Kaufman Signals

June 2017 Performance Report

Industry Benchmark Performance

Early reporting shows small gains in the hedge funds, but adding to a reasonably good year-to-date return. The futures funds (CTAs) continue to struggle with no major trends being sustained in interest rates, the main driver of profits. Some gains from the weakening dollar were not enough to offset the uncertainty in yields, and equity index markets have either been quiet (as the S&P), or sharply lower with high volatility, as in the case of Nasdaq. Those patterns make it difficult to capture profits.

Blogs and Recent Publications

(We’ve moved this section to the end of the report.)

June Performance in Brief

The Weekly and Daily Equity Trend programs both finished lower by 1% to 2%, a big disappointment after being well ahead through the middle of June. But a sharp reversal in the tech stocks, previously the big winners, erased those gains. We look at those price moves in the analysis below. Both the Timing and Divergence Equity programs gained varying amounts up to 2% in June.

Futures were mostly lower after a big gain last month. Only the smallest 250K Trend portfolio had a gain of 4%. The Daily Futures Trend is still well ahead for the 250K and 1M portfolios, but down for the year in the 500K. The Weekly Futures are posted losses after being back to unchanged last month.

Major Equity ETFs. Nasdaq took a hard reversal down in the last two weeks, giving back more than 5% from its highs, but not affecting either the S&P or the Russell. There doesn’t seem to be any news explaining it, so we think the market was just overextended and traders/investors were getting nervous. In the chart below, you can see that Nasdaq had been running ahead of the other index markets for the past three months. The small caps (IWM) gained the most in June, up 3.3%, while SPY gained only 0.6%. We could predict that the markets will flatten or reverse here, but we would have been wrong for the past nine years.

The Two Big Events This Month

Two events dominated market action this month: the tech rout and the Amazon purchase of Whole Foods. Both are worth looking at in more detail.

Amazon and Whole Foods

Amazon (AMZN) continues to be a disruptor. It’s announcement of the Whole Foods (WFC) was clearly a surprise. The immediate reaction was that traditional food chains, such as Kroger (KR) plummeted 25%, even though nothing has yet happened. CostCo (COST) and Wal-Mart (WMT), the biggest competitors, dropped the least. Amazon stock first fell, the recovered to unchanged. My own take was that CostCo serves a different customer and should not be affected, but the market sees it differently, and we don’t fight the market.

The interesting part is that it’s not clear Amazon has dealt with perishable merchandize at this magnitude of business. Not that anyone would want to underrate the ability of Jeff Bezos to implement this new venture, but it seems to be breaking new ground, yet again. The competition seems to be with the companies that deliver groceries, of which there are at least ten bigger ones. We expect Amazon to have a structure that will compete directly with these companies.

Does the drop in price for other food chains say that customers will opt for on-line shopping and delivery rather than go to the store and squeeze the melons or look at how much fat is on the meat in the cooler? Personally, I have a difficult time with that concept.

The shopper in our family sees this as Bezos genius at work again, creating nationwide brick and mortar stores fast and with built-in quality foot traffic! Offering a familiar and pleasant shopping experience where people can buy their fresh foods (maybe even ordering them online first), pick up their Amazon online purchases and eat lunch in the café. They have already market-tested this concept with the Amazon Locker where customers can pick up or return items they have ordered online (instead of prime’s free 2-day delivery and prepaid returns).

Lockers are located in grocery and department stores and often not available due to over capacity. They have been welcomed by stores due to the increase in foot traffic. Shoppers who choose to direct an online purchase to a department store they have not frequented in 10 years do so because it has the Amazon Locker nearest their home. The lockers are in high demand, but to expand them would be impractical. Bezos has also observed that consumer pick up and return points, a favorite Walmart strategy, eliminates more expensive truck deliveries. Brilliant or obvious?

On the other hand, we see that record companies are starting to produce vinyl again, and more regular books are selling again, rather than ebooks. Maybe consumers have had enough of remote shopping and high-tech options. Maybe they want to touch something before they buy. I did buy COST after the initial drop, but got out unchanged. I tried again the next day and got out unchanged. Then I gave up. The market sees the takeover of Whole Foods as a structural change.

 

What Happened to the Tech Stocks?

Our portfolios tend to hold high beta, more volatile stocks and the average in the S&P, or even in Nasdaq. Stocks such as Tesla (TSLA) or Apple (AAPL) continue to outperform. Recently, we have held Yahoo (YHOO, which changed to Altaba, AABA, this month), Tesla, NetFlix, and Google, all performing well ahead of their equity index counterparts. So what happened in early June to change that?

We don’t know. The first drop seemed to be coordinated, much like a “flash crash” but not as severe. NetFlix (NFLX) lost nearly 10% within a few days, and Apple (AAPL) caught up to it a few days later. Then there was a two-week recovery before prices turned down again.

It seems to be all about nervous investors rather than anything economic. The Fed is planning to raise rates, perhaps twice more this year, but that affects companies in all sectors. The tech companies are not affected by Health Care legislation and not by a new Tax Bill, which is still without shape. The confusion and mixed messages coming from Washington DC makes it difficult to formulate a strategy.

Our conclusion is that prices go up and down. After a very long run, which can be seen in the QQQ prices in the previous section, investors will get nervous and react to news that has no immediate effect on prices. A 5% to 10% drop in prices is well within the range of “normal.” The only protection we have is in diversification and rational behavior. Following a trading system that can control risk is a good way to keep your perspective. Even if you don’t take all the trades, and change the size of your positions, you should not trade against a system that has a history of success.

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.

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 270. 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.

In June, the Trend Strength Index recovered slightly from its lows, while the SPY gained fractionally. The result is that this index still sees the market as marginally upward trending. It has not dropped below zero since the very beginning of 2016, not a year and a half. It’s difficult to predict the end of a 9-year bull market, but the Index shows a normal range of about 10 to 50. We can expect a slow climb back towards the top of the range, but a value under 20, representing new lows, would likely reflect the start of a major reversal in stocks and a try at the lows of the TSI values, at -50.

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 May positions:

Preferred (PFF), Technology (XLK), Consumer Discretionary (XLY), Staples (XLP), Utilities (XLU), and HealthCare (XLV)

End of June positions:

Preferred (PFF), Industrials (XLI), Technology (XLK), Staples (XLP), Utilities (XLU), and HealthCare (XLV)

Undervalued

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

At the end of May positions:

Financials (XLF)

We now hold:

Technology (XLK), Utilities (XLU), and Consumer Discretionary (XLY)

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.

Even the disappointing performance in June does not change the upward pattern of the equity NAVs. Both the 10 and 30-stock portfolios remain near all-time highs and are keeping pace with the major equity index markets.

It’s also difficult to see the marginal losses in the three ETF portfolios, which continue to look as though they want to keep going higher.

 

As with the Daily Program, it’s hard to see small losses in June on the Weekly Equity charts. Both the 10 and 30-stock portfolios maintain a strong upwards bias.

The ETF portfolios is also steady after very small losses in June. The upward turn looks intact.

 

Income Focus and Sector Rotation

A lot of interest rate news moved those stocks around in June. That resulted in a marginal loss for the Daily Income Focus program and a marginal gain for the Weekly program. Sometimes it’s better not to react quickly to price changes and volatility.

 

The Weekly Sector Rotation gave back part of its gains in May, losing 1.6%. The charts still maintains its recovery pattern.

DOW Arbitrage

A second good month for this new program, one of the few to post a gain in June, up nearly 2%. While the overall market looks as though it’s struggling to go higher, the best of the Dow 30 seem to be doing better.

 

 

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.

It’s unusual for the larger portfolio to outperform the smaller. Normally, the smaller one does best, but is more volatile. Both Divergence stock portfolios gained marginally this month, with the 30-stock portfolio now up over 5% for the year. The 8 ETF program lost a fraction but continues its slow, steady rise.

 

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.

The Equity Timing program put in the best performance of the month, up 1.54% and 2.08%. The 30-Stock Portfolio looks steady in its uptrend, while the smaller portfolio is holding in a sideways pattern. Even with a small loss this month, the 4 ETF program maintains its uptrend.

 

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.”

As someone who has traded futures for his entire career, I can attest that it can be frustrating. Long periods of mediocre returns followed by gigantic profits. For the Weekly traders, it’s the period of poor returns, but for the Daily program, not so bad. In the long run, these two programs have evened out.

June saw a gain of 4% only in the smallest 250K portfolio, and losses of 3% in the others, reversing the nice gains of last month and cutting into the year-to-date returns, which remain mostly profitable.

The Weekly program had mixed medium losses, while we continue to expect the end to this drawdown. There are some major trends developing in the EURUSD and interest rates, which could improve results. But the big profits come from the unexpected, such as the move in crude to $150, or the strengthen US dollar from 140 euros to 120, then down to 105. Part of the program’s long-term success comes from taking trending positions without knowing where they will lead.

 

Group DF2: Daily Divergence Portfolio for Futures

Moderate losses in all portfolios, from less than 2% to about 3.5% does not change the recovery pattern for the Divergence program.  The smallest portfolio has a gain for the year of 12.5% while the other portfolios are up 6%. This program tends to be more volatile because it seeks a special pattern in fewer markets. Often there are only a few trades at a time, and those are leveraged up. Given all that, performance looks good.

Blogs and Recent Publications

Mr. Kaufman will give a 1-day seminar on Developing an Algorithmic Trading Strategy for the Chicago Institute of Investing on Monday, September 4. It will be held in Chicago. Check their website for details.

Mr. Kaufman will be a Keynote Speaker at the IFTA annual conference, hosted by the Swiss technical analyst’s association (SIAT) to be held in Milan, Italy, in mid-October 2017.

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

Technical Analysis of Stocks & Commodities has published The Return of High Momentum in the July issue, a new intraday system that combines both high momentum and mean reversion into a single strategy.

Technical Analysis of Stocks & Commodities will also publish “Optimization – Doing It Right,” now scheduled for the September issue

Modern Trader will print Dogging the Dow. It’s a full-length write-up on the new trading program was presented in last month’s report.

The Swiss Technical Analysis Society (SMAT) has published Creating Your Own Sectors in their current quarterly publication. If your focus is higher returns, It shows that simple market selection is far better than a packaged ETF.

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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