Portfolio Rebalance / January 18
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 Horizon forming a 10 stock portfolio in its attempt to squeeze shorts at the SPY $400 level. Nostromo’s pick on the ETF side is also in alignment with Horizon, as both models are saying that they prefer technical performers over relative-value at this point (and we agree). Enterprise is not joining this party, as it’s more conservative style emphasizes safety over risk-taking. As usual, by the end of the article, after reviewing every step of the process, we will rebalance our real life portfolio accordingly.
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. Only SPY and TLT are investible, as they are trading at more reasonable Z-Scores (GLD appears overbought). Commodities have rallied nicely and are also an investible option.
The US Dollar is showing continued weakness and has proven unable to hold support. After a short-lived bounce, UUP got clearly rejected at the S1 Level, and did not recover those losses after the CPI report was released. It’s next level of support (S2 @ 26.65) has us contemplating significant downside. The bullish longer-term picture for the US Dollar is unaffected, however.
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.
However, we do note a technical breakout of sorts for the “major asset classes”. Establishing a short term higher high and a trend-line break are in the works.
Enterprise has been targeting long bonds exposure for quite a while. It got the entry point it was looking for last week, but a tight STOP-LOSS signal put an early end to that trade. Sometimes this happens. Enterprise is also targeting SPY for allocation.
The Enterprise Strategy
Enterprise, our most conservative model, is entering the week with a 100% cash allocation.
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.
Equities are also targeted for exposure at 17% of portfolio value, via SPY ETF.
Neither position has a good chance of getting bought this week, as all momentum signals are already positive (we need a “bounce from oversold” or “positive crossover” in order to trigger these trades).
Cash reserves (USD) are currently at maximum.
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 (again) an investible asset class, we’ll take a look at how different Factors are performing and check for any notable opportunities.
A much more healthy picture emerges when analyzing the various factors. Most of these ETFs are now in positive medium-term trends (M-Trend), are trading above all of their major moving averages, and some are even overbought.
It’s also striking how much Relative Outperformance is on display (bottom right panel). SPY used to be leader in performance, and only pockets of outperformance existed. Right now, it seems like almost anything has outperformed the major index-tracking ETF.
There is one opportunity that is obvious for both us and our Nostromo model:
MTUM (Momentum Factor ETF)
MTUM stands out because it’s both a relative out-performer (Z-Score Relative above 0, right-low panel) AND it’s trading below it’s normalized 50-day Moving Average (Sigma 50 below 0, left-low panel).
On the flip side, there appears to be an excess building up in the international markets etfs (EFA, EEM), as well as mid-caps (MDY) and value factor (IVE). Those are not worth chasing for the moment. Neither are the pure growth plays (QQQ, IVW), whose poor performance continues.
Here’s how we stand on the Sectors front:
On the sectors side, the picture is much more “unbalanced”. We’ve got huge short term deviations in Communications (XLC), but on the Z-Score scale, this sector barely registers. A similar set-up can be noticed in Transports (XTN). Basic Materials (XLB) and Industrials look to be the most overbought, with Financials also putting in a strong performance.
If equities were targeted for exposure, we would find good opportunities in the following ETFs:
XLE (Energy)
XLV (Healthcare)
The usual reasoning applies here as well: XLV is a relative out-performer according to its Z-Score AND it’s trading below its 50-day Moving Average. Energy has healthy deviations above all of its moving averages, but is not overbought on the Z-Score scale.
The weakness shown by Real Estate, Consumer Discretionary and Technology 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, hold on to HYG for the moment, and target MTUM for exposure (instead of SPY).
The Nostromo Strategy
Nostromo, our tactical allocation model is starting the week holding corporate bonds (HYG) at 3% weight.
Treasuries are targeted for allocation via the TLT ETF, at 15% of portfolio value.
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).
On the equity allocation side, Nostromo selects MTUM, the only factor fitting its selection criteria. A BUY signal has just triggered 2 days ago, so the model will keep to the sidelines for now.
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 Tomorrow’s Winners Screener. The screener focuses on unprofitable companies that are investing at least 25% of gross profits in R&D in the span of the last 2 years and have a strong operating model. Here are the rules:
EBITDA < 0; currently, the company is NOT profitable
R&D / Gross Profit 2YR Average > 25%; at least one quarter of gross profits have been invested in R&D on average in the past 2 years
Operating Leverage Mean > 1; this ensures that for every percentage point of revenue increase, EPS will increase by at least 1% - proves a great business model
We have manually added a basic momentum filter in order to refine the list: both 6 month AND 1 year returns need to be positive.
The screener output is short:
All of the companies on this list are notable. Further research is available via our new Fundamentals Explorer. APPF seems to be an outlier in terms of Operating Leverage, and we need to carefully scrutinize its business model.
At current levels, Horizon will form a 10 stock portfolio and initiate long positions at today’s market close.
Horizon Strategy
Horizon is entering this week’s rebalance holding a bonds portfolio (TLT). It will take profits in this position, and reduce it from 19% to 14% at today’s close.
Equities will weigh 18% of portfolio value, with each position taking up to 1.8% of NAV. Here is the list of single stocks to be purchased at the session’s close:
SMCI
CMC
TDW
EXTR
LPG
SJM
SLB
MRK
HES
EME
See the correlations table below for specific exposure values. Correlations are dominated by Energy, Industrials and Financials - the same themes we have discovered during the Sectors analysis.
The common theme for all Horizon positions is a combination of fundamental quality with strong performance (momentum).
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.
The amount of stocks that are trading above all key moving averages have previously marked short term topping points in the market. There is also a negative divergence between the average Sigma Score and SPY’s Sigma Score - to us, this looks like a warning: the market is getting hot (short-term).
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 starting a new uptrend.
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.
We are getting a surge in volume, for the moment at least. Although the improved volume sits above the polynomial average, it is historically low. This level of market activity should form a base-line rather than a “high”. We mark this indicator as bearish for the time being.
Bearish signal in Average Dollar Transaction Volume and Volatility
Volatility has cooled off lately. With the VIX below 20, there appears to be little fear in the markets.
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 88%, with a minimum and maximum of 67% and 100% respectively. Our models are only aligned in terms of target exposure for now, but execution differs with each model’s risk factor.
The Market Environment view is improving. The market is “hot’ right now, and the “pain trade” appears to be to the upside. Our strategies are starting to cautiously turn bullish on stocks and bonds (and bearish on cash).
We will mix Nostromo’s ETF selection with our own observation on the Sectors front with Horizon’s aggression in execution. Part of the reasoning for this trade is the Dollar’s weak short-term technicals. Executing the following orders at market close:
BUY 9% of portfolio value in MTUM (initiate 7% position)
BUY 9% of portfolio value in XLV (initiate 7% position)
The Sigma Portfolio is currently allocated 11% Long, 11% Short equity exposure. Bonds will be maintained at 19% of the portfolio. Buying 14% of broad equity exposure via ETFs is just a trade. It’s like placing poker chips on the table. It does not represent a longer term market view, and we are just playing a technical breakout.
Any trade has exit rules: in our case, the exit rules are either a downturn in the broad market, or volume dropping off a cliff. There is also the possibility that this “trade” will turn into an “investment” as we progress through 2023 - if the market gets oversold without breaching key technical levels. In that case, we will exchange the broad ETF exposure for single stock exposure.
Neither the bulls or the bears know what the future holds. We need to trade the market that is in front of us, and for the moment this seems like the most sensible approach.
Andrei Sota