Portfolio Rebalance / March 27

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.

As we prepare to wrap up the month of March and the first quarter of 2024, the equity rally getting long in the tooth. This would mark the 5’th consecutive month of positive performance in the stock market. While such stretches have previously occurred in recent history, often times they have been followed by a month or two of declines. Sometimes, 5-month winning streaks have been followed by even deeper corrections, with only an episode in 2013 proving to be a “buy signal”. The deviation above the long term average is also getting historically elevated and unsustainable.


  1. 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 fully investible;

SPY remains highly extended above its channel median trendline, at 1.34 standard deviations (representing about -9.2% of potential retracement). The technical and fundamental targets are starting to align, as the chart below has not been adjusted for fundamental assumptions. Our $545 median price target is now within the span of the regular technical channel, albeit at the very high end.

A retracement to the M-Trend level would not necessarily be our base case scenario for the next quarter, but it would not come as a complete surprise either, given the current extension. Such a retracement usually occurs 3 times per year on average.

Tha rally in Commodities (DBC) has run out of steam this week. We still maintain a constructive view here, but other constituents of DBC need to gain as well, besides oil and gold.

Similar to the price action in Commodities, Gold (GLD) has consolidated during the past week as well. Further gains could push the yellow metal closer to $209, but technicals are stretched at the moment. Sideways movement is not surprising here.

TLT, the benchmark ETF for long dated government bonds, has been under continuous selling pressure and will face a renewed test on Friday, when PCE data is released. The outlook for inflation is critical for the viability of any investment in bonds, especially at the very long duration. The treasury market is still lacking direction, as most participants are yet undecided about the trend that interest rates will ultimately have.

Judging by the recent price action, “higher for longer” seems to be the prevailing view.

Enterprise, our core investment strategy, has reduced equity risk yet again this week. The adjustment takes SPY from 64% weight last week to 56% today.

Bonds exposure is increased from 22% last week, to 35.6% today.

A bit of profit taking is occuring in Gold, which is being reduced from 4.8% last week to 4.28% today.

Commodities are being maintained at almost 2% of portfolio weight.

Cash is being reduced from 7% last week to 2% now.

Since this model only trades 4 ETFs, we use it to judge overall portfolio positioning. The strategy’s risk profile is now clearly defensive, as the portfolio is run below benchmark targets for both stocks and bonds.

 

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).

Both the Nasdaq (QQQ) and the Dow Jones Industrial Average (DIA) are now trading in a negative Medium Term Trend. We expect more factors to join this change in trend gradually, as the market top matures.

All factors are trading well above all of their moving averages this week, and only Mid-Caps (MDY) and the Momentum Factor ETF (MTUM) look extended in the short term. Longer term, MTUM is also the one to watch for profit taking price action, along with Growth Stocks (IVW). Otherwise, factor ETFs are surprisingly well behaved.

Among more granular Factor Returns, Operating Margin is performing consistently well in the short term (and much worse longer term).

Ranking shown for Operating Margin

On longer timeframes, the Pietroski F-Score continues to rank exceptionally well.

Ranking shown for Pietroski F-Score

Across all timeframes, we’ll highlight R&D / Revenue due to the fact that an opportunity may be presenting itself. At the long term, this factor is performing great, but it’s been ranking very low at shorter durations. Buy the dip in companies with high R&D / Revenue?

 

Here’s how we stand on the Sectors front:

We have included 3 former tables from previous articles, for your convenience.

The deterioration in momentum continues this week as 5 out of 12 sector ETFs are now in a negative Medium Term Trend. Last week, only 4 sectors were negative on this metric. If we sort this table by Beta to SPY, 4 of the negative trending ETFs are in the top 5 spots. In other words, it’s the leadership of the rally that’s losing steam (beta is a measure of both correlation and covariance, which is a characteristic of leading ETFs) .

Tech (XLK), Real Estate (XLRE) and Healthcare (XLV) are trading below their 20-DMA’s to various degrees. Only Basic Materials (XLB) looks truly overextended in the short term.

Longer term, the only sector that looks extended is Financials (XLF). Bear in mind, however, that a lot of banks are recovering from the CRE crisis that occurred almost 1 year ago, so the excess performance is just “catching up”.

 

Nostromo, our tactical allocation model, is only holding treasuries, via TLT, same as last week (and last month).

The model will also initiate a position in SPY on the next available BUY signal.

Nostromo has completely missed the mark recently, as its primary allocation has been cash. In a market moving ever higher in low volatility, Nostromo’s trade signal system has been unable to catch any kind of break.

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 continues to perform great. The portfolio is weighted toward Industrials, Tech, Mid-Caps and Momentum stocks.

One of the unsuccessful picks from this system is Lululemon Athletica Inc. (LULU), which may present an interesting technical opportunity if one is inclined to take on some “buy the dip” risk. LULU has recently reported lackluster guidance and soft U.S. demand on the latest call, but overseas sales should make up for domestic losses in the longer term.

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 SPY and the broad market in terms of moving average breadth contains no notable clues this week. With such low volatility in the market, it’s quite hard to spot durable longer term trends. The number of stocks trading above their 20-DMA has retraced somewhat, but this is part of a normal consolidation.

Neutral Signal in Stocks trading above their 200-day Moving Averages

As a contrarian indicator, sentiment works best near extremes. There’s been some softness in sentiment recently, but the short term trend is positive and should eventually lead to “Extreme Greed” sooner or later.

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).

Small caps are closing the performance differential with larger caps. This trend has been slow to form, but it’s definitely there! This is, in fact, great news for the market, as support from the smaller capitalization stocks can support the equity market rally further.

We can also look at how the Market Cap factor is performing on different timeframes, and findings are consistent with the Z-Score differential: a higher market cap is beginning to weigh on performance.

Neutral Signal in Market Internals Z-Score

Dollar Transaction Volume has retraced heavily in the past week - it’s now down to the polynomial average. As grinding, low volatility is creating a perception of safety, we wouldn’t want this measure of liquidity to drop any further.

Neutral 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.

The most recent rebalance of the Enterprise strategy is now very close to our own real life positioning. In order to match it, we would need to increase our bonds allocation, which is something we shall do.

The other notable observation is that small caps have started to work. It’s only logical to shift equity exposure towards that space, as we have done last week as well. However, with markets trading near all time highs, we would avoid single stock exposure for now and simply allocate toward a broad market ETF like IWM. This offers more downside protection when the market finally turns.


Automated Strategies and Market Outlooks


The Sigma Portfolio (Live)

Our portfolio is currently very tight, with each position performing a certain “role”. Another option would have been to further diversify by adding another individual position, but we decided against that. We will be running the equity side of the book a bit above target, but given the actual stocks that we own, it’s fine (low correlation with SPY and QQQ).

We are executing the following orders at today’s close:

  • BUY 5% TLT (Add 5% to Position)

  • BUY 3% IWM (Add 3% to Position)

Following the execution of these orders, here’s how the asset allocation will look like in the Sigma Portfolio:

We are prepared to reduce risk if and when it will be technically necessary. For now, none of our stops have been hit, so there is no reason to sell.

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 $13.124 by risking $8.985 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 1.46-1, lower than our general desired ratio of 2-1 (risking $9.000 should net us at least $18.000 in potential gains).

We are underweighting Momentum (MTUM) and Growth Stocks (IVW) exposure, as these factors are the most prone to profit-taking. Instead, high correlation to small and mid caps is preferred.

On the sectors side, we are underweighting Tech (XLK) and overweighting Financials (XLF), with a balanced correlation profile to all other sectors.

If you have any questions, please contact us using your favorite channel. Have a great week everyone, and happy investing!

Andrei Sota

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