Portfolio Rebalance / January 31

Jan 31

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 we need to rely on Enterprise and Nostromo for guidance, as we are experiencing issues with one of our data providers. Horizon requires historical fundamental data for stocks to work properly, and we currently cannot access it. Nevertheless, it does not affect our overall stance very much, since we are not including Horizon in the Sigma Portfolio anyway.

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 are also an investible option, but the rally appears to be losing steam. The overall asset class picture has not changed from the last 2 weeks.

The US Dollar is bouncing from an oversold condition. Although currently caught between technical levels (with a lot of wiggle room in between), the “magnet” of the medium term trend seems to be the Low Trend-Line (which also happens to be the median growth rate before the Dollar took off in March 2022). Short-term, a retracement to the 50-day Moving Average is certainly possible, and would coincide and test the S1 technical level. The fundamental basis of this move could be a hawkish speech by Jerome Powell tomorrow.

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 are showing signs of fatigue in the current rally. As the dollar bounced from oversold conditions, so did every other asset class retreat from overbought. As in any short-term technical move, it is important to see where the consolidation of the price happens, so that we can assess the viability of the current trend.

“We are not out of the woods just yet” when it comes to this bearish market environment, as the US Dollar is still significantly negatively correlated to everything else.

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 in both equities and bonds. 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 17% of portfolio value, via SPY ETF.

TLT has just triggered a MACD SELL Signal. As such, a period of consolidation is expected, after which a BUY Signal can trigger the trade. TLT will need to consolidate above $103.36 in order for the signal to be viable.

SPY is still on a positive MACD Signal. We need to see a SELL signal occur first, followed by a period of consolidation above $402 in order to trigger the BUY.

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 healthy. With the exception of MTUM and DIA, all ETFs are now in positive medium-term trends (M-Trend). International developed market stocks continue to remain overbought (EFA), although to a lesser extent than the last week. Mid-Caps (MDY) also seem relatively overbought vs SPY.

One opportunity continues to stand out from the rest:

MTUM (Momentum Factor ETF)

MTUM is a relative out-performer (Z-Score Relative above 0, right-low panel) AND it is trading below its normalized 50-day Moving Average (Sigma 50 below 0, left-low panel).

As the current rally in the equity markets fizzles in the short term, we can expect a rotation from international stocks, mid-caps, and value into momentum and Dow components. Nasdaq (QQQ) and Growth Factor (IVW) are still underperforming despite the recent rally in January. We suspect these factors will not find bids in the event of a broader downturn. However, as we check this performance table on a weekly basis, all options are on the table in the event that dovish Fed policy fuels further upside.

Here’s how we stand on the Sectors front:

On the sectors side, the overall picture is deteriorating. Last week, there were 3 sectors posting negative M-Trends, today there are 5. As it turns out, the sectors that have outperformed SPY for the last year are now trending to the downside, while laggards are catching bids. Moving average deviations (Sigma Score) still look extended for Communications. Going forward in 2023, we expect this sector rotation to continue only if we don’t get a recession. The “soft landing scenario” favors 2022 laggards (Consumer Discretionary, Tech, Communications, Real Estate).

There are currently no obvious opportunities for trading purposes.

Healthcare (XLV), included in the Sigma Portfolio, has been performing poorly. As a defensive sector, it would be favored by conservative investors and outperform SPY in a mildly recessionary environment. For the moment, this is our base case that justifies the selection.

Taking all of these into account, Nostromo will apply the same allocation logic as Enterprise. It will allocate to bonds using TLT, sell HYG on a MACD signal, and keep exposure to MTUM mostly unchanged.

The Nostromo Strategy

Nostromo, our tactical allocation model is starting the week by selling corporate bonds (HYG) and holding 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 at the close of today’s session, as it is no longer outperforming TLT.

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

Since Horizon is not running properly, we will focus on the Momentum + Quality Screener. It is the next best thing, as it functions in a very similar way to how Horizon operates when selecting its stock portfolio. To recap, here are the screener’s rules:

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

The screener outputs 19 stocks to be used for further research:

Using our Fundamentals Explorer, we suggest researching names that are closest to the trend-line in the graph above (SLB, PBH, HES, VLO, AEHR, MPC).

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. The increasing number of stocks trading above their 200-day Moving Averages is an encouraging sign - we need to see this trend hold, in order to trust any potential rally. However, it is worth noting that the cumulative number of stocks trading above ALL 3 moving averages is now at levels associated with previous market “tops”.

SPY’s Sigma Score is higher than the average of the market (0.68 vs 0.51). This could signal that SPY is getting a bit ahead of itself for now.

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 of this indicator is 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). The average for the broad market is 0.29, while SPY’s is -0.05. The gap has closed recently, but the overall picture is still bullish.

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 it does affect volatility. Fortunately, we are witnessing a possible regime change in SPY’s realized volatility (lower panel). It’s still too early to tell, but consistent readings below the 2 Standard Deviation line are certainly encouraging.

Recent volume has been relatively strong for the current rally. However, volume is only just reaching values that have previously denoted bottoms in 2021 and early 2022. In order for the rally to be sustained, we would need to see continued strength in this metric. If volume were to drop off below the polynomial average, that would bode poorly for short-term returns. We certainly don’t want to see fresh new lows in transaction volume. As long as the trend points downward, this indicator remains bearish, despite the improvements.

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. We will keep Horizon’s last known allocation from last week, as the model shouldn’t see any significant changes this week.

First of all, we will take an average of CASH position sizing from all of our models. This will come down to roughly 81%, 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 risks remain to the outlook. There is an increased possibility that we are going through another bear market rally. In order to technically “kill” the bearish technical picture, we would need to see some healthy consolidation first. Once all of our models align in their long-equity exposure, we will remove hedges from the Sigma Portfolio and start building longer term positions in individual stocks.

On the fixed income side, we will take Nostromo’s SELL signal for HYG and apply it to TLT in the Sigma Portfolio. The reasoning is that for the moment 2/3 models are not allocated to treasuries at all. We expect Jerome Powell to deliver a speech with a hawkish tone tomorrow, which will bode poorly for long-term assets (both stocks and bonds, namely TLT and QQQ, which have been highly correlated). The HYG position is fine for now, as credit spreads are not under pressure, and the size is small. TLT has also triggered a SELL Signal, so we are also honoring that. We expect to add back to the position when our models re-initiate the trade following a consolidation. Executing the order at today’s market close:

SELL 100% TLT (Close Position)

In the event stocks will weaken post Powell’s press conference, it is crucial to see where support forms. If the cluster of Moving Average support does not hold on SPY at 393-394, we might be on track to re-test recent lows. In that case, we will re-add to hedges. For now, the long-equity positions are not concerning, as both MTUM and XLV are relatively oversold, and should outperform SPY in a downturn.

The Sigma Portfolio’s allocation will be 25% Long, 11% Short and 64% Cash.

Andrei Sota

Andrei Sota