Industry Benchmark Performance
We have no indication yet as to how equity funds performed in April, but the SPY finished up slightly, adding to small YTD gains. The NASDAQ did the opposite, posting a 3% loss and more than a 5% loss for the year, no doubt helped by Apple’s drop of 8% a few days ago.
Futures funds had a negative return in April, not reflected in our performance, which was nicely positive for the Trend program. Short-term traders continue to do better in a market that has not developed any significant trends since the dollar rally and the energy decline. Both of those sectors seem to be turning now.
April Overview: Mixed Returns in Equities and Futures, Sector Rotation the Big Winner with Timing a Good Second
An odd mix of returns, with the Trend Stock portfolios losing their gains for the year while the Trend ETFs posted very nice gains. The Timing Stock portfolios added another 3%, netting over 9% this year for the smaller portfolio and 5% for the larger.
The Sector Rotation program, which started this year with a loss, has had profits each month since then and posted a gain of 7.59% in April, netting over 3% for the year.
Futures were mixed, with the Daily and Weekly Trend programs posting nice gains but the Divergence program adding to losses. More detail on all of the portfolios later in this report.
Getting More Gain from Sectors
We use sector ETFs as an easy way of targeting an industry, and that’s true, but it’s not the best way to generate profits. The SPDRs ETFs weren’t intended to maximize your returns or reduce risk, just to track an industry. Capitalization weighting, the way the S&P is calculated, is the way most sector ETFs are constructed. If you want to extract the piece of the S&P that is exactly like the S&P, they have it right. If you’re looking for profits, you can do much better.
Two Simple Changes
We’re going to make two simple changes to the SPDR sectors, using Healthcare (XLV) as an example, but the reasoning behind this should convince you that it will work on all sectors.
- Choose the fewest stocks that represent 50% of the weighting of the index, and ignore the rest.
- Weight them equally, that is, invest the same amount in each of the stocks
Stocks with the largest weighting have the greatest impact on performance. If the top few health care companies post big losses, then it hardly matters what the rest of the sector does, you’ll end up with a loss. That’s not the way diversification should work. Each stock should have the same risk and should contribute equally to the returns.
For an investor’s portfolio, there are too many stocks. At least half of the index have weights of less than 1% (see Chart 1). That means a lot of trading and a lot of cost with little impact. Once you’ve got more than 8 to 10 stocks in a portfolio, the amount of diversification becomes marginal.
Chart 1. Health Care components in order of descending weight.
We’ll take the top 9 health care companies representing 51% of the index, beginning with JNJ, shown in Table 1. That makes a manageable number of stocks and allows a small investor to participate.
Table 1. Nine largest Health Care companies representing 50% of the XLV index.
In Chart 2 we see that an equally-weighted portfolio (each stock gets the same initial exposure) of the 9 largest stocks consistently outperforms XLV. A quant might argue that there is some ex poste selection here, that is, the largest cap stocks may be the ones that have outperformed others. If that were true, then XLV, which weights those more, would outperform our new portfolio. As we can see, the equally-weighted portfolio gains steadily over XLV.
Chart 2. Comparison of Health Care (XLV) and an equally-weighted portfolio of the largest 9 health care stocks.
The statistics show that XLV had a 15.9% return with almost the same volatility, giving an information ratio of 1.021. Our new portfolio had a return of 22.0%, volatility of 18.1%, and a ratio of 1.215, a nice improvement.
Table 2. XLV versus a portfolio of the largest 9 equally-weighted stocks.
The Main Points
The sector SPDRs were never intended to improve returns of those sectors, simply to create industry benchmarks. A portfolio that is capitalization weighted means that the largest cap stocks must perform best for an investor to capture the best returns. That rarely happens.
Using a large number of stocks correctly isolates the industry performance, but those companies with the smaller weights don’t contribute much and more likely cause over-diversification and added cost when viewed as a portfolio.
Equal-weighting is a simple, safe, and effective way to build a portfolio. That’s what we do in all the KaufmanSignals programs, and it has proved itself over and over.
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 an investor, you must understand their risk tolerance and their financial well-being.
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 250 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.
We thought that we had gained from the rally following our bullish divergence pattern, but we didn’t expect it to continue in such a dramatic way. The Trend Strength Index now shows that the momentum of the market has fully recovered and we stand at “neutral,” not overbought and not oversold. It also corresponds to a double (or even triple) top in SPY. Our experience is that triple top are rare because they disappear, that is, prices keep going up, eliminating the pattern. Because we’ll long the equity markets, we would like to see that happen again. Currently, the momentum is positive and near the highs seen since we’ve started tracking.
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.
The Trend Sector ETF program buys the 6 strongest sectors of the SPDRs. April started with the following:.
Utilities (XLU), Reits (VNQ), Industrials (XLI), Technology (XLK) Staples (XLP), and Metal & Mining (XME)
At the end of April, we had switch off XLI, XLK, and XLP for oil and gas sectors, reacting to the recovery in industry prices. We now hold:
Utilities (XLU), Reits (VNQ), Metal & Mining (XME), Oil & Gas Equipment (XES), Oil & Gas Exploration (XOP), and Materials (XLB).
The Timing Rotation program was changed to trade fewer ETFs, concentrating on the ones with greater potential. Instead of 8 markets, we now trade only 4. At the beginning of April we held:
Healthcare (XLV), Preferred stocks (PFF), Reits (VNQ), Energy (XLE), Staples (XLP), Utilities (XLU), and hedged 1/6 of the risk using SPY:
At the end of April, the four ETFs were:
Reits (VNQ), Technology (XLK), Consumer Staples (XLP), and Retail (XRT).
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
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.
The Equity Trend portfolios for stocks fell about 3% in April but the ETF programs gained 3% to 4%, an unusual turn of events. Because ETFs are an index, they will be less volatile than individual stocks; therefore, we don’t expect a move of this magnitude. The main mover was XME, Metals & Mining, which reflected the jump in precious metals prices and, in some way, the weakening of the U.S. dollar. We’ve now also moved into Energy ETFs, expecting to benefit from both a move higher in metals as well as oil.
Weekly Equities came off their recent high in the 10 stock portfolio, while the 30 stock portfolio still lags. ETFs posted a gain, not as much as the daily portfolio but enough to show a turn up in the 10 stock portfolio.
The Sector Rotation Program posted two excellent weeks, netting up 7.59% for the month. It benefited from a serious rally in Metals & Mining (XME), a good move in Utilities (XLU) which rarely move, and a gain in Energy (XLE). The chart below looks much more encouraging.
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.
The smaller 10 stock Divergence portfolio posted a small loss and has a net loss for the year, but the 30 stock portfolio as well as the 8 ETF portfolio are sitting at new highs, always a nice event.
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.
Last month we notified traders that we were making a major change to the way the Timing Stocks were selected for the portfolio. Instead of predetermining which index they tracked, we added a dynamic feature that allowed the strategy to generate arbitrage signals on whichever index best represented the moves of the stock, and we could change that reference as the market changed. We would like to think that this month’s performance is a reflection of that change, but it’s really too soon to tell. The gains in all portfolios are encouraging, and well ahead of all the benchmark indexes.
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 new report describing our revised portfolio allocation methodology. It can be found in the drop-down menu under “Articles.”
We changed the roll dates on some futures contract because they were too close to first notice day, a problem particularly critical for Weekly traders. That reduced the historic returns for the 250K portfolio but did not affect the others. As you get close to delivery, prices tend to be more volatile. The 250K portfolio had clearly benefited from this, but it would have also presented increased risk in the future. All three portfolios are now tracking closely.
Both daily and weekly portfolios posted nice gains this month, up from 2% to 4%. Only the $250K daily portfolio is flat for the year, while the other daily and weekly portfolios are up from 2.68% to 6.55%
Group DF2: Daily Divergence Portfolio for Futures
The Divergence Program posted the only significant losses for the month, down 2% to 5% and 3% to 7% for the year. The chart below shows that this program tends to be volatile, mainly because it often has only a few trading signals. It’s easier to find enough signals when you’re looking at 300 stocks rather than 60 futures markets. We expect this program to continue to ratchet up.
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