Kaufman Signals

August 2017 Performance Report

Industry Benchmark Performance

Positive returns for both equities and CTAs, good news for investors. Equity funds added less than 1% in August but added to the 2017 returns. They still lag the major index ETFs by 50%. CTAs also posted gains, bringing the overall CTA Index for Barclays and SG within a percent of breaking even for the year. Trend programs had the best return of 2.45% in early postings.

Blogs and Recent Publications

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

August Performance in Brief

While the Nasdaq 100 is now up 24% for the year, the broader S&P is up a respectable 11.7%, well ahead of inflation and good news for investors. Most of our equity portfolios are competitive with the S&P for the year, even though August posted a split of small gains and small losses. Our best performer was the 10-stock Timing portfolio, up 2.32% in August bring it to 9.05% for 2017. Our two weekly stock portfolios fared the worst, down about 1.3% for August, but still up 6% to 10% for 2017.

Futures were also mixed, with small profits and losses in the 3 programs. Nothing much to speak about there.

Major Equity ETFs. Another month with the stock market refusing to go down, even in the face of chest thumping about Korea, doubt about whether financial maven Gary Cohn would stay after the Charlottesville event, and anticipated Fed tightening and drawing down the balance sheet. What could possibly be the reason for this market continuing to move higher, albeit tentatively?

This month: On the Defense from Foreign and Domestic Threats

This is a case where the market seems to know more than the analysts, and acts before the government acts. The rhetoric between the U.S. and North Korea has be heating up for some time, but the prices of defense stocks have been anticipating this. The next chart shows Boeing (BA), Northrop Grumman (NOC), Raytheon (RTN), and Lockheed Martin (LMT), all moving higher over the past two months.

Chart 1. Defense stocks anticipating problems: Boeing (BA), Northrop (NOC), Raytheon (RTN), and Lockheed (LMT).

If you select stocks by trend strength, or returns, and subscribe to the principle that price strength persists, that is, strong stocks continue to be strong, then these four companies would be in your portfolio. They are all in our Equity Trend portfolios. Given the tension between the U.S. and North Korea, we can’t see the problems going away any time soon.

Fighting Amazon

It seems insightful that Jeff Bezos named the company Amazon, a reference to what we have always thought “gigantic.” It would have been hard to see where this was all going when Bezos began with books, and laughed every quarter when the financial analysts asked him “when will the company be profitable?” Who needed profits when you have a vision to take over every industry in the country, and become the middle man for all sales of all merchandise? Who woulda thought?

In Chart 2 we see the first announcement of Amazon taking over Whole Foods on June 16 followed by a formal announcement on June 23. Prices of Costco, Wal-Mart and Kroger dropped 7% to 10% during the trading session. But the reality of implementing the new policies and dealing with perishables must have started to cast doubt on Amazon’s future success. All three competitors rallied and Amazon started to retreat. Then last week, on August 24, Amazon announced a 40% cut in Whole Foods prices. Well, maybe not on all prices, but enough to take notice. Another 7% drop in Costco and Kroger followed. We understand why Kroger is weak, but we’re still not sure that Costco has the same audience. Wal-Mart seems to be rising to the occasion. Nevertheless, if Whole Foods is now more competitive, and delivers, then they will siphon business, just as iPhone manufacturers, good and bad, impact Apple’s sales.

Chart 2. The Grocery War

Each chain has a somewhat different demographics but the traditional grocery, such as Kroger, is likely to be hurt more than Wal-Mart and Costco. If you could buy a better product at Whole Foods, for the same price as Kroger, in a nicer atmosphere, where would you shop?

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 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.

The Trend Strength Index continues to weaken, which is what we would expect of the overall market. For us, this indicates that the stock market advance is supported by few stocks doing better, while a large number of stocks languish. Just like the overall economy, reports of its robustness seem grossly overstated.

We expect that a reversal in the stock market will show up soon, because the Trend Strength Indicator seems to be a leading indicator. We don’t know how much that reversal will be, but history shows that it’s already late to the party.

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 June positions:

Industrials (XLI), Technology (XLK), Utilities (XLU), HealthCare (XLV), Materials (XLB), and Consumer Discretionary (XLY)

End of July positions:

Preferred Stocks (PFF), Technology (XLK), Utilities (XLU), HealthCare (XLV), Materials (XLB), and Metals & Mining (XME)

Undervalued

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

At the end of June positions:

Preferred Stocks (PFF), Industrials (XLI), and Utilities (XLU)

We now hold:

Financials (XLF), Industrials (XLI), 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.

Small losses in stocks but slightly better gains in ETF programs leave the long-term charts looking much the same. The Sector ETF program, although not exciting, is making new highs while the other ETF programs continue their uptrend.

The Weekly Equity Program was had similar returns to the daily program, with the stock portfolios declining a little more than 1% and the ETF programs mixed. Still, 2017 returns are up between 5% and 10%, with more opportunity in the Fall.

Income Focus and Sector Rotation

August posted a small gain in the daily program and a small loss in the weekly Income Focus program. The daily program shows a consistent uptrend in equity, while the weekly program has been flattening in the past month. In the long run, they seem to come out the same.

The Sector Rotation program was flat in August, even while it is clearly in a recovery mode. This classic approach to sector selection has been disappointing, which only small gains in 2017, lagging well behind the overall market. Still, having survived across many years, we won’t give up on it.

 DOW Arbitrage

This program gained 42 basis points, beating the S&P in August and is now posting a gain of 18% for 2017, ahead of its long-term returns of about 12%. We would expect performance to revert to a more moderate gain, but this may represent a “flight to quality” by investors.

 

 

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.

Small losses in all three Equity Divergence program leaves the performance picture unchanged in August. The larger 30 stock portfolio continues to look smoother and outperforming the smaller portfolio.

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 smaller 15-Stock Equity Timing portfolio gained 2.3% in August, while the larger portfolio gained only 0.47%. That continues the upward march for the smaller portfolio and increases the spread between the two programs. The ETF program lost less than 1% and keeps its sideways 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.”

The 250K Futures portfolio gained 1.72% in August while the more diversified larger portfolios posted losses. Sometimes diversification works against you. The chart shows that the equity is still on the rise, with only the 500K portfolio yet to make new highs. The weekly program gained a small amount in the 250K and 500K portfolios, but lost fractionally in the 1M portfolio. A recovery is overdue.

Group DF2: Daily Divergence Portfolio for Futures

Mixed results in the Divergence program continues to show good returns in the 250K and 500K portfolios, but a small 2017 loss in the 1M portfolio.  This program shows more volatility due to less diversification, but remains in an upswing.

Blogs and Recent Publications

Seeking Alpha has just published “What Are the Odds?” a look at how to assess the risk of loss for any investment. The previous article was “Living Off Profits.”

Technical Analysis of Stocks & Commodities will publish a two-part article on profit-taking and resets. The first part looks at trend following systems and the second at short-term trading.

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

Modern Trader will publish “Dogging the Dow” next month and a new article “Trading Opening Gaps” in stocks, scheduled for January, 2018.

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.

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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