Portfolio Rebalance / November 29
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, there is very little change in our overall portfolio allocation and targeting from last week. No major changes have impacted the markets since the last rebalance on November 22. An interesting read on the current environment is found in the “2. Sector / Industry Selection” section of the article - make sure not to miss that!
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.
There are no changes in asset class investment eligibility this week.
According to our methodology, all major asset classes would be fit to receive allocation from our system: Equities, Treasuries, Commodities and Gold.
What about CASH? The US Dollar is currently forming an 11.28% Compound Annual Growth Rate trend-line. We believe this sort of annual growth is impossible to sustain for a reserve currency such as the USD. As such, we have modified the assumptions used for the technical analysis below with more manageable assumptions: CAGR set at 5% and a Price Target of 30 for UUP (USD bull ETF).
The US Dollar is Oversold and trading at the midpoint of its risk-reward channel. There is a lot of overhead resistance at the M-Trend level ($29) and at the 20-day moving average (also near $29). The path of least resistance seems lower for the Dollar right now, and is the main reason our strategies are looking to allocate away from cash.
As discussed last week, Enterprise will attempt to find a favorable juncture to close out the position in commodities, and instead balance the portfolio using treasuries. While DBC has not yet reached a stop loss level, TLT is still rated as Overbought and unlikely to trigger a buy signal this week.
Equities (SPY) on the other hand are starting to consolidate as expected. While a SELL signal has not yet triggered (this would be the precursor to the BUY signal we are looking for), a downturn is starting to take shape.
The Enterprise Strategy
Enterprise, our most conservative model, holds 40% exposure to commodities, and 60% cash.
Since this model only trades 4 asset class ETFs, we use it to judge overall portfolio positioning.
The strategy will aim to close out the position in commodities on the next available SELL signal. That could come as a result of a stop-loss, by breaching the lower trendline of DBC, at $24.06. DBC is already under selling pressure, and both the MACD and the WR% are near the lows - we would need to see these come back up first, before they can signal a SELL.
Equities are targeted for allocation at 90% of portfolio value. This sizable chunk of exposure will be bought on the next available BUY signal for SPY that DOES NOT VIOLATE support at the lower trendline ($385). We will most likely need to go through a consolidation phase first, as both the MACD and the WR% are currently positive. In order to signal a BUY, these have to turn negative first.
SPY is also getting compressed between the 20-day ($389) and the 200-day ($404) moving averages.
Treasuries are targeted for allocation via the TLT ETF, at 14% of portfolio value. Getting a BUY signal for TLT is still tricky, because both the MACD and the WR% are highly extended and short term overbought. We would need to see a consolidation first, but that would most likely coincide with TLT trading below it’s stop level. We will have to wait for a couple more weeks before committing to this position.
Cash reserves (USD) are at 60%, offering plenty of optionality. If all trades would trigger, CASH would be negative, as the strategy would employ leverage.
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 now a viable asset class for investment, we will first take a look at how the different Factors are performing and see if there are any notable opportunities.
Similar to last week, with the exception of QQQ (Tech) and IVW (Growth), every equity factor has been outperforming the S&P500 (See Z-Score Relative column and the positive pink columns in the right panel). This would give us plenty of options to choose from, if any of these factors were on sale. However, none of them are. All factors are trading above their 50-day Moving Average
The plan is to wait for more selling pressure to accumulate and put these factors to the test. Then we can determine which of them are trading with a Relative Z-Score in positive territory AND are still holding above the 50-day Moving Average,
For now, it looks like the Dow remains overextended and ripe for a pullback. In a rotation scenario, money could flow from the Dow to the growth part of the universe that is currently underperforming (QQQ, IVW). We will keep an eye out for this sort of action, although yields will surely play an integral part to any serious capital flows to growth stocks.
The same situation is found when looking at Sectors as well.
This week, there is a clear emerging trend among Overbought sectors. Besides Industrials (XLI), Healthcare (XLV) and Consumer Staples (XLP) have also become Overbought. Energy’s lead has been reduced significantly, as concerns about future growth and oil demand is starting to bite. Instead, defensive sectors are emerging as the new winners. Even Utilities, which have suffered along bonds, have moved up the ranking this week.
Along with Consumer Discretionary (XLY), Tech (XLK) and Real Estate (XLRE), the Transports sector (XTN) is also starting to under-perform. This is hardly an environment I would call risk-on, although you wouldn’t know it from the SPY itself.
The only sector trading below its 50-day Moving Average is XLY. It is not on the list of relative out-performers (Z-Score Relative is below 0), so it will not make it into Nostromo’s selection.
The same logic applies to bonds as well, with TLT being targeted. No other bond factors are out-performing.
Commodities fall out of the portfolio targeting this week.
The Nostromo Strategy
Nostromo, our tactical allocation model is starting the week with 100 % cash positioning.
The strategy will perform almost identically to Enterprise this week.
The only difference between the two models lies in the exposure to commodities. Enterprise needs to close that position, while Nostromo does not need to bother with commodities almost at all (the residual position is a hedge from former positioning and is not material).
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 Buy The Dip Opportunities Screener. While not the type of screener Horizon employs, it will give us some additional ideas that could fly under the radar. This screener takes into account the following factors:
Regression Trend is Positive; the stock is trending up, on a 2 year historical window
Sigma 50 < 0; currently, the stock is trading below the level where it’s normally been trading relative to its 50-day Moving Average
Z-Relative > 0; the stock is outperforming its benchmark ETF
In addition to these standard metrics, we have filtered for a Pietroski F-Score of minimum 6.
Here are the results:
I would certainly keep in mind a couple of names from this list for further research and keep them under close scrutiny in the event of a downturn (for getting long at a later date): CMG, DAR, ALB, JAKK. The differentiating factor besides technicals? Sales Growth and Operating Leverage that look very healthy.
At current levels, Horizon will form a portfolio of 10 stocks and rebalance them at the close. This model is the most aggressive and has no need for any other confirming signals. The logic by which its internal selection process works is similar to the new Momentum + Quality Stock Screener.
Horizon Strategy
Horizon, our most aggressive strategy, will rebalance the equity portfolio so that each position keeps its equal weight (9% of NAV).
Favoring a risk-taking approach, Horizon will not wait for any other signal and simply fill the orders at the end of today’s session.
The portfolio overall keeps the same composition as last week. The most notable changes come by selling SMCI, PI and AEHR after good runs in order to keep these positions in line with our equal weight approach.
CASH will sit at -4%, indicating a small amount of leverage is being employed.
Horizon’s equity portfolio will be primarily correlated with the Industrials and Basic Materials sectors - showing the best momentum so far. It should be noted that Industrials seem heavily overbought at this point (BDC, EME, EXTR, RMBS and SANM positions).
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.
Overall, we find that conditions are still Overbought and extended both on a market-wide basis and an individual stock basis. The current rally must be put to the test and it must succeed, if we are to give it credence. There are two developing bullish signals occurring underneath the surface of the market.
Bullish Signal in Stocks trading above their 200-day Moving Averages
During this latest rally, the number of stocks trading above their 200-day Moving Average has increased versus the last time we had similar overbought conditions. We recorded 497 / 1000 stocks above their 200-day MA on August 16 (the peak of the previous rally), and registered 572 / 1000 stocks at Friday’s close.
Since the start of 2021, while SPY was rising, the number of stocks above the 200-day MA was slowly grinding lower in what is known as a bearish divergence. Now, the opposite is occurring. This improvement in breadth is undeniably bullish.
Bullish Signal in Market Internals Z-Score
Another bullish divergence can be observed in the average Z-Score of a stock in the market versus the Z-Score of the SPY itself (the Z-Score measures how many standard deviations a certain reading is above or below a computed trend).
While the SPY’s Z-Score readings have been grinding lower and lower since the start of the year, the average stock is faring much better. The divergence in Z-Scores starting in the middle of June is obvious on the chart. Put simply, the average stock has been doing much better than the SPY itself. Again, an undeniably bullish development below the surface.
Bearish signal in Average Dollar Transaction Volume and Volatility
Dollar transaction volumes have been trending lower, as the Fed removes liquidity from the market. A byproduct of lower volume is higher volatility, as shown in the panel below. If transaction volumes cannot sustain current prices, then volatility will remain elevated. All other things being equal, higher volatility is discounted into lower prices.
The transaction volumes recorded recently are near a record low of the past two years. Simply put: people (+funds and banks) are taking money out of their brokerage accounts and 401k’s. If there’s less money to invest, there’s less of a push higher in prices.
All things considered, if Enterprise or Nostromo start to get long equities, we will close all short positions in the Sigma Portfolio and start to tilt bullish as well.
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 52%, with a minimum and maximum of 100% and -4% respectively. We are at a stage where our models are in dissonance with each other in terms of actual allocation, but starting to converge on the same target portfolio.
The Market Environment view is still defensive this week. While taking note of bullish developments below the surface of the market, this rally seems to be running out of steam. As such, there is little evidence that we should initiate new long positions right now.
In the Sigma Portfolio, we are comfortable with the exposure that we have. More specifically, the portfolio is 9% Long, 21% Short and 4% allocated to Commodities. We will let the market dictate our next move.
We are waiting for a successful period of consolidation in the equity market and in the US Dollar. This might lead to either some BUY signals getting triggered or a breakdown in prices below STOP levels. If Enterprise or Nostromo start to get long equities, we will close all short positions in the Sigma Portfolio and start building long positions.
If we get another surge in equities, without triggering a MACD SELL signal first, we will acquire more inverse exposure (SH, PSQ, RWM).
If the consolidation fails at the lower trendline support or the 50-day Moving Average support, we will also look to sell the remaining long positions, so that our portfolio turns completely short.
According to the Correlation Screener above, the Sigma Portfolio contains a position that might be prone to a technical pullback: GPC. This is highly correlated to DIA - a factor that is highly extended. We will look to trim this position in favor of more general exposure, or replace them with those identified in the Screener (section 3 - CMG, DAR, ALB, JAKK).
Andrei Sota