August 2015 Performance Report

­­August Overview

Jul performance table

The end of August was all about running for cover. Our worries about the Greek default, the Fed raising interest rates, and Russia taking over Eastern Europe seem to have quickly pushed aside. It’s more personal when the S&P drops nearly 10%, a move not seen since 2008. Unless you have special insight, it is not possible to anticipate that NetFlix (NFLX) will drop as it did (see chart below), then rally nearly back to its highs before falling again (today). Then there is crude oil, rallying 7% in one day on yet unknown news, then dropping back 7% two days later. First the Chinese slowdown means that demand will be down, then there is a rumor that supplies will be cut, then there is Iranian oil coming on the market sometime in the future (no one actually knows when).

NFLX and Crude

The chart of the VIX, which reflects the implied volatility of S&P options (always more conservative than a single active stock), shows the pattern from 2006 on the left, and the 2015 implied volatility on the right. The peak seems to match the highest historic peaks, with the exception of 2008. The only take-away from this is that volatility can occur without warning, and it’s likely that it’s now near its peak, although the peak can last a few days and then volatility seems to decline in an orderly manner following the peak.

VIX

Should we be worried? Even though some investors do panic, a drop without an understandable change in the economy doesn’t justify a prolonged decline. We attribute it to a lot of nervousness. The media reminds us each day that we are overdue for a correction, so investors are on edge and react on impulse. Even in the worst case, 2008, investors who followed a clear plan recovered nicely. Most of those that got out and waited, never got back in. Granted, it’s hard to throw yourself in front of a train, but trend following waits until the trend changes, it doesn’t try to anticipate the change. It’s late getting out (an annoying feature) and late getting in (another annoying feature), but because of that it has outperformed any other systematic approach over the past 40 years.

For those readers not following our programs, there are defensive considerations, independent of the specific trading system, that may be helpful:

  1. Don’t buy a stock that is in a downtrend.
  2. Hold stocks that are strong, even if the index is in a downtrend.
  3. Hedge your portfolio using ETFs. Scale into the hedges as the downtrend expands. If the market turns back up and you lose a little on the hedge, that’s OK. You’ll make more on your portfolio.
  4. If you trade futures, remember that futures go short, and that servs as a hedge in a steep sell-off. It’s called “crisis alpha,” and it’s the reason why institutions use futures.

August System Performance

We were not immune from the volatility in August, and long-only portfolios only deleverage by removing positions and by not being fully invested. While the last month shows a tendency to decline, index prices remained high and trends were all long, as can be seen in the Major Index ETFs chart below. Our ETF programs were better at recognizing the pending downturn than the stock programs. There are always some stocks that remain strong but ultimately fall when the whole market collapses.

The larger, more diversified programs outperformed the smaller portfolios in August, and the Timing Program hedged nearly the entire portfolio as the downtrend in equities increased.

The Futures Trend Portfolio had mixed results, but the Futures Divergence Program posted the best profits of the year. But then it can take both long and short positions, held for only a few days.

Major Index ETFs

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.

In the chart below we see that the Trend Strength Index has been diverging from the SPY since June. Unfortunately, you can only be cautious when these patterns occur because they are not always good at telling you when the decline will occur, or how deep it will be. You have to be willing to sacrifice some gains in order to stay protected. Missing a few smaller rallies is not a bad trade-off for being protected during a more serious sell-off. The Trend Strength Index, now reading -45 shows a strong downtrend.

Trend Strength Index

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.

Strongest

The Trend Sector ETF program buys the 6 strongest sectors of the SPDRs. This month started with

Financials (XLF), Healthcare (XLV), Consumer Discretionary (XLY

 During August, few positions were held in ETFs and on the last day of the month, the last position un Utilities (XLU) was exited.

No positions held

Undervalued

The Timing Rotation program (buy low) entered some positions during July, hedged them with up to two of three possible hedges in both the SPY and QQQs (showing weakness reflected in the Trend Strength Index), then exited all positions, leaving us again with no positions at the end of July.. Buying weakness in a market that is declining in the majority of stocks is not a successful strategy. This program will outperform when there is an upward move in the broad market by buying stocks that are likely to rebound faster

This month started with no position and ended with no positions. The ETF must qualify by having some uptrend value. As of the end of August, all SPDR ETFs were either in a downtrend or not undervalued relative to the tracking index, the SPY

No positions held

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.

 PEFORMANCE 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.

Both Trend Equity Portfolios declined slightly more than the benchmark SPY in August, first taking defensive action following a big drop, then adding back some positions before exiting again. The pattern of returns had been flattening as the market struggled to make new highs, so this is not unexpected even if we never know when it will occur. While the market has been nervous about the 5-year bull market, there is so far no compelling reason for a bear market to be sustained. We remain optimistic about a recovery soon.

Trend daily equities

The Weekly Stock programs shows mostly the same picture as the daily charts. In some way, the Weekly Program will be a bit smoother than the daily and won’t jump in and out if the volatility continues.

Weekly Trend equities

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 Divergence Program held its own in the smaller portfolios (the highest beta) and outperformed the benchmark in both the larger 30 stock portfolio and the ETF portfolio. While the ETF portfolio does not have the long-term returns of stocks, it has far less risk.

Divergence for stocks

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 Timing Program posted only marginal losses during August, due to exiting a large number of positions after the first decline, then being fully hedged once new positions were entered. While hedging doesn’t make money in a bear market, it significantly cuts losses and allows these stocks to outperform once the overall trend starts to turn up.

Timing equities

Futures Programs

The Divergence futures program posted large gains in August, even after a small pullback in returns during the last days of the month. It is now well ahead of the benchmark CTA index. The Trend programs had mixed returns, better for the smallest portfolio and slightly down for the larger ones. Year-to-date, the larger portfolios still reflect the battering due to the Swiss Central Bank intervention earlier in the year.

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.”

In August, the CTA industry returned losses that turned the year-to-date performance negative. At this point, the marginal loss in the average trend system returns looks much better than returns in equity programs.

Benchmark CTA

We can see that the retracement of the past few months seems to have halted for the Trend Program. The smallest portfolio posted a gain of 1.35% while the larger portfolios lost 3.5%. So much for diversification! Still, the charts look better, showing the possible end to the retracement that has followed the exceptionally good 2014.

Futures Trend

Group DF2: Daily Divergence Portfolio for Futures

The Divergence Program posted unusually large but welcome returns in August, turning a losing year into a very positive one. Portfolios gained from 7.6% to 14.6% with the larger ones doing better. From here, it would not take much to show new equity highs.

Divergence futures

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