Portfolio Rebalance / January 10
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 a solid signal from both Enterprise and Nostromo for buying treasuries. Equities are still missing from our asset class allocation, as SPY is trading below the level required for our systems to get long. It should be noted that the equally weighted S&P500 (RSP ETF) is doing much better, and if used for allocation purposes, it would confirm a more bullish stance.
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.
SPY, GLD and TLT are all forming down-trends. The only investible option out of all 3 is TLT, since the current price movement could constitute a “bear market bottom”. DBC is trading below an up-trend, a signal to avoid exposure for now.
The US Dollar is showing continued weakness and has proven unable to hold support. The technical issue for the Dollar is that there is no immediate level of support that could stop its grind lower. The status of “best performing asset class” might be threatened in 2023 if performance does not pick up markedly. It looks like the reserve currency is headed to its “pre 2022 crisis” trend-line (which is the lower channel bound on the chart below). While the outlook for the USD is still bullish, this set-up is a signal to start looking for an alternate asset class. The only probable near-term catalyst for the Dollar is Thursday’s inflation report. We’ll be watching for a possible bounce above $28.11.
We are constantly checking for a break in the current negative correlation regime between the US Dollar (white) and every other asset class (orange). There is no meaningful such break as of yet.
Translation: “we are not out of the woods just yet” when it comes to this bearish market environment.
Enterprise has been targeting long bonds exposure for quite a while. Today, it’s finally time to act on that targeting signal.
The Enterprise Strategy
Enterprise, our most conservative model, will initiate a position in TLT at today’s market close, using a MACD crossover 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 15% of portfolio value.
Cash reserves (USD) are currently at maximum - 100% CASH and will be lowered to 75% after the trade is completed.
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 not 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 various factors present a mixed picture. In terms of M-Trend (that stands for Medium-term Trend), just 4 factors are Positive: EFA (Developed Markets EX-US), IVE (Value), RSP (Equally weighted SPY) and EEM (Emerging Markets). In terms of relative performers, DIA (DOW Jones), RSP, EFA and MDY (Mid Caps) stand out with their impressive out-performance of SPY.
While no factor qualifies for a basic BUY signal (both positive 6mo and 1yr returns), we could pick out the winners and losers of a rotation trade. If equities would be targeted for exposure, the following factors would present viable investment options:
MTUM (Momentum)
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), RSP and MDY could also weaken in the event of a rotation. That rotation should benefit the SPY itself, as well as momentum stocks.
Here’s how we stand on the Sectors front:
The picture is mixed in terms of Sectors as well. Energy’s performance has been lagging recently, and other sectors have made impressive strides. Namely Industrials (which are now overbought) Basic Materials (XLB) and Financials (XLF). Communications have bounced as well, but are still lagging in all measures of returns.
If equities were targeted for exposure, we would find good opportunities in the following ETFs:
XLE (Energy) - also the only sector with positive 6mo and 1yr returns
XLV (Healthcare)
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 allocate to bonds using TLT and initiate a 15% position today. HYG (high-yield corporate bonds) will also be part of the portfolio, but will be sold on the next signal. For now, these are considered “just a trade”.
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. The only notable difference is the inclusion of HYG in Nostromo’s portfolio.
Treasuries are targeted for allocation via the TLT ETF, at 15% of portfolio value. The model will trade at today’s close and fill the order for this position.
HYG will be sold on the next available SELL signal, which could be a MACD crossover if the continuation fails to hold (the signal is now positive, so a negative crossover could occur).
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 Momentum + Quality Screener. This is a very similar approach to the way Horizon’s logic works. Momentum (as a factor) is also favored in our factor selection approach. Here are the rules for the screener:
Piotroski F Score => 6; this ensures Quality
6 month & 1 Year Absolute Returns > 0; a basic momentum requirement
Sharpe Ratio > 1; very favorable risk-reward
Z-Relative > 0; stock outperforms its benchmark ETF
MACD Trend is Positive; medium term momentum is trending up
We have manually excluded the following factor correlations (due to these factors being overbought or underperforming): RSP, QQQ, EFA, EEM, DIA.
Here are the results:
Companies worthy of further investigation (try to see their financial metrics through the lens of our new Fundamentals Explorer): SXC, HAL, MRK, ULTA, ASO, GLP, PBH.
At current levels, Horizon will not form a stock portfolio, and instead solely rely on allocation to bonds.
Horizon Strategy
Horizon is entering this week’s rebalance holding a bonds portfolio comprised of HYG (High Yield Corporates) and TIP (Inflation Protected Bonds).
Horizon is an aggressive, momentum based strategy, that aims to follow the best performing instruments. It does not use any confirming signals and simply trades every week in accordance to its targeting logic (borrowed from Enterprise and Nostromo).
This week, it so happens that all of our models are aligned in execution. Horizon will initiate a 19% position in TLT at today’s close.
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.
Judging strictly by the amount of stocks trading above key moving averages, it looks like the equity market is putting in a medium-term bottom. All 3 metrics (and especially the number of stocks trading above the 200-day MA) seem to have bottomed in September 2022.
Right now, the number of stocks trading above their 200-day MA’s is 533. The last time we registered more than 530 stocks above their 200-day MA’s was March 29 2022. SPY was priced at $450 back then, was close to a bear-market-rally top and within striking distance of fresh all-time-highs. We will count this as a bullish signal, for now.
Bullish Signal in Stocks trading above their 200-day Moving Averages
Another bullish divergence can be found in the average of Z-Scores in the market, compared with SPY’s own Z-Score (the Z-Score measures how many standard deviations a certain reading is above or below a computed trend). As is evidenced on the chart, SPY is forming a defined downtrend, while the average stock seems to be holding support.
There is a caveat to this analysis - RSP, MDY, DIA (alternative factors to measure the performance of “the market”) are all historically overbought versus SPY. This is reflected in the chart below. Our guess is that SPY is being dragged lower by several mega cap stocks (AAPL, AMZN, MSFT, NVDA) that are performing poorly at the moment.
Bullish Signal in Market Internals Z-Score
Dollar Transaction Volume is continuing its pronounced down-trend, as the Fed removes liquidity from the financial markets. Reduced liquidity by itself does not mandate lower prices, but what we would like to see is an improved trend, for a change.
Friday’s surge in risk assets has pushed transaction volumes significantly higher than the polynomial average. Despite the surge, volumes are still around the lower baseline for the last 2 years. It’s premature to take the rise in volume as confirmation of any move the equity market might be staging.
Bearish signal in Average Dollar Transaction Volume and Volatility
While liquidity does not mandate prices, it does heavily impact volatility. Less liquidity in the market leads to higher volatility and this in turn contributes to lower prices. While realized volatility has come down a bit from 2022’s extremes, it’s too early to tell if a persistent trend change is in the works.
We’d like to see normalized volatility and higher transaction volumes in order to get more constructive from this vantage point.
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 82%, with a minimum and maximum of 81% and 85% respectively. Our models are aligned in terms of bond allocations this week, with weights ranging from 15% to 19%.
The Market Environment view is defensive, but improving. The equity market seems undecided at this point. We need a bit more patience in order to tease out a direction.
According to our models, the place to look for opportunities is the bond market. This could make sense, since in the event of recession (bad outcome for stocks) bonds will benefit, while a “Fed pivot” narrative will also help bonds. Technically, TLT has been in a pronounced bear market and has put in what could turn out to be a reliable bottom. While going “all in” on bonds is not advisable right now, we do believe a 15%-20% allocation makes sense. This position will form the base of our bonds allocation going into 2023. Therefore, in the Sigma Portfolio, we will execute the following trade at the session close:
BUY 15% of portfolio value in TLT (initiate 15% position)
The Sigma Portfolio is currently allocated 9% Long, 23% Short equity exposure. Bonds will take up 19% of the portfolio. We will further assess the equity side of the portfolio following Jerome Powell’s speech and Thursday’s inflation report. Anything is possible at this juncture, but we must be patient and let the market guide our next move.
For now, given the weakness in the US Dollar, it makes sense to reduce the cash position, since it does not appear to be the winning asset class of the future. And we are doing so by using the safest alternative - a mix of government and corporate bonds.
Andrei Sota