Portfolio Rebalance / May 03
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.
The market still can’t seem to break out of the current trading range. Major asset classes have mostly been confined to a tight pattern for the past few months, with little advance either to the upside or downside. The current earnings season has so far failed to become the catalyst we were expecting. Instead, what we are getting is a lot of choppy price action from week to week, which might be bullish or bearish depending on your current view.
Our own opinion is more constructive, as headlines print from bad to worse (“Economic slowdown”, “Bank failures”, “Debt ceiling”), yet the market manages to not collapse. In this sense, no news is good news.
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 and Treasuries continue to be the preferred asset classes for allocation in our system, as Gold continues to be very expensive, and Commodities are breaking below the lower channel trendline
The US Dollar keeps hugging the lower unadjusted Trend-Line; the dollar’s resilience makes sense if we consider it a proxy for a risk-off mindset. With perceived risks accumulating, it’s no wonder the dollar is being kept afloat, albeit in an unexciting manner.
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 change in the overall environment yet. The recent downturn for the combined asset classes makes the dollar’s rise look weak by comparison, suggesting a lower correlation is emerging. We’ve seen timid hints about this correlation break earlier this year, but there’s still room for improvement.
Enterprise keeps allocation unchanged from last week.
The Enterprise Strategy
Enterprise, our most conservative model, is entering the week 15% long Treasuries, and 85% in CASH.
Since this model only trades 4 asset class ETFs, we use it to judge overall portfolio positioning.
Equities are targeted for exposure at 54% of portfolio value (similar to last week), via SPY ETF. The position will be filled when SPY triggers a BUY signal without violating M-Trend support (now at $388).
The model’s treasury allocation is underweight for the time being, and is meant to be increased on the next available BUY signal (from 15% currently to 20%).
At 85% Cash is still the dominant position for this model by far.
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.
We have included tables for this week and the prior 3 weeks in order to help you compare developments (click on the arrows or thumbnails to cycle through the tables).
Small Caps (SLY) are by far the worst performing factor both on a long and short term horizon. Similarly, the Equally Weighted S&P500 (RSP) is also a notable under-performer on a relative-to-SPY basis. Emerging markets have recovered nicely from last week. On the outperformers side, Nasdaq (QQQ) and Foreign Developed Markets (EFA) continue to lead higher, still pushing the statistical limits of upside deviations.
By using our proven selection criteria (Z-Relative > 0, while Sigma 50 < 0), there are no factors that are buyable for a technical trade.
Charts Emphasis:
Nasdaq (QQQ) at the upper trendline.
SPY compared with Mid and Small caps, revealing a huge gap.
Here’s how we stand on the Sectors front:
We have included the last 3 weeks of tables as well, for your convenience.
Energy (XLE) leads to the downside in the short term, after oil plunges more than 5% on the week. Financials (XLF), Real Estate (XLRE) and Utilities (XLU) are lagging the broader market and reflecting economic weakness concerns. Tech (XLK) and Communications (XLC) are leading the advance, and highly deviated to the upside, with all of the other sectors sitting somewhere in between.
There are no sectors that fit our selection criteria for a technical play at this point. Only XLK and XLC are relative out-performers, and we need them to trade a bit lower before considering a buy. Remember - this rally has been driven by high beta outperforming sectors, prone to profit taking at this point. Consumer Discretionary (XLY) is an interesting proposition at this juncture, with the sector managing to hold on to recent performance nicely, without being overbought.
Charts Emphasis:
Consumer Discretionary (XLY), range-bound despite the perceived consumer weakness; Energy (XLE) tracking the recent drop in oil.
The Nostromo Strategy
Nostromo, our tactical allocation model, is targeting equity risk exposure via SPY. No other Sectors or Factors qualify for inclusion at this point.
On the treasuries side, Nostromo plans to allocate towards LQD (Investment Grade Corporate Bonds) on the next BUY signal.
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 are running a completely custom Stock Screener. We’d like to select stocks with strong technicals and fundamentals that happen to be mispriced exclusively as a function of their market cap. As a consequence, we will be focusing on small(er) caps.
The screener rules are:
Market Cap (M): limited to 1.000 (1B Market Cap)
Pietroski F-Score: minimum 6 (quality component)
Operating Leverage: minimum 1 (strong business model)
Relative Z-Score: minimum 0 (out-performs benchmark)
Regression Trend: Positive (momentum requirement)
The screener outputs 12 stocks, mostly correlated with Small Caps (SLY) - unsurprisingly. All of them are worthy candidates for further research.
We can use the Fundamental Explorer instrument to take a deep dive into their financials. Then, use the Valuation Wizard to generate a Price Target, and see the target on a chart using Technical Analysis. We might uncover some potential candidates for our portfolio!
The Horizon Strategy
Horizon has rebalanced positions, with no major changes from last week’s portfolio on the equity side.
On the treasuries side, Horizon has replaced TLT with LQD.
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, and has touched previous-low levels.
As an aggressive equity exposure model, Horizon has got trapped in repeated “bear-market rallies”. Eventually, those will end sooner or later and this model will start performing closer to its historical metrics.
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.
This week, we are noting a persistent divergence between SPY’s Sigma Score (0.87 this week vs 0.48 last) and the Broad Market’s (0.11 this week vs -0.14 last). Capital is flowing to the largest capitalization stocks, leaving many individual names behind. Despite this set-up, equities are showing resilience, with the “head and shoulders” pattern apparent in stocks above 200-DMA’s not breaking the neckline (yellow line below),
With more than 50% of stocks trading above each key moving average, there’s nothing really bearish about the current environment. The broad market is equally likely to catch up to SPY at some point, as it is for SPY to “catch down” to the broad market.
Neutral Signal in Stocks trading above their 200-day Moving Averages
The market is no longer oversold. It is not yet overbought either, and we can see the graph turn lower with the risk-off mood. This indicator works best at extremes, and now there is little it can offer us. Notably, in the lower part of the graph, the 2-std Stocks Oversold level sits significantly higher than the 2-Std Stocks Overbought level. This denotes a rather bearish past environment.
Neutral Signal in Stocks Overbought / Oversold
In terms of Z-Score divergence, the bearish difference persists, at similar levels to last week.
The same “head and shoulders” formation can be witnessed in the lower panel, for the average stock’s Z-Score. This indicator seems to be “breaking out” however, which would be a bullish development.
Neutral Signal in Market Internals Z-Score
Dollar Transaction Volume is sitting just around the average, with no notable divergence to speak of. Volatility continues to be supressed.
Neutral 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.
Our models continue to diverge this week, despite having the same overall targets. Nostromo and Enterprise have no exposure to equities at the moment, and Horizon’s risk profile remains subdued.
To start, we will take an average of CASH position sizing from all of our models. This will come down to 72%, with a wide 85% - 35% allowed. Equity exposure stands at 16% on average, while on the treasury side models average 11.6%.
Automated Strategies
The Sigma Portfolio (Live)
Our positioning remains similar to that of last week.
The Sigma Portfolio has a reduced risk profile currently, with treasuries able to hedge most of the equity risk. Pure cash sits at 18% of portfolio value, which is a little high. We’d like to put this cash to work sooner rather than later by pursuing the next opportunity in equities or treasuries, whichever breaks higher decisively.
For now, this portfolio is at target. A single position is flirting with its stop level (ADM), but there has been no violation so far.