Observations on Signal Sigma Strategies yearly performance and our 2023 predictions for stocks and bonds

First of all, I would like to wish a Happy New Year to our readers and share my hope for a prosperous and rewarding 2023. As traders slowly trickle back to their desks in the new year, I plan to start by reviewing Signal Sigma’s performance relative to various markets. We will then take a look at stocks and bonds and try our best to predict what the near-future might hold in store.

- Andrei

Examining the factors that influenced asset prices in the past is essential in predicting trends for 2023. In hindsight, it is clear that the Federal Reserve's monetary policy and policy expectations played a significant role in determining asset values. To combat inflation, the Fed raised the Federal Funds rate by 4.25% and decreased its balance sheet by more than $400 billion. Both higher rates and reduced liquidity had a negative impact on stocks and bonds throughout the year. In retrospect, stock rallies were driven by investor optimism that the Fed would halt rate increases and change course. On the other hand, hawkish Fed rhetoric and projections for prolonged higher rates contributed to selloffs.

The Fed is attempting to reduce consumer demand in order to bring inflation down to 2%. To achieve this goal, they believe it may be necessary to weaken the labor market. A review of various Fed statements and speeches reveals that they recognize the possibility of causing a recession in order to meet their objectives.

While it is impossible to know for certain whether there will be a recession in 2023, we do know that the effects of rate hikes and quantitative tightening often take time to be fully realized. The full impact of these measures has yet to be seen, but as 2023 unfolds, we will have much more clarity in this regard.

Here’s how the major asset classes performed in the previous year:

• SPY -19.92%

• TLT -31.00%

• DBC +18.17%%

• GLD +0.78%

Hedge Funds have performed better in 2022. We will estimate their performance by using some popular ETF proxies:

• HDG (ProShares Hedge Replication ETF): -9.02%

• FTLS (First Trust Long/Short Equity ETF ): -5.99%

• QAI (IQ Hedge Multi-Strategy Tracker ETF): -10.31%

What about the classic 60% stocks / 40% bonds portfolio? According to LPL Research, 2022 marked the second-worst year on record for this strategy going back to 1976. Through the close on December 28, a hypothetical 60/40 portfolio comprised of the S&P 500 and the Bloomberg Aggregate Bond Index would be down 16.9%, a decline only topped by 2008's 20.1%.

In conclusion, 2022 has been a very challenging year for all types of investors, weather retail or institutional, buy-and-hold or actively managed. Most Signal Sigma Strategies have performed more in line with the hedge funds, with only Horizon performing worse than the S&P500 due to its highly aggressive risk-taking nature. 3 out of 4 Strategies also outperformed the classic 60/40 portfolio.

Signal Sigma Strategy Returns

Our models aim to blend asset classes that “work” into a portfolio that returns a smooth, upward sloping equity curve. The strategies differ in allocation method and aggressiveness, with good risk-reward characteristics for each. The Sigma Portfolio is our live-trading portfolio, using real capital and directed on a discretionary basis, by blending all the automated models and using all the available resources on the platform.

• Enterprise (least risky strategy): -12.24%

• Nostromo (moderate risk): -10.79%

• Horizon (high risk): -24.36%

• Sigma Portfolio (discretionary blend): -7.27%

Detailed performance tear sheets are available via our Reports Page for Signal Sigma Strategies.

Predictions for 2023

While playing the predictions game is a futile exercise most times, it has become somewhat of a new years ritual for Wall Street analysts. Let’s see what the strategists of the biggest firms believe will happen by the end of 2023 with the price of the S&P500:

Plotting SPY with a 410 Price Target and a 6.7% CAGR rate with the help of our Technical Analysis Instrument outputs the chart above. This is an accurate representation of the median Wall Street view, which feels optimistic to us (Wall Street always sounds overly optimistic regarding year end price targets).

Instead, we propose a much more realistic approach, based on earnings and valuations. At present, earnings projections are still 20% higher than their long-term growth trend, even after taking into account all of the downward adjustments.

During economic downturns or slowdowns, earnings tend to return to their growth trend (and dive below it), as earnings growth is ultimately determined by the overall growth of the economy. However, the potential for disinflation in 2023 is currently being overlooked by Wall Street. As the Federal Reserve has noted, the economy must experience below-trend growth in order to counter inflationary pressures. If this is the case, then slower earnings growth will likely lead to a reduction in asset prices as valuations are adjusted. As we previously noted, there is a wide range of potential outcomes depending on how valuations and earnings are adjusted. Unfortunately, many of these possibilities suggest lower prices compared to the more optimistic views held by Wall Street.

Tha latest round of downward revisions to 2023 EPS puts us at $203.75 / share. Discounting 10% from the “official” expectations puts us at $182 / share. Using a very reasonable P/E Ratio of 19 gives us a $3471 price target for the S&P500. On a chart using a -10% CAGR slope, things start looking much more realistic and in line with the Fed’s goals: an orderly decline in asset prices (a.k.a. “soft landing”).

The chart above perfectly expresses our view for SPY in 2023. The real risk to this outlook is that the Fed “overdoes” the tightening and the rate hikes, creating panic instead of “an orderly decline”. Investors have already had a rough year in 2022 and there is a point where they will simply want a return OF their investment instead of clinging on to hopes for a recovery. This would lead to indiscriminate selling behavior, which would prompt the Fed to step in and “pivot” as “financial conditions” would no longer be “stable”.

The outlook for bonds

In our view, the outlook for bonds looks much more promising. After posting one of the worst yearly returns in 100 years (-31% for TLT), bonds are now in an entrenched bear market. There is increasingly little that can go wrong for bonds going forward. Most of the inflation and rate hikes narrative has been priced in, to the extent that bonds are now yielding attractive risk-free returns.

Given the fact that most inflation has been a result of excess money being created and injected in the economy via stimulus, the reversion of this effect via QT will most likely bring the opposite - disinflation. More and more consumers will simply run out of money (and max out credit). Bonds should benefit from both a disinflationary trend, as well as “safety flows” (money rotating from the risk of stocks to the safety of bonds that provide a risk-free return).

Reversing the previous decline, bonds might see significant upside in 2023. This represents a summary of our expectations for TLT.

Conclusion

A Short stocks / Long bonds positioning might make the most sense for 2023, at least in the first half. Once equities reach more reasonable valuations, picking up select names to go long on makes much more sense than buying at current levels.

The unusually strong correlation between stocks and bonds is bound to break down in a recessionary scenario. We have already glimpsed this effect in the last 2 weeks of 2022, as there have been days with SPY declining and TLT surging. While still incipient, this trend is worthy of our attention, as it will signal the opportune time to shift a good chunk of our cash allocation to bonds.

Detailed performance tear sheets are available via our Reports Page for Signal Sigma Strategies.

Andrei Sota