current close prices ($412 on SPY), there is less fundamental upside than we would like to see. It all depends on happens to the price after the latest inflation report. Enterprise will buy the close in any case.
The Enterprise Strategy
Enterprise, our most conservative model, is entering the week with holding a 20% long treasuries position and 80% 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, via SPY ETF. The position will be filled at today’s market close.
The model is also aiming to up the allocation to treasuries modestly, from 186 shares to 188. This adjustment will not materially affect performance.
Cash reserves (USD) will fall to 33%.
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.
Factors are going gangbusters! It seems like the current advance is lifting all boats with 2 notable exceptions. One is understandable, the other is puzzling:
Emerging Market Equities (EEM)
Momentum Factor ETF (MTUM)
The understandable exception is EEM. As noted at the beginning of the article, Emerging Markets are under pressure due to the rally in the US Dollar. As the local currencies depreciate, it’s only natural that this ETF (priced in Dollars) will follow suit lower.
However, it is the stagnant performance of the Momentum Factor that is bizarre. Momentum is a factor that incorporates stocks that lead the market. By definition, it is these stocks that have “wind in their sails” or momentum behind them. Yet it is the former market leaders (from sectors like Energy, Healthcare, Consumer Discretionary) that are now lagging. High beta ETF’s (Tech, Growth, Small Caps) have been the leaders of the advance so far in 2023. Yet in a healthy bull market (2012 - 2021) Momentum has seen a clear outperformance over the broad market, as the leaders kept leading.
Weather this rotation is healthy remains to be seen. For the moment, there are no obvious trading opportunities here.
Here’s how we stand on the Sectors front:
On the Sectors side, the rotation we were noticing in Factors is manifesting as well. Low-Beta defensives (Utilities, Healthcare, Staples) and former leader - Energy, are all taking a backseat to Tech (XLK) Financials (XLF), Consumer Discretionary (XLY) and Communications (XLC).
All recent leaders are former laggards and closing a hefty performance gap. All of the current laggards are former leaders. The move resembles short-covering rallies - similar accounts have occurred throughout 2022 and in other historical bear markets.
There are no notable trading opportunities present.
Taking all of these into account, Nostromo will apply the same allocation logic as Enterprise. It will simply buy SPY using the MACD Signal we have previously discussed.
The Nostromo Strategy
Nostromo, our tactical allocation model is starting the week by holding a long bonds position in TLT (20% weight), with the rest of the portfolio allocated toward Cash (80%).
On the equity allocation side, Nostromo will buy SPY at today’s close.
Similar to Enterprise, the model’s Cash levels will decline towards 33%.
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 will run a custom screener. We would like to find high-beta stocks (recent leaders) that might be worth researching and buying on a pullback. As discussed last week, it is time to form a “shopping list”. Here are the screener settings:
Piotroski F-Score => 6 (ensures quality)
Operating Leverage > 1 (solid business model)
NOT correlated with XLP, XLU, XLE, XLV (lagging, low beta sectors)
Beta to SPY => 1 (potential market leadership)
Z-Score Relative > 0 (outperforming benchmark ETF)
Positive Regression Trend (despite market turbulence, these stocks form positive trading channels)
Current Drawdown Duration (use as flip between 2 extremes)
The screener outputs a very interesting list, that we can further screen using the last criteria (Current Drawdown Duration) - this will help us choose between recent leaders (those that hit fresh all time highs recently, and have low Drawdown Duration) and stocks that have reached their all-time highs one year ago (high Drawdown Duration).
Whenever we encounter a split graph like this, we need to consider a barbell approach and select stocks from either “side”. In this case, the split is between stocks with high drawdown duration, and stocks that just hit their fresh all time highs. Names like ADI, LSCC, KEYS, KNX, AEHR, NUE, KNX, ON catch my eye. We can use the Fundamental Explorer instrument to research their financials.
The Horizon Strategy
Horizon will maintain its overall exposure to the main asset classes.
A rebalance will occur across the both the equity and bond portfolios. Stock positions are brought back to target weights of 4.8% each.
Treasuries will see a rotation from TLT to IEI, MBB, LQD and HYG (other classes of bonds, including high-yield).
Cash will get reduced to 32%, a recent low.
This model has performed poorly as of late. It’s equity curve is more related to the Momentum Factor ETF than SPY. As we discussed above, Momentum has lagged the broader market.
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.
595 stocks. That’s how many we need to see maintain their 200-day Moving Averages to make sure we are getting a positive consolidation in the market. That’s the number we find associated with the previous peak in the market (November 2022).
From a Sigma Score perspective, SPY is getting more extended versus the average stock than last week. The difference in Sigma Scores was -0.57. Now, it sits at -0.75. It would not be surprising to see SPY lower in the short term. Also, the fall in 20, 50 and 200 day moving averages (yellow lines) was quite brutal last week. It looks like an incipient bearish divergence short term.
On a longer term basis, the breadth numbers look solid, as long as most 200-day MA’s are held.
Bullish Signal long term in Stocks trading above their 200-day Moving Averages (Bearish Short Term due to Sigma Score)
The bullish divergence in terms of Z-Score has evaporated (the Z-Score measures how many standard deviations a certain reading is above or below a computed trend). The average for the broad market is 0.44 (0.43 last week), while SPY’s is 0.43 (0.29 last week). The gap has completely closed now, and the slope at which the market has lost Z-Score suggests short term caution.
Neutral Signal in Market Internals Z-Score
Dollar Transaction Volume has dropped from elevated levels. It hasn’t exactly “dropped off a cliff’, but it is noticeably lower. This move has not been associated with higher volatility, for now. We don’t want to see volume move counter to prices, and this is something we monitor daily. If transaction volume continues to deteriorate, with prices hovering near recent highs, it would be a cautionary signal. Same if we get a selloff on high volume.
Bullish signals would be a drop in prices on low volume or continued upside on high volume.
Mixed 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.
First of all, we will take an average of CASH position sizing from all of our models. This will come down to 33%. Our models are perfectly aligned, something which is noteworthy, as it does not happen very often. Noteworthy simply means we are sitting at an important market juncture, which I suspect will be defined by the upcoming inflation report.
The Sigma Portfolio is out of sync with the trading models at this stage. We will need to bring portfolios in alignment rather soon. While our “read” on the market environment is far more cautious than our strategies suggest, we are not dismissing their message.
And that message is simple, drawing from the STOP-LOSS and PROFIT TAKER instructions of the latest order:
We can buy equities on a pullback and consolidation that does not violate $400 on SPY, and hold on to positions until the technical target has been reached - $431 (which is also mirrored by our fundamental analysis of SPY, that targets $435).
A BUY trigger can also be a break above resistance at $417. However, I suspect that we will get the pullback we are looking for. There are some deteriorating internals creeping in, and inflation has a good chance of surprising to the upside.
For now, HOLD is the name of the game in the Sigma Portfolio until we get a better read on the market’s reaction to CPI numbers. We will most likely follow up soon with a relevant trade alert.
Andrei Sota