Portfolio Rebalance / February 28
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 our strategies are adopting a wait-and-see approach. This makes sense from a lot of standpoints, as the market’s direction is still in the balance. The US Dollar has made a significant technical breakthrough and appears to be headed higher for the time being. This will pressure all of the other asset classes going forward.
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 remain below the rising lower trend-line, which makes the un-investible.
The US Dollar has now achieved a clear breakout above the S1 Level (currently at $28.18) and is overbought in the medium term (scale on the right, reading 99/100). We expect a shallow consolidation in the near term, but the momentum is clearly on the dollar’s side for now. Eventually, we expect the dollar will make its way higher into the next resistance level (M-Trend at $29.45, with 4% upside).
The outcome of this move will strain all of the other asset classes, along with emerging market equities and bonds. The technical channel shows a 10.81% CAGR, which is clearly unsustainable long-term. For now, however, the technical rebound appears to stick, and we have to respect it.
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 current regime started in April 2022, and has shown no signs of fading.
The combined asset classes are now testing the previously established trading channel. Most vulnerable to a dollar rally are gold, equities, commodities and (lastly) treasuries, in that order. The performance delta graph (below the chart) already shows that the emerging trend of dollar weakness v.s. all other asset class strength has been broken.
The Enterprise Strategy
Enterprise, our most conservative model, entering the week being 100% long CASH.
Since this model only trades 4 asset class ETFs, we use it to judge overall portfolio positioning. By sitting in cash, the strategy implies continued upside for the US Dollar as an asset class.
Equities are targeted for exposure at 17% of portfolio value, via SPY ETF. The position will be filled at the next available BUY signal. This could be a MACD crossover in the coming weeks, if the current consolidation phase is successful.
The model is aiming to allocate to treasuries up to a similar 14% 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.
Despite the fact that 9 out of 10 equity factors are outperforming the SPY near term, we are noticing breadth deteriorate across the line. Medium-term trends have turned negative for 5 / 10 ETFs that we track (previously just 2 / 10). Note that the worst performing factors on an absolute and on a relative basis (January’s leaders) - namely Growth (IVW) and Nasdaq (QQQ) have started to lag in relative performance. Click on the relative to SPY charts below:
Former leaders in relative performance include the DOW Jones (DIA), Equally Weighted SPY (RSP), and Value (IVE) ETFs. Joining these, are new leaders in relative performance, namely Momentum (MTUM) and Emerging Markets (EEM). Our selection technique works by taking these relative leaders and figuring out if there are notable buying opportunities (trading below their normalized 50-DMA, for example). As it turns out, all of the outperforming factors are buyable!
Our Z-Relative > 0 and Sigma 50 < 0 filter outputs the following results:
RSP (Equally Weighted SPY)
MTUM (Momentum Factor)
IVE (Value)
EEM (Emerging Markets)
DIA (Dow Jones)
It is a rarity that so many factors qualify for this selection criteria. This unusual set-up could turn out to be very bullish, if the market maintains its composure and avoids a deeper selloff in the next couple of weeks.
Here’s how we stand on the Sectors front:
Defensive sectors Utilities (XLU) and Healthcare (XLV) have become very oversold near term, despite outperforming on a longer term basis. Industrials are still overbought, even more so than last week. Real Estate (XLRE) is also getting quite extended to the downside, but is not buyable yet (see charts). Consumer Staples (XLP) are enjoying a nice set-up on an absolute and relative basis. Energy is trading in a relatively tight range and is unusually stable, with a beta-to-SPY of 0.68 (the third lowest of all sectors!). High beta Tech (XLK) and Consumer Discretionary (XLY) have lost steam recently, with profits being taken quickly after record runs since the start of the year.
Our selection method works similarly to the Factors approach. We identify relative out-performers that are simultaneously trading below their normalized 50-DMA’s (negative Sigma 50 score). As far as sectors are concerned, none of them fit this selection method.
We’d like to point out the difference between a buyable sector on a more significant dip (XLP) and a non-buyable dip (XLRE):
Taking all of these into account, Nostromo will select all of the outperforming factors for allocation: RSP, MTUM, IVE, EEM, DIA. When the right BUY signals get triggered, the model will buy these positions, resulting in a diversified equity allocation.
On the treasuries side, last week’s positioning is preferred: MBB, LQD, IEI, HYG.
The Nostromo Strategy
Nostromo, our tactical allocation model, is holding a 5% position in DIA at the moment. This is the only ETF that has triggered a BUY signal so far.
On the equity allocation side, Nostromo will attempt to buy the rest of the targeted positions:
RSP
MTUM
IVE
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 see what comes up on our Buy The Dip Opportunities Screener. Since we are in the consolidation phase of the current advance, it might make sense to see if there are any notable opportunities here. As a reminder, here are the screening 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
Furthermore, we are restricting factor correlation to RSP, MTUM, IVE, EEM, DIA in order to match factor analysis
Setting Pietroski F-Score > 6; quality component
Setting Operating Leverage > 1; solid business model
The list includes stocks that in a correction pattern (as the name of the screener suggests, and confirmed by the medium term MACD Trend):
Standing out on a Z-Relative and Sharpe Ratio basis (columns A & B corresponding to the X and Y axis), the following stocks would make good further research candidates: XOM, TR, GILD, CAT, HAL, MCD, AME, FCFS.
We can use the Fundamental Explorer instrument to take a deep dive into their financials.
The Horizon Strategy
Horizon will hold its overall portfolio positioning this week.
The strategy maintains exposure to equities at 17%, and bonds at 14%.
Rebalance will only occur at the individual securities level, in order to bring each at target 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.
As an aggressive equity exposure model, Horizon has got trapped in repeated “bear-market rallies”.
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). If the market is truly going from strength to strength, it would make sense that more and more stocks would be trading above their 200-DMA’s. A healthy bull market regularly registers more than 800 stocks above on any given day. Currently 614 out of the top 1000 stocks are trading above their 200-DMA.
From a Sigma Score perspective, SPY is slightly below the overall market (-0.14 vs -0.01). 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 -0.01, while the market is slightly positive, at 0.22. 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 and is now nearing the average. As the consolidation works off some overbought conditions in the market, we would like to see volumes go even lower (bullish). We have circled the volume extreme that usually signifies the end of a “move” either to the upside or the downside. That is usually the place where sellers no longer meet buyers, and the direction changes due to a supply and demand imbalance.
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 88%. While still much higher than our current allocation, we are maintaining a more constructive view on the equity market for the moment. Defensive positioning due to the presence of Healthcare, Energy and Momentum stocks helps bring the beta of our portfolio down.
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 market has still “not made up it’s mind” about a clear direction near-term. Fundamental bearish forces are clashing with some positive technical signals. S&P500 EPS has declined 6.3% in Q4, and hope exists that this is pretty much it in terms of contraction. Inflation has remained sticky on the other hand, and in certain parts of the world is starting to re-accelerate.
However, it is the US Dollar’s strength that is bothersome at the moment. At a very basic level, our strategies are saying that CASH as an asset class will continue to perform better. In the Sigma Portfolio, we are still waiting for the right opportunity to allocate more capital to treasuries (although this may not come if the Fed’s terminal rate keeps getting priced in at a higher level), and waiting out the conclusion of the latest rally.
The Sigma Portfolio is now 12% net-long on the equity side (21% Long / 9 % Short), with 24% allocated to treasuries (4% Corporate Bonds, 20% Long Term Treasuries). 46% of the portfolio is net CASH, a clear overweight decision in today’s uncertain environment.
Andrei Sota