Kaufman Signals

April 2017 Performance Report


Industry Benchmark Performance


Hedge funds eked out a small gain for April, adding to 2017 returns, but running at about half of the SPY returns. Given the market uncertainty, prices have not moved in a smooth pattern, so the industry should be pleased with net gains.

CTAs did not fare as well. Barclays shows fractional gains in April, but net losses for the year. The SG returns show larger losses everywhere. Compared to the benchmarks, our futures programs are doing well

Recent Publications

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

April Performance in Brief

Good gains for most of the equity programs, with the Trend program beating SPY, our benchmark. All weekly equity programs gained with the new Dow Arbitrage up the most at 3.38%. So far, the equity market major indices have put in a good showing, anticipating a better business environment. Unfortunately, it hasn’t been a smooth ride, so our trading strategies are profitable but lagging.

Futures were mostly better, and in the case of the Divergence program, much better, gaining from 5% to 6.5% in April. The Weekly program had nice gains while the Daily program posted mixed results.

Major Equity ETFs. A surge in Nasdaq and the Russell resulted from a few earnings pops towards the end of the month, which had less impact on the S&P. Still, the market refuses to die, despite statements from pundits, such as Paul Tudor Jones, to expect a drop of as much as 50%. When would that be? The markets always retrace, but without a time window, a forecast is not a forecast. Meanwhile, no one wants to sell as long as there is hope of some major tax reform. Executive orders have eased some of the regulatory burden, but it’s still just fiddling at the margin.


A New Program Trading the DOW

This month we introduce a new weekly program, Dow Arbitrage. It’s not a continuous arbitrage, but only sells stocks short under certain high-volatility conditions.

There are many theories about how to trade the DOW. The Dow components are an interesting group because they have extraordinary liquidity. At the same time, they are “mature” companies. Wisdom says that mature companies are unlikely to grow as fast as newer companies, which have unique products and more available market share to capture. Or so we thought.

If we compare the 30 DOW stocks with the rest of the S&P 500 (Figure 1 left). When adjusted to 100 at the beginning of 2004, both the DIA and SPY ETFs performed nearly the same. In Figure 1 (right), we can see that the DOW stocks represent about 25% of the S&P total capitalization, which still leaves enough room to separate the performance of one index from the other.

On the whole, we can say that the DOW components perform as well as the overall market.


Figure 1 (Left) Returns of the DIA and SPY from 2004. (Right) Percentage of DOW to S&P total capitalization by year.

Should You Buy Strength or Weakness?

The Dogs of the DOW was popularized by Michael O’Higgins in Beating the Dow (1992). In those rules, you bought the 10 highest yielding Dow stocks on January 1 and held them for the rest of the year. For the period 1973 through 1989, that method would have beaten the average return of the Dow by 6.8% per annum. However, in 2017, the current thinking is that high yields mean low returns. After all, why pay shareholders a high yield when the stock is soaring, like Apple? We’ll use the concept that a high yield generally means lower returns, and take an easier path analyzing the Dow.

Buying the 10 Worst Performers in the Dow

The Dow members are all substantial companies. When they want to attract more buyers they raise dividends. They are always trying to improve their market share by introducing new products or some new innovation. For those reasons, it is possible that the worst Dow stocks might rotate upwards in their returns.

Figure 2 show the results of buying the 10 Dow components with the worst returns, then rebalancing annually (actually, every 252 days). Based on a $200,000 investment, each stock is allocated $20,000 and the position size is $20,000 divided by the price at the beginning of each year, a simple way to get volatility parity.

Figure 2. Buying the weakest Dow components every 252 days.

The chart shows a drawdown of about $30,000, or 15%, from 2008 through 2010, far less than the drawdown of the whole market. Otherwise, it only returned about 62 basis points (6/10ths of 1 percent each year. Not a return anyone would want, but could be useful when viewed as a hedge. At the same time, Figure 1 showed that DIA had a return of 7.65% and an annualized volatlity of 17.8%, and SPY with a return of 7.55% with an annualized volatility of 19.1%. The reward to risk ratio for DIA is 0.429 while SPY is 0.395. Both are far better than buying the 10 worse performers of the Dow.

Buying the Strongest

Most of us have figured out that a high-quality antique or painting is more likely to appreciate in value than a “bargain.” The high-end appreciates faster (and is more volatile) than the low-end.

If we buy the strongest of the Dow components, rather than the weakest, we get returns that are much more attractive, and slightly better than either the full Dow or the S&P. In Figure 3 (left) the rebalancing is done yearly, and on the right, the rebalancing is monthly. Using a faster, monthly rebalancing, returns far exceed both DIA and SPY, but with a slightly larger drawdown during the financial crisis of 2008.

Figure 3 (Left) Buying the strongest 10 Dow stocks, rebalancing yearly. (Right) Buying the strongest 10, rebalancing monthly.

These results shouldn’t be a surprise. Stocks that are performing well most often continue to perform well. The idea that a price is technically “overbought” and should be sold, is nonsense. Look at Apple or Amazon or Tesla. The biggest winners defy fundamental analysis, except in retrospect.

Reducing Risk Using Volatility

Having settled on the stock selection, we need to reduce the drawdowns. We change the rebalance period from monthly to every two weeks, which makes us more responsive to change, and does not burden the program with costs. If we plot the daily returns of our strategy (not the prices), we can get the 20-day annualized volatility shown in Figure 4.

Figure 4. Annualized volatility of returns for the strategy that buys the strongest 10 Dow stocks using a linear regression.

We take risk seriously, and the simplest way to reduce risk and avoid unnecessary losses is to deleverage when risk gets extreme. Then whenever we are rebalancing (every two weeks), we reduce our position by 50% if the annualized volatility is greater than 90. When volatility drops below 90, we reset our full position.

Hedging at the Same Time

We can do more. Because we have 50% of our investment available above our volatility threshold, we can now go short the 10 worst performers in the Dow at the same time we reduce long positions. We don’t know that these worst performers will move in the opposite direction, but we do know that they will underperform. In fact, the combination of reducing position size using volatility, and hedging at the same time using available funds, gives the performance in Figure 5.

The final method has a return of 15.7%, a volatility of 24.28%, and a return to risk ratio of 0.646. That’s twice the return of the Dow or S&P, with a ratio about 50% better. It doesn’t eliminate the drawdown during the 2008 financial crisis, but it shows good overall stability.

Figure 5. Results of the Dow strategy compared to SPY and DIA.

A strategic or tactical approach to investing doesn’t need to be complicated to be good and it doesn’t need to use obscure markets or chase the latest fad. Active management can generate the same returns as passive investing with half the risk. It’s your money. You can track the performance in the table at the beginning of the report and get the trading signals by subscribing to the Weekly Equities Program.

April Insight: Choosing Volatile Stocks

As we’ve discussed before, and repeat each month in the next section, we choose stocks based on performance. But good performance also means volatility – they go hand in hand. If we look at 6 of the 10 stocks in our $100K Equity Trend Portfolio, we see that the standard deviation of the daily returns are far greater than the overall market, represented by SPY. This week, WYN jumped 9.02% on earnings, followed by a retracement of 4.63% the next day (see the table below).

TSLA has also been an unbelievable story, gaining 7.27% on the first day of April, then bouncing up and down, but netting a large gain for the month. The total capitalization exceeds most other auto companies. The numbers show that our stocks can have four times the volatility of SPY. Professionals have often said that volatility attracts volume. When you get a price jump, day traders are immediately attracted, causing additional volatility until it plays itself out.

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 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.

The Trend Strength Index declined, as expected when it reached near the previous highs of 60, but SPY has remained near its highs. Predicting that the S&P will drop precipitously has not worked out for any forecaster. Because the Trend Strength Index tends to lead an SPY decline, we can wait for a bigger retracement before predicting the inevitable 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.


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

At the end of March, we held Industrials (XLI), Technology (XLK), Consumer Discretionary (XLY), Staples (XLP), Financials (XLF), and Utilities (XLU). We replaced only Financials (XLF) with Materials (XLB). We now hold:

Industrials (XLI), Technology (XLK), Consumer Discretionary (XLY), Staples (XLP), Utilities (XLU). And Materials (XLB)


The Timing Program buys 4 ETFs that are undervalued with respect to SPY, in expectation of rotation. We started April with Energy (XLE), Reit (VNQ), Financials (XLF), and Industrials (XLI). We continue to hold financial (XLF) but have exited all previous ETFs and added Oil & Gas Equipment (XES). We hold only two positions because none of the other sectors are oversold by enough. We now hold:

Financials (XLF), and Oil & Gas Equipment (XES)

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.



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.

While both stock portfolios were profitable, the larger 30-stock portfolio is now at new highs and gaining on the smaller one. Because of much greater diversification, the larger portfolio should have a smoother profile.

The ETF programs both posted fractional losses, turning the pattern sideways, while the sector ETF program gained 1.32% for April.


A better move up in Weekly Equities, taking the larger, 30-stock portfolio to new highs and putting the smaller portfolio within reach of new highs. The ETF programs gains fractionally, which is difficult to see on the chart.


Income Focus and Sector Rotation

Both daily and weekly Income Focus performed as expected, gaining about 1% for the month. The daily program posted new highs while the weekly program hangs near its highs.



Fractional gains in the Sector Rotation program doesn’t do much for the recent recovery. The pattern looks good for a recovery, but we’d rather have it sooner than later.


 DOW Arbitrage

For this month, please refer to the full article written earlier in this report, and the associated performance chart, Figure 5.

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.

All portfolios in the Divergence program were profitable, although some only fractionally. The 10-stock portfolio is holding near all-time highs while we are still waiting for a breakout in the larger portfolio. Meanwhile, the ETF program continues to march upward, slowly but steadily.


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.

After an encouraging start to the year, the Timing program has pulled back from its all-time highs, although not by much. This month it posted a loss in both stock portfolio but is holding on to a gain for the year. The ETF program gained slightly, but is still marginally down for the year. Both NAVs are still in a nice upward pattern.


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.”

Mixed results for futures this month, but better than the BTOP 50, the CTA benchmark performance, which was down by 0.63% as of April 27th (Thursday). This month the daily Trend program was down fractionally in the 250K and 500K portfolios, but up 2.29% in the larger 1M portfolio. All three daily portfolios are heading for new NAV highs. The weekly programs did much better, posting gains from 1.62% to 2.05%, paring the year-to-date losses, even while it’s difficult to see on the chart.



Group DF2: Daily Divergence Portfolio for Futures

After suffering a decline and then a sideways period, the Divergence program is showing signs of life. Back-to-back good monthly returns puts the NAVs back in the normal pattern that we’ve seen for years. If it continues to new highs, the program will be performance up to expectations.

Blogs and Recent Publications

There are two new articles pending, and one republished article.

Modern Trader will print Dogging the Dow. It’s a full-length write-up on the new trading program that we present in this report.

Technical Analysis of Stocks & Commodities will publish The Return of High Momentum, a new intraday system that combines both high momentum and mean reversion into a single strategy.

The Swiss Technical Analysis Society (SMAT) will reprint Creating Your Own Sectors in their next 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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