Sector & Stock Selection

This article is meant as a primer on how to use the tools available on Signal Sigma to generate investment ideas. I will reference the selection of DVN as part of the Sigma Portfolio and steps to filter down to it it using a top-down process.


Sector Selection

In a top-down technical approach, the first step is always asset class selection, then sector or factor selection. In our automated strategies, allocation to stocks as an asset class is not allowed since we are experiencing a large drawdown on SPY, taking the benchmark ETF way below our stop-level (which is Z-Score -1). However, since the Sigma Portfolio is a manual portfolio, we can use a slightly different approach and compare it to the machine models.

Normally, every equity sector or factor is experiencing a drawdown similar to SPY, with Z-Scores lower than -1. With a few notable exceptions. Take a look at the Sectors Overview:

We can clearly and quickly see the sectors that are trading within the bounds of their respective technical channels, denoted by the fact that their Z-Scores are within a -1 to 1 range. So, how do we further refine from the basic selection of XLE, XLU, XLP, XLV?

First of all, we need to make sure that the sector’s relative Z-Score is higher than 0 (right side of the chart). That simply means that they are outperforming the market when plotting a relative regression. You can check this by yourself by going to any chart and selecting the relative to SPY option in the upper left corner.

The second check that we make is related to the positioning vs moving averages. The ideal setup is a sector that is holding support at the 200-day moving average, but is experiencing a drawdown below the 50-day. The colored bars tell us which moving average (and what distance) the instrument is positioned against. Out of the four sectors studied, XLE is the only one that has the required setup. Let’s recap:

Absolute Z-Score > -1 : XLE, XLU, XLP, XLV

Relative Z-Score > 0 : XLE, XLU, XLP, XLV

Holding 200-day Support: XLE, XLU

Currently below 50-day MA: XLE

This is the exact recipe used by trading algorithms to repeatedly “buy the dip” in QQQ, MTUM, SPY during the equity bull run in the easy money era of QE. However, from a technical standpoint, the setup is no different for us at this juncture. We could stop at the sector selection step in the idea generation process and simply add XLE to the portfolio as it is. But what if we want to take the process one step further and select energy related stocks?

For this, we need to use the Stock Screener.

  1. Select Sector Fundamentals

We will be needing to screen based on correlation with sectors, and based on fundamentals, so select this option.

2. Screen for XLE Correlated Stocks

From the Top Sector Correlation menu, select the checkmark for XLE only.

3. Use a custom screening criteria - Sharpe Ratio

By default, the criteria of column A is Market Cap. Click on it and replace it with Sharpe Ratio. This will give us the “risk-reward” score for every stock. We need to simply make sure that this is positive.

4. Constrain Sharpe Ratio to 0

Click on the number in the left handle of the filter to set a minimum. In this case we need the sharpe ratio of every stock screened to be a minimum of 0, so we eliminate stocks with poor risk-reward characteristics.

5. Add 6 month Excess Returns on column B, constrain to a maximum of 0.

We need to make sure that our stocks are not technically short term outperforming the benchmark sector (in this case XLE) so they are less ripe for a pullback.

6. Constrain Piotroski F-Score to minimum 6

A fast way of ensuring a company is fundamentally sound is checking its Piotroski F-Score. It also helps that companies with a minimum of 6 on this scale tend to outperform longer term according to our backtests.

 

Finally, click on the header of column D (Operating Leverage) to sort the remaining stocks by this metric and get the final standing.

Operating Leverage is a metric designed to give us an accurate idea of how much a company’s revenues affect its bottom line. If an increase of 1% to its top line leads to a 1% EPS increase, then Operating Leverage equals 1. High Operating Leverage companies tend to be more risky, but over the longer term provide better risk-reward prospects.

 

This is the list that we can start to work with. PRO users can load up their preferred Tickers for more advanced charting and in-depth research. In this case, we will use the Advanced Technical Analysis instrument from Signal Sigma PRO to chart DVN and select a stop-level (blue line) that comes down to 49.02 according to our methodology.

 

Furthermore, we also get a nice margin of safety, as the current stats imply both EV/EBITDA and EV/Sales measures for Devon Energy Corporation are sitting below median values for the past 2 years.

 

CONCLUSION

There are numerous ways to go about the screening and stock selection process. I have just illustrated one way in which I prefer to do it, but it is by no means the only way. As opportunities arise, I will make it a priority to go through all of our methods, both manual and automatic. For now we have initiated a starter position in DVN with the disclaimer that “it is just a trade”. We’ll see how it goes.


Andrei Sota

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