Portfolio Rebalance / March 21
Following the Signal Sigma Process
The approach to this article follows the step by step process described here. All visuals are sourced from various instruments available in the platform. If you are using the Portfolio Tracker, you’ll be able to see how we set it up for our own portfolio at the end of this article.
This week, we have elected to delay our Portfolio Rebalancing process up until after the FOMC meeting. So far, it has proven to be a wise decision, with the market working in our favor. As noted last week, there was no immediate reason to aggressively reduce equity positioning, despite some metrics becoming stretched.
We’ll continue our process this week and arrive at the optimal conclusion.
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.
All asset classes are now investible; Commodities have successfully bounced back;
SPY’s rally continues unabated, on a +62% Compound Annual Growth Rate that would take the benchmark ETF to $750 by year end if sustained. This analysis is simply to prove that the rise in prices that has occured over the last 6 months will come to a stop sooner or later, for a reason or another. By comparison, the CAGR for the past 24 months is a very respectable+10.1%, and a normalization to this trend will take SPY to ~$466 (representing a -10% correction).
Over an even longer time horizon, SPY’s CAGR is around +7%, so one could make the argument for an even deeper drawdown. On the plus side, it’s quite hard to envision equities advancing even more than the immediate supply-demand equation would imply (around $534).
Commodities (DBC) have rebounded nicely and are now fully investible. The gains have mostly been powered by oil (USO) and agricultural products (DBA) prices. Nat Gas (UNG) and copper have failed to post similar spectacular rallies. The rise in raw commodity prices is not particularly good news for inflation numbers going forward, so a bet on DBC would represent a good hedge.
Last week, these were our thoughts on Gold(GLD):
“Our best guess would be that Gold takes a breather here, consolidates, and then rallies further.”
We’ve seen this textbook pullback occur, and now Gold is set to climb to fresh higher highs. We see no reason to sell the yellow metal just yet.
TLT, the benchmark ETF for long dated government bonds, is trading below key resistance at $94.5 (200-DMA, S2 level). The medium term condition remains oversold, but other than that, given the fact that TLT is trading below all key moving averages and on a sell-signal, reversal prospects are unexciting just yet.
Enterprise, our core investment strategy, has reduced equity risk exposure this week, after previously increasing it. The adjustment takes SPY from 73% weight last week to 64% today.
Bonds exposure remains the same, at 22%.
Gold is being slightly increased to 4.8%.
Commodities are being maintained at almost 2% of portfolio weight.
As the strategy gets a bit more defensive, cash jumps from ~2% last week to ~7% now.
Since this model only trades 4 ETFs, we use it to judge overall portfolio positioning. The strategy’s risk profile is balanced at the moment, favoring equity risk as long as it adds to performance.
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 article editions in order to help you compare developments (click on the arrows or thumbnails to cycle through the tables).
The Nasdaq (QQQ) has officially slipped to a negative Medium Term Trend. This is not entirely surprising given that momentum has been weakening for some time now in the broad market. However, we’re now getting the first technical confirmations that a top is forming, as factors start to lose steam. QQQ has previously been one of the factor leaders in the rally over the past 6 months, with the second best relative to SPY excess returns (+3.08%). On a 1-year lookback window, QQQ has been the #1 factor outperforming SPY, so the loss of momentum is certainly acting as a warning in the medium term.
All factors are trading well above all of their moving averages this week, so we can safely conclude that risk sentiment is very much “ON”. However, when looking at the long term as well, the Momentum Factor ETF (MTUM) stands out as egregiously overbought along with Growth Stocks (IVW). Healthy performance has been registered by Mid-Caps (MDY), Emerging Markets (EEM) and the Equally Weighted S&P500 (RSP), which are not yet overbought longer term.
Among more granular Factor Returns, pure Gross Margins have fallen a bit out of favor (#43 at the 1 week) and we’re seeing the resurgence of R&D / Revenue as a high performance factor in the short term. P/Sales is also up in the rankings, as expensive growth stocks continue to dominate.
Ranking shown for R&D / Revenue
On longer timeframes, the Pietroski F-Score continues to rank very well since it is a quality factor - and the market has rewarded quality.
Ranking shown for Pietroski F-Score
Across all timeframes, the best performing factor this week is R&D / Revenue. There is no timeframe where this factor ranks lower than position #3.
Here’s how we stand on the Sectors front:
We have included 3 former tables from previous articles, for your convenience.
We’re seeing the deterioration in momentum as 4 / 12 sector ETFs are now in a negative Medium Term Trend. Last week, all sectors were positive on this metric. What’s interesting is that previous rally leader Tech (XLK) is now trending negative, joined by Consumer Discretionary (XLY), Real Estate (XLRE) and Transports (XTN).
Some sector ETFs (XLRE, XLV, XTN) have now lost 20-DMA support. Simultaneously, Basic Materials (XLB), Industrials (XLI), Financials (XLF) and Energy (XLE) posted very strong short term performance.
Longer term, the only sector that looks extended is Financials (XLF) - but this has to be taken with a grain of salt since over 1 year and 6 months, the relative to SPY performance of XLF is about 0%. Basic Materials (XLB) could have even more catching up to do, as commodities recover from their slump.
Nostromo, our tactical allocation model, is only holding treasuries, via TLT, same as last week.
The model will also initiate a position in SPY on the next available BUY signal.
By holding on to 80% cash, Nostromo is taking on another risk - the risk of not performing in an up-market, as has been the case recently.
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.
While underperforming in real life, this quirky model has its uses as a decision support tool. There is a clear case to be made here that equities are overbought and due for a correction. Nostromo is the only strategy to have almost zero drawdown during the Covid-19 crash in 2020, owing to its “unconventional” decision making style.
3. Individual Stock Selection
Millennium Alpha, our star stock-picking algorithm has refreshed its portfolio this month. Closed positions in:
These outgoing positions are replaced with the following new picks for the next 4 weeks:
Millennium Alpha is up over +18% in 2024 and +38.1% in the past two years. The portfolio is now primarily correlated to Industrials (XLI) and Tech (XLK) on the sectors side and Mid-Caps (MDY) + Momentum Factor ETF (MTUM) on the factors side.
As per usual, you can tweak this system using your own inputs if you wish.
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.
The divergence between the market’s advance and stocks trading above their moving averages continues this week, to a lesser extent than last week. We’re seeing a pickup in performance at the 20-DMA and 50-DMA levels, while the number of stocks trading above their 200-DMA is flat. We will upgrade this indicator to “Neutral” from “Bearish”.
Neutral Signal in Stocks trading above their 200-day Moving Averages
As a contrarian indicator, sentiment works best near extremes. Currently, there is still enough skepticism in the market to fuel runs to fresh new highs. Take the following excerpt from a survey done by J.P. Morgan on their clients:
The result is clear: an overwhelming majority of clients anticipate a correction. Is this a contrarian indicator in itself? Maybe… but we’ll stick with our own indicator, which is NOT in “Extreme Greed” territory just yet.
Neutral Signal in Sentiment
The comparison of Z-Scores reveals the disparity between large cap performance (SPY) and the top 1000 stocks by dollar volume (the broad market).
The divergence is subtle, but it’s there if you look closely! SPY has been losing momentum recently and, as a consequence, it’s been printing a Z-Score curve which is arching lower (despite higher highs in raw closing price). In contrast, the broad market has been holding steady over the last 2 months, and moving higher in terms of Z-Score. The divergence (lower panel) is slowly normalizing, which is good. The trend is enough for us to put this indicator into Neutral for now.
Neutral Signal in Market Internals Z-Score
Dollar Transaction Volume is healthy and liquidity conditions are some of the best we’ve seen recently in the market; this lends credence to the bullish price move, as it does not appear to be the effect of short covering (who’s shorting this market anyway?). Rather capital is being pulled from the sidelines (and other asset classes) and being put to work in the stock market.
Bullish Signal in Dollar Transaction Volume
5. Trading in the Sigma Portfolio (Live)
After reviewing all of the above factors, it’s time to decide on the actual investing strategy for our real-life portfolio.
With markets not yet overbought enough to reach “melt-up” levels of FOMO risk-taking, we see no compelling reason to become aggressive sellers of equities at this juncture. Our systems have pulled back a bit and prefer a balanced approach to risk-taking.
It’s hard to find value in this market and meaningfully put capital at work, however. Buying relatively beaten down stocks (AAPL comes to mind) doesn’t make sense either. If they aren’t performing well with markets at all time highs, what’s going to happen to these stocks once sentiment turns?
Automated Strategies and Market Outlooks
The Sigma Portfolio (Live)
As a result of few options in the equity market, we’d rather look to commodities for diversification and hedging purposes. On one hand, broad exposure via DBC is a safe play in the space. We also can’t discount the opportunity presented by a hypothetical rebound of Nat Gas. We already have RRC in our portfolio to benefit from a price surge, but recently LPG has also caught our attention. The recent 2 standard deviation drawdown (~20%) presents a compelling opportunity for an entry point.
We are executing the following orders at today’s close:
Following the execution of these orders, here’s how the asset allocation will look like in the Sigma Portfolio:
Click here to access our own tracker for the Sigma Portfolio and understand how the positions contribute to the overall exposure profile.
In total, we stand to gain $11.980 by risking $8.028 if our targets are correct. As the market goes higher, our risk / reward profile gets worse. Right now, the win-to-lose ratio stands at 1.49-1, lower than our general desired ratio of 2-1 (risking $8.000 should net us at least $16.000 in potential gains).
The factor exposure profile contains minimum Momentum Factor ETF (MTUM) exposure, as this is the most prone to profit-taking.
On the sectors side, exposure remains balanced as well, with intentional extra focus given to Financials (XLF).
If you have any questions, please contact us using your favorite channel. Have a great week everyone, and happy investing!
Andrei Sota