Portfolio Rebalance / February 22
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 features yet another demonstration of why we don’t blindly follow our investment strategies. As Enterprise and Nostromo got stopped out of their stocks positions, we are just beginning to add to equity exposure in our real-life portfolio. We are now almost at the limit of equities being investible, so our stop will be very tight. In reference to yesterday’s article, we are not fully convinced of this being either a “mean-reversion” environment or a “trend continuation” one.
The dollar is starting to strain all of the other asset classes again, and a lot will depend on whether its recent rally will stick or fail.
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, Gold and Treasuries remain investible this week. Commodities have struggled recently and are flirting with the lower trend-line, but remain barely un-investible for now.
The US Dollar is at a critical juncture. While technically overbought, the Dollar is attempting to push through a major resistance level (identified by our system as S1). This level has provided both support and resistance to past moves, and if a breakthrough should occur, upside is rather large. All other asset classes will incur losses, as we are still in a negative correlation environment (see below).
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 convincingly pulled back from highs, while the dollar has rallied. The performance delta graph (below) shows us just how critical the current level is.
Enterprise is selling SPY at the close of the trading session today. Unfortunately, the strategy got “fooled” into buying the breakout by a very shallow MACD signal (shown below, at the time it triggered).
Right now, the signal has moved clearly into negative territory, which is exactly what we wanted to see in the first place. This way, when a BUY signal occurs, it will come from a lower level that signifies a completed consolidation pattern.
If SPY manages a bounce from current levels, then we will increase equity exposure, as it will be the signal that the “trend continuation” environment is back. If the benchmark ETF fails at $398 support, it will likely mean this was just another bear market rally, and we are trading in a “mean reversion” environment.
Counterintuitively, it makes more sense to buy the dip in SPY at $400 than at $390.
The Enterprise Strategy
Enterprise, our most conservative model, is getting 100% long CASH. SPY has triggered a stop-loss, and the strategy will sell the position at today’s close.
TLT has also triggered a stop-loss earlier in the week, as no asset class is continuing its breakout.
Since this model only trades 4 asset class ETFs, we use it to judge overall portfolio positioning.
Equities are still targeted for exposure at 15% of portfolio value, via SPY ETF. The position will be filled at the next available BUY signal.
The model is aiming to allocate to treasuries up to a similar 15% portfolio value at the next available BUY signal.
Cash reserves (USD) will be kept at a maximum, 100% in the meantime.
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.
There are still a couple of overbought sectors by Z-Score metrics: Foreign Developed Markets (EFA), Mid-Caps (MDY), Small Caps (SLY). We expect these extensions to come down in the next period, as the relative to market deviations of these factors are unsustainable. Our rules to identify opportunities are:
> Trading below the 50-DMA, while at the same time…
> Trading above Z-Score Relative 0.
The 3 ETFs that match these conditions are:
MTUM (Momentum Factor ETF)
DIA (Dow Jones)
EEM (Emerging Market Equities)
We like the top 2, because of their relative safety to the US Dollar trade. Emerging Market Equities are heavily dependent on a lower USD, and would be vulnerable if the dollar rallies further. Check out the Relative to SPY charts of MTUM and DIA below. Note the sharp pickup in relative performance.
Here’s how we stand on the Sectors front:
Sectors are… all over the place! Industrials (XLI) are overbought, but to a lesser extent than last week, while Utilities (XLU) are oversold, and seeing a pickup in relative performance. According to our selection rules, stocks in the Basic Materials sector (XLB) are worth a look, since XLB is trading below its 50-DMA, while also exhibiting a Z-Score Relative > 0.
However, it’s very useful to study the Relative to SPY charts and search for opportunities this way. The traditional defensive sectors stand out in this regard. Check out the relative charts for Healthcare (XLV), Utilities (XLU) and Consumer Staples (XLP). They are seeing sharp improvements, from low levels, signaling this is probably where money will rotate to, once the “2022 laggards” trade loses steam.
Taking all of these into account, Nostromo will select 3 factors for allocation, in regards to equity positioning: EEM, MTUM and DIA.
On the treasuries side, last week’s positioning is preferred: MBB, LQD, IEI, HYG.
The Nostromo Strategy
Nostromo, our tactical allocation model will go to CASH 100% at the end of today’s close. SPY has triggered a stop-loss, so the position will be removed.
On the equity allocation side, Nostromo will attempt to split exposure to the 3 identified factors, following a BUY signal for each: MTUM, DIA, EEM.
On the treasuries side, instead of TLT, the model will attempt to buy MBB, LQD, IEI, HYG, on their respective BUY signals.
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 stocks that match correlations to the 3 factors identified by Nostromo. We do that, by going to the Factor Correlation Screener and setting our Factor filter to include EEM, MTUM and DIA. Furthermore, we apply the following filters:
Pietroski F-Score => 6 (quality component)
Operating Leverage > 1 (solid business model)
Z-Score Relative < 0 (relative weakness, indicating “catch up” potential
Sharpe Ratio > 0 (positive risk-reward performance profile)
Dividend Yield % > 1 (assures a degree of portfolio income)
The list includes stocks that we already own, confirming our portfolio allocation is on the right path.
The screener outputs positions like CF, DVN, PXD, UNH, ADM - already included in the Sigma Portfolio. Other stocks that stand out include ABBV, OXY, HP, ADP, BMY, IBM.
We can use the Fundamental Explorer instrument to research their financials.
The Horizon Strategy
Horizon will rebalance it’s equity portfolio this week. This operation happens once per month. Some positions will get closed out completely, others will be initiated.
Overall, the strategy maintains exposure to equities at 17%, and bonds at 14%.
Closed Positions:
VLO
PI
HES
AEHR
JBL
Initiated Positions:
RS
NVT
TA
INSW
XOM
The other positions will be rebalanced at 1.7% portfolio weight.
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, but may be seeing a pick-up in relative performance, as discussed above.
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 slightly below the overall market (-0.05 vs 0.05). The difference is not notable enough.
On a longer term basis, the breadth numbers look solid, but the current advance in stocks above the 200-DMA needs to hold.
Bullish Signal long term in Stocks trading above their 200-day Moving Averages (Neutral Short Term)
In terms of Z-Score divergence, there is no notable difference this week. SPY is at 0, while the market is slightly positive, at 0.25. The difference is not notable, with SPY and the market trading harmoniously.
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. As the consolidation works off some overbought conditions in the market, we would like to see volumes go lower (bullish). High volumes on selling action would be bearish, as it would mean volume confirms lower prices.
For the moment, Volume is painting a neutral picture. Volatility has risen, but not to alarming levels.
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 89%. This is much higher than our current allocation, but it is subject to change when / if we get through this consolidation period.
As discussed in our previous article, our trend-following models are inefficient in a mean-reversion environment. In reality, we need to invert their signals to a certain extent, at least until we get back to “normal”, trending markets.
The factor selection displayed by Nostromo resonates with our own thinking. It makes sense that money would eventually flow to previous leadership, and safety. However, we would only consider adding equity exposure aggressively once the current consolidation period completes, without breaking support.
On the fixed income side, we are looking for the right opportunity to increase exposure, both at the short and at the long end of the curve.
In any case, it looks like the market is at a very important crossroad. It is a question of the U.S. Dollar v.s. all of the other asset classes. Before committing more dry powder to either stocks or bonds, the dollar must reverse its advance. Once we get a clear resolution to this set-up, it makes sense to deploy capital.
If the dollar rally continues, on the other hand, all of the other asset classes will be crushed. In that case, we’d like to own as many $USD’s as possible (or short term bonds) and get paid while we wait for the next investible opportunity.
Andrei Sota