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 rebalancing its stock portfolio, while adding to its bonds position. While Enterprise is still on the sidelines and not joining the current rally, Nostromo managed to find an entry point for MTUM (Momentum Factor ETF) last week. Not a lot has changed in overall positioning.

1. 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.

The US Dollar is showing continued weakness and has proven unable to hold support. Weakness has not subsided this week either, as the Dollar can’t seem to find its footing. Its decline has been less pronounced lately, but the path of least resistance seems to be lower for now.

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.

The breakout of the combined major asset classes continues. Their recent strength seems to continue unabated for now, with Gold being the main beneficiary of the Dollar’s weakness and overall driver of the rally.

Enterprise is targeting both equities and treasuries for exposure, but neither of these positions have triggered BUY signals yet. For a BUY signal to trigger, we should go through a period of consolidation and weakness first. The model remains in “wait and see” mode, until something changes.

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 20% of portfolio value.

Equities are also targeted for exposure at 18% 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 an investible asset class, we’ll take a look at how different Factors are performing and check for any notable opportunities.

The Factors table looks mostly healthy. With the exception of MTUM and DIA, all ETFs are now in positive medium-term trends (M-Trend). International stocks continue to remain overbought (EEM, EFA).

We find opportunities in the following factors:

• MTUM (Momentum Factor ETF)

• DIA (Dow Jones ETF)

Both MTUM and DIA stand out due to their relative out-performance (Z-Score Relative above 0, right-low panel) AND trading below their normalized 50-day Moving Averages (Sigma 50 below 0, left-low panel).

The excess building up in international stocks has not subsided, with both EEM and EFA remaining overbought and extended. Mid-caps (MDY) and value (IVE) have subsided somewhat, and have entered a healthy consolidation.

Here’s how we stand on the Sectors front:

On the sectors side, the overall picture is “all over the place”. 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). Industrials are now less overbought than they were last week, and have even fallen below their 50-day Moving Average. Basic Materials, the best recent performer, still looks frothy. Energy and Healthcare are holding on to their relative out-performance over SPY, but only just.

If equities were targeted for exposure, we would find good opportunities in the following ETFs:

• XLE (Energy)

• XLV (Healthcare)

• XLI (Industrials)

The usual reasoning applies here as well: XLV and XLI are relative out-performers according to their Z-Score AND they are trading below their 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, despite the most recent rally. It takes more than a couple of weeks of positive performance to reverse the technical damage these sectors have seen.

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 keep exposure to MTUM.

The Nostromo Strategy

Nostromo, our tactical allocation model is starting the week holding corporate bonds (HYG) at 3% weight and the Momentum factor ETF (MTUM) at 18% 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 will maintain exposure to MTUM, and only attempt to adjust the position slightly if a SELL Signal triggers.

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 Dividend Growth Screener. In an uncertain market, and in inflationary environment, companies that manage to grow dividends stand out as potential quality picks. Furthermore, we have added several other quality requirements to this screener, including the growth of margins:

• Dividends per Share > 0; make sure that the company is currently paying a dividend

• Piotroski F Score => 6; this ensures the “Quality” component (column E)

• Operating Leverage > 1; solid business model, with revenue growth that translates to EPS growth (column D)

• Gross Profit Margins that are increasing compared to 2 years ago; (columns A, B, C)

The screener output is quite extensive (92 companies), but the investment opportunities look solid:

You can take the research further, using our Fundamentals Explorer. 2 companies already included in the Sigma Portfolio made it on this list (CF and DVN).

Horizon will rebalance its stock portfolio this week, in addition to a full re-selection (this happens once per month).

Horizon Strategy

Horizon will increase its allocation to bonds (TLT) at today’s close, taking the position from 14% to 20%.

The equity portfolio is rebalanced and re-selected as follows:

SELL:

• EME

• EXTR

• LPG

• TDW

• CMC

• SJM

• MRK

• SMCI

BUY:

• AEHR

• VLO

• MPC

• SLB

• JBL

• WFRD

• ACLS

• PI

See the correlations table below for specific exposure values. The list is dominated by Energy names and the overall correlation with MTUM is not surprising since Horizon is a trend-following system.

Also standing out are the inclusion of QQQ-correlated positions ACLS, AEHR (both semiconductor stocks) and JBL (printed circuit boards manufacturer).

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. Furthermore, we seem to be making new highs in the number of stocks trading above the 200-day MA.

According to a backtest that we did, after a significant drop in equity prices, 90% of stocks should be trading above their 50-day Moving Averages to insure a trend reversal. We are currently at 72%. The overall picture is still bullish.

Bullish Signal in Stocks trading above their 200-day Moving Averages

The bullish divergence continues in terms of Z-Score as well (the Z-Score measures how many standard deviations a certain reading is above or below a computed trend). It has been weakening in the past week, as SPY “caught up” with the rest of the market, making this divergence less significant.

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, and that is not currently happening.

It is notable that volumes have been healthy (compared to the recent trend) in the latest equity rally. We will use volume as short term indicator to time some profit taking. The overall picture in volume is bearish.

Bearish signal in Average Dollar Transaction Volume and Volatility

Volatility has decreased lately, in a positive development.

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 80%, with a minimum and maximum of 62% 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, but we are not out of the woods just yet. Massive positive and negative forces are at play simultaneously, and we are trying to stay nimble and open-minded. We would like to play both sides of the market for now, using extremes to position.

The Sigma Portfolio is currently allocated 25% Long, 11% Short equity exposure. Bonds will be maintained at 19% of the portfolio. Pure cash is 45%.

For the moment, there are no adjustments that need to be made. We are looking for a breakout in SPY above $402, that will get everyone on board the “new bull market” bandwagon. The deterioration in Z-Score divergence is something to keep an eye on as well.

The Federal Reserve's meeting next week is likely to be closely watched by investors, as the central bank's tone and any potential policy changes may have a significant impact on markets. Additionally, upcoming economic data releases, such as the unemployment and inflation reports, could also shape investors' views on the state of the economy.

Andrei Sota