Kaufman Signals

January 2018 Performance Report

Industry Benchmark Performance

In the table below, January’s returns are shown in the left column, and the 2017 returns to the right.

A good start for 2018, especially for futures. Equity hedge funds gained from 1.93% to 3.37% for program similar to ours, although ours were up by 6% to 8% in January. Also, one of the best starts in futures for the industry, ranging from 4% to 6%, but falling short of our returns of 13% for Daily and 23% for Weekly program. We attribute our outperformance for the past few years to the portfolio selection, which is described in brief later in this report. Large-scale diversification is not always a benefit.

Blogs and Recent Publications

Find this at the end of this report. We post new interviews and reference new articles each month.

January Performance in Brief

It’s difficult to expect a better performance than this month. The Equity Trend programs beat the SPY with the 10-stock portfolio up 8.28% and the 30-stock up 7.70% The Divergence and Timing programs had good returns, but not nearly as exceptional.

Futures was the outlier this month. The weekly program gained 20% to 24% while the daily program lagged with about 13%. Without looking at it’s history, it may be the largest monthly gain.

The Income Focus program, which serves as a hedge, posted the only negative return, but then the dividend income cannot overcome the rising rates.

Major Equity ETFs. Another leg up in January, with SPY gaining 5.64% and QQQ gaining 8.76%. Only IWM seemed to lag with 2.56%. The chart below shows that SPY has had very little volatility in its upwards march, and IWM moves in “fits and starts.” This month we discuss how the rest of the year should shape up, in the section “The After-January Effect.”

Bitcoin and Cryptocurrencies

In our year-end review, we cautioned against trading cryptocurrencies due to the combination of high volatility, which means high risk, lack of fundamental basis, counterparty risk, and various legal obstacles, and now the danger of hacking. We believe that, if it is really a US dollar surrogate, it will eventually trade at the same value as the dollar. Meanwhile, it has lost at least 40% of it’s value and can bounce 10% in a day. We strongly advise not to trade it. The reward is not worth the risk.Portfolios Selected by Performance are High Beta

As a reminder, our automatic portfolio selection process uses past performance to select stocks and futures. Markets that are outperforming the averages tend to continue to outperform, but they also have higher volatility than the broad index. Outperformance means that profits on any day are higher, which also means that on a losing day, losses will usually be larger. It’s the basic principle of volatility and risk: you can’t achieve higher returns without higher risk.

Smaller portfolios that are less diverse are more likely to generate higher returns during “good” markets (the ones that work well for the strategy) and larger losses during “bad” markets. More diverse portfolios will have smaller gains and losses. To decide which is best for you, you must determine your risk tolerance and how much capital can be put at risk.

The After-January Effect

Whether you’re new to the market or an experienced trader, we all know the phrase “As January goes, so does the market.” It’s called the January effect. If it’s true, 2018 could be a remarkably good year. By looking back at monthly returns of the sector SPDR SPY, from 1999 through 2017, we can find out.

There’s good news and there is good news. First the good news.

14 of the 18 years were higher in December than at the end of January, regardless of how January closed. That’s 77.7% of the years. Then the chances of an annual gain after a higher January are pretty good. During those 18 years, 8 had a higher January close, and 6 of those closed the year higher than at the end of January. That’s 75%, about the same as the average year.

Then “As January goes” is the same as “No matter how January goes…”

However, the years with a higher January outperformed the market during the rest of the year. The average return for the remainder of those years with a higher January was 10.1%, compared to the overall annualized rate of return of 6.41%. Then the January effect added 3.7% per year. We can definitely say “as January goes” so goes an extra profit.

But only 8 of the past 18 years posted a higher January and most investors would like something more consistent.

There is a Seasonal Pattern

Figure 1 shows the average returns for each month. January is negative, on balance, but the picture looks very seasonal. February through April are strong, as are November and December. The summer months, June through September are weak. That might confirm our belief that traders are not as active in the summer.

Figure 1. Average return of SPY by month, 1999-2017.

We can see a similar picture in the percentage of years that prices rise during each month. While Figure 1 shows that prices decline in September, Figure 2 shows that they actually rise 56% of the years. Then the positive years have smaller gains than the losses in negative years.

Figure 2. Percentage of years with positive returns, but month, for SPY 1999-2017.

Looking at the Year Without January

If we remove January, we get a picture of what happens the rest of the year. It turns out that January is unpredictable, but the rest of the year is far more consistent. Figure 3 shows the net returns for each year for February through December.

Figure 3. Returns by year, February through December, for SPY.

Given the Financial crisis of 2008, which shows as the largest loss, it was the only losing year of the past 15 years. And by not including January of 2008, the loss was about 30%, not the 50% seen by most investors. The results of the Internet bubble, the years from 2000 to 2002, taken collectively, were worse.

The right investment strategy seems to be to avoid January and accept an average return of 8.75% for the remaining 11 months. Compounded, that can be nice.

Similar Years

There are four years in which January posted high returns: 1999: 3.52%, 2001: 4.45%, 2012: 4.63%, and 2013: 5.12%. Had you entered at the end of January, your returns for those years would have been 16.8%, -16.2%, 11.3%, and 27.2%, on average pretty good, but still with risk. It does show that a highly volatile start of the year seems to result in volatile returns for the remainder of the year.

What about 2018?

Similar years show that we can expect volatility, but history shows that, barring a financial meltdown, the year should produce good returns from February on. You might enter at the end of January, exit at the end of April, reenter at the end of September and hold until year-end. That way you combine the “after January effect” with seasonality and get to take a holiday in the summer.

Trend Strength Index

One measure of market strength is our Trend Strength Index. Our Trend strategy is a composite of many trends, medium term to slow applied to about 275 stocks. When combined, these determine the position size of the current trade. If the faster trends are down but the slower one up, then the position size might be zero. The appearance is that trend positions scale in and out based on the strength of the trend. The Trend Strength Index appears at the bottom of the Trend Stocks All Signals report each day. We’ve tracked it from the beginning of 2014, and the chart below compares it with the SPY. TSI is the Trend Strength Index and SPY is the SPDR ETF. TSI values about zero indicate a positive trend. The range of the TSI is +1 to -1.

The Trend Strength Index reflects the internal strength (momentum) of all the stocks that we track, about 275. These stocks tend to have a stronger trend than the typical stock. It is also a mix of stocks from the S&P and Nasdaq, with a few smaller caps, but none trading fewer than an average of 1 million shares per day.

We all know by now that the equity index markets are overbought. However, that has not stopped them from continuing higher. The Trend Strength Index is not testing its highest historic level, but some confirmation is needed to say that a retracement is going to happen soon. The only concern, from a technical viewpoint, is that the SPY is now accelerating to the upside, a situation that cannot be sustained. It could just stabilize, so we’ll wait until the chart gives a clear signal of a pullback.

We offer this Index for those investors who select their own trades rather than following our sample portfolios. Daily Index values are available to subscribers.

Strongest and Most Undervalued Sectors

There are two ways to view sector rotation, trade the strongest expecting them to stay strong, or trade the weakest expecting the business cycle to rotate them to the top. We have both. The Trend Rotation trades the strongest and the Timing Rotation trades the weakest. The Trend program may hold positions for a long time, so it’s possible for two ETFs to be in both programs. For example, XOP (Oil and Gas) can be in a long-term uptrend, but a short-term oversold situation. The new Sector Rotation program also buys the strongest sectors and is reviewed with the Trend Equity Program.

Strongest

The Trend Sector ETF program buys the 6 strongest sectors of the SPDRs.

At the end of December we held:

Materials (XLB), Industrials (XLI), Technology (XLK), Consumer Discretionary (XLY), Financials (XLF), and Metals&Mining (XME)

At the end of January we held:

Industrials (XLI), Technology (XLK), Consumer Discretionary (XLY), Financials (XLF), Metals&Mining (XME), and Energy (XLE)

Undervalued

The Timing Program buys 4 ETFs that are undervalued with respect to SPY, in expectation of rotation.

At the end of December we held only two positions:

Reit (VNQ) and Utilities (XLU)

At the end of January we added one position:

Reit (VNQ), Utilities (XLU), and Preferred Stocks (PFF)

When an ETF appears in both the Trend and Timing programs, it means that market is very strong but is in a short-term retracement.

A Standing Note on Short Sales

Note that the “All Signals” reports show short sales in stocks and ETFs, even though short positions are not executed in the portfolios. Our review of using inverse ETFs to hedge stocks during a decline showed that downturns in the stock market are most often short-lived and it is difficult to capture those moves with trend systems. This confirms our approach to the Timing systems, which hedges up to 50% of the long stock risk using multiple trends. In the long run, returns from the hedges are net losses; however, during 2008 the gains were welcomed and reduced losses.  In any correction, we prefer paying for risk insurance, even without the expectation of a net gain.

Portfolio Methodology in Brief

All of the programs, stocks, ETFs, and futures, use the same basic portfolio technology. They all exploit the persistence of performance, that is, they seek those markets with good long-term and short-term returns, rank them, then choose the best, subject to liquidity, an existing current signal, with limitations on how many can be chosen from each sector. If there are not enough stocks or futures markets that satisfy all the conditions, then the portfolio holds fewer assets. In general, these portfolios are high beta, showing higher returns and higher risk, but have had a history of consistently out-performing the broad market index in all traditional measures.

PERFORMANCE BY GROUP

NOTE that the charts show below represent performance “tracking,” that is, the oldest results are simulated but the newer returns are the systematic daily performance added day by day. Any changes to the strategies do not affect the past performance, unless noted.

Groups DE1 and WE1: Daily and Weekly Trend Program for Stocks and ETFs, including Sector Rotation, Income Focus, and Dow Arbitrage

The Trend program seeks long-term directional changes in markets and the portfolios choose stocks and ETFs that have realized profitable performance over many years combined with good short-term returns.

PLEASE NOTE: On January 1st we changed the ranking algorithm for the Trend Program for Stocks with the goal of increasing returns and reducing the switching of stock positions in the portfolio. We do this as part of our continual research and monitoring effort.

January continued the steepest performance gain seen in the history of both stocks and ETFs. Stocks gained 8% on average and ETFs gained over 4% in January. An algorithmic program doesn’t predict where this move might go or how long it will last. When a reversal comes, the program will switch out of those stocks that are reversing and into those that are still strong, or are at least less volatile with positive returns.

The Weekly Trend Equity programs showed similar returns to the Daily Program, gains of 6.80% and 8.64% for Stocks and nearly 5% for the ETF programs. For the Weekly Program, both 10 and 30-stock portfolios are tracking closely.

Income Focus and Sector Rotation

Small losses in both the daily and weekly Income Focus programs are the result of the move to higher rates causing a drop in prices greater than the dividend income. It’s a scenario that may go on for 2018 given the expectation of at least three interest rate hikes. This program has little risk and is intended to provide a hedge for an equity portfolio.

A welcome gain of 6.5% in January for the classic Sector Rotation program. After a 2-year recovery from a retracement, the program has made significant new highs.

DOW Arbitrage

Even with its outstanding performance, we’ve changed the hedging algorithm for this program. It doesn’t affect performance recently because there have not been any hedges, but we take protection based on market volatility rather than price direction. That should allow us to anticipate a change, rather than act after-the-fact. In January, this program gained 8.38%, beating SPY’s gain of 5.64%.

 

 Group DE2: Divergence Program for Stocks and ETFs

The Divergence program looks for patterns where price and momentum diverge, then takes a position in anticipation of the pattern resolving itself in a predictable direction, often the way prices had moved before the period of uncertainty.

A good start to 2018, although not as strong as the Trend program. Both Divergence portfolios gained just under 4% and the ETF program 1.29%. Performance remains good and offers exceptional diversification.

 Group DE3: Timing Program for Stocks and ETF Rotation

The Timing program is a relative-value arbitrage, taking advantage of undervalued stocks relative to its index. Its primary advantage is that it doesn’t depend on market direction for profits, although these portfolios are long-only because they are most often used in retirement accounts. When the broad market index turns down this program hedges part of the portfolio risk. The ETF Rotation program buys undervalued sectors, expecting them to outperform the other sectors over the short-term.

The Timing Program buys undervalued stocks so that it will buy the weakest even in a declining market until that stock shows that it is not expected to rally. Risk is protected with an absolute stop of 15% and also by hedging the broad index.

A solid good start for the Timing Program after an excellent 2017. The stock portfolios gained about 1.5% although the ETF program lost 1.5%. The stock programs continue their strong uptrend while the ETF program is holding onto its recovery.

Futures Programs

Groups DF1 and WF1: Daily and Weekly Trend Programs for Futures

Futures allow both high leverage and true diversification. The larger portfolios, such as $1million, are diversified into both commodities and world index and interest rate markets, in addition to foreign exchange. Its performance is not expected to track the U.S. stock market and is a hedge in every sense because it is uncorrelated. As the portfolio becomes more diversified its returns are more stable.

The leverage available in futures markets allows us to manage the risk in the portfolio, something not possible to the same degree with stocks. This portfolio targets 14% volatility. Investors interested in lower leverage can simply scale all positions equally in proportion to their volatility preference. Note that these portfolios do not trade Asian futures, which we believe are more difficult for U.S. investors to execute.

Using the same strategy and portfolio logic, the Weekly Trend Program for Futures has the added smoothing resulting from looking only at Friday prices. While it will show a larger loss when the trend actually turns, most price moves are varying degrees of noise which this method can overlook.

Please read the report describing our revised portfolio allocation methodology. It can be found in the drop-down menu under “Articles.”

It would be difficult to expect a better start to the year than we see in both the daily and weekly Futures Trend portfolios. The daily programs gained over 13%, while the weekly ranged from up 20% to near 24%. As you can see in the Weekly chart below, we would never expect the recovery to occur in a single month. Of course, we’re not complaining. Both programs are far outdistancing the Industry benchmarks.

Group DF2: Daily Divergence Portfolio for Futures

Under normal circumstances we would think that a gain of 3.2% to 4.5% is an excellent month, but compared to the Futures Trend program, it seems disappointing. Still, the Futures Divergence program is off to a good start this year, and the charts show new high equity in all portfolios.

 

Blogs and Recent Publications

A new interview with Mr Kaufman has been posted on the FXCM website (Forex Capital Markets) as of a few days ago.

Mr. Kaufman will be a speaker at the Money Show Expo in New York on Monday, February 26th. His presentation will be on ways to reduce risk that traders forget to use.

Mr. Kaufman has a presentation in Jack Schwager’s FundSeeder webinar, which should now be available online.

The 3-day seminar in Chicago on developing a successful trading strategy, sponsored by the Chicago Institute of Investing has been changed from early March to mid-April to avoid conflicts with the Chinese New Year. It will be in English and Chinese. For more information contact Katie.Tian@chicagoii.com.

There is an interview on YouTube conducted by Alex Gerchik for his Russian audience. We think you will find it enjoyable and helpful. The link is:

https://www.youtube.com/watch?v=TznkQtPQXgM&t=3s

Technical Analysis of Stocks & Commodities published Part 1 of a two-part article on profit-taking and resets, in their January issue.  The first part looks at trend following and the second at short-term trading. Part 2 is scheduled for the February issue. Before that, they published “Optimization – Doing It Right,” in the September issue.

Mr. Kaufman was a Keynote Speaker at the IFTA annual conference, hosted by the Swiss technical analyst’s association (SIAT) held in Milan, Italy, in October 12-16, 2017. A video of the presentation has been posted on the IFTA website.

“Portfolio Risk in Uncertain Times” was just posted on Seeking Alpha. It shows a better way to structure your portfolio. Prior to this, you will find “Living Off Profits,” which shows how much you can safely withdraw from your account without seeing spiral down out of control. Before that Seeking Alpha published “What Are the Odds?” a look at how to assess the risk of loss for any investment.

Modern Trader published “Dogging the Dow in the current edition, and a new article “Trading Opening Gaps” in stocks, scheduled for January 2018.

The IFTA Journal published an interview with Mr Kaufman in the most recent quarterly issue.

The broker FXCM will post a live interview with Mr Kaufman, taped on October 30.

ProActive Investor Magazine published Keeping Risk Under Control on June 22. Check their website. It will be publishing other articles later this year.

Andrew Swanscott at BetterSystemTrader.com (a good source for trading systems) has put up an edited version of an older presentation of Mr. Kaufman’s. It’s all about price noise and the Efficiency Ratio.

Look for past articles by Mr. Kaufman on Seeking Alpha (www.seekingalpha.com), Forbes (http://www.forbes.com/sites/perrykaufman). www.equities.com, Modern Trader, Technical Analysis of Stocks & Commodities, and Proactive Advisor Magazine. You will also find many articles posted under Articles on our website, www.kaufmansignals.com. You can address any questions to perry@kaufmansignals.com.

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