Industry Benchmark Performance
Equity returns continue their unprecedented gains, although funds are posting less than half of the S&P. CTA returns are also showing gains, driven mostly by the interest rate markets. Only four months to go and traditionally good months for the market.
Kaufman’s Fast Strike Systems on MetaStock
If you are interested in short-term trading, look at Kaufman’s Fast Strike strategies. Contact MetaStock at 800-882-3040 or go online to www.metastock.com/kaufmana. This link is now working!
As of August 27 our system tracking had the following results for a sample of futures markets and Equity Index ETFs, and you can choose your own markets to trade.
Blogs and Recent Publications
Don’t forget our new book, “Kaufman Constructs Trading System.” You can find it on Amazon or on our website, www.kaufmansignals.com.
Find recent publications and seminars at the end of this report. We post new interviews and reference new articles each month.
August Performance in Brief
Almost all portfolios posted good gains in August, the exception being the Income Focus program which continues to fight against traders pushing rates higher. Our Weekly Equity Trend program continues to outperform the Daily Trend, but markets change. The Timing program continues to creep higher, but the most consistent program has been the Futures Trend portfolio, all up about 20% for the year.
Once again, the stock market fools us. It looked as though Nasdaq (QQQ) was flattening last month, but it has taken another step up. The S&P also shows a nice upward trend, while the Dow is now lagging and the small caps (IWM) have not made a new high since early this year.
We thought that stay-at-home stocks would go sideways as shoppers prefer to visit stores, but that is not the case. Technology seems to be consistently good.
CLOSE-UP: Trading Inflation
Traders think that inflation is here to stay while the Fed says it’s “temporary.” What we know is that many products are more expensive. That also translates into volatility, a chance to profit as prices come down, or go long if we see prices continuing higher. Which will it be?
So far, lumber has been the most volatile. The cost of lumber has driven up the price of new houses, its primary use. Lumber prices have dropped back to their old levels, shown in Figure 1. As of the last week of August, it was $482, off from $1,650 and not much above “normal.”
Figure 1. Lumber cash prices (source CME).
If new homes are selling at much higher prices because of lumber (and copper), and lumber prices have fully corrected, what has happened to the price of houses? The largest home builder, Lennar (LEN), and a smaller home builder, KB Homes (KBH) are shown in Figure 2. Lennar has gained significantly and shows no sign of declining, while KB Homes lags far behind and is showing some weakness.
Figure 2. Price history of Lennar (LEN) and KB Homes (KBH).
One lesson that I learned in the oil business is that gas stations raise prices quickly when they pay more for gasoline supplies, but they are slow to lower prices as their own costs decline. Given the chance, I expect most businesses will do the same. Home builders will continue to benefit from the move away from the city until buyers realize they have overpaid, or bought before doing their homework. As a consumer and as a trader, it is easy to buy and hard to sell.
Copper is the second biggest materials cost in home construction, and prices have rallied from $200/ton to nearly $600 in the past year (Figure 3). But copper is also in demand for green energy. It is used for solar panels, wind turbines, electric cars, and batteries, in addition to plumbing. China is the biggest consumer of copper, buying nearly half the ore mined each year.
It is possible that copper prices will fall on lower housing demand but be offset by new usage. There are also the known unknowns: China buys 50% of copper ore and does not disclose their inventory or their usage. Then we cannot expect copper to decline significantly, and a new high will look like the beginning of another leg up.
Figure 3. Copper prices.
The last important factor is labor. Labor costs are rising, in construction, in tech business, and even at Walmart, from $9/hour to $15/hour, plus free college. It is a combination of luring workers back and recognizing that they need a living wage. That cost is not likely to decline.
This means that the cost of building a home will decline, and the demand will decline, but the price will be higher than a year earlier. At some point, the home builders will have more inventory than they want and be forced to sell at a lower price, cutting their profits. I could see LEN prices dropping to under $80 and KBH back to $30.
Food and Other Stuff
Housing is not the only obvious sign of inflation. We see prices higher at the grocery store, car dealers, and even gold. To get a broad look at commodities, we use the Goldman Sachs Commodity Index ETF (GSG). But Figure 4 hardly looks like inflation, which is odd because it has weighted energy as more than 50% of its value (see Figure 5). It shows that our idea of inflation is very selective.
Figure 4. Goldman-Sachs Commodity Index ETF (GSG).
Figure 5. Weighting of the GSG.
To get a broader look at inflation, we will select items that are easy to understand. How about beef? The cost at the market is a combination of feed (usually corn) and finished cattle (traded on the CME). Figure 6 shows the cash prices of corn, and Figure 7 the cash prices of cattle.
Figure 6. Corn cash prices.
Figure 7. Cattle cash prices.
What do we see? Feed corn has rallied sharply, which should be reflected in the cost of cattle 6 to 9 months later. $7 corn is a farme’rs dream, but prices have started declining to about $5.50. We’ve been there before, and it tends to be a short-lived spike. Because crops start all over each year, shortages tend to disappear. We expect prices to retrace to about $3.50/bu.
Cattle is different. Prices have been rising for the past 10 years. If we ignore the peak in 2014, it still looks as though it will settle at $1.00 to $1.20/lb, higher than the $0.70/lb we saw from 1980 through 2003.
One last look at the cost of bread. We judge the price by the Hard Red Winter Wheat contract traded in Kansas City, not the CME Wheat contract that is used for feed. Figure 8 shows a sideways, if volatile, price pattern. While there is a recent peak, it is nowhere near previous highs. If the price of bread is higher at the grocery, it is going to be labor in processing the bread and higher labor costs delivering it to us.
Figure 8. Cash wheat prices.
U.S. Dollar and Interest Rates
Now we come to what I think is the real indicator of inflation, the value of the U.S. dollar and interest rates. If the dollar strengthens, we pay less for imported goods, and the U.S. imports a great deal of what it consumes.
Interest rates are another matter. Higher rates are negative for consumers and companies, especially for new home buyers and companies looking to refinance. Higher rates are a drag on the economy but dampen inflation, which is why the Fed would raise rates. But they have not.
Figure 9 is the U.S. Dollar Index, a weighted average of the dollar-cross major world currencies. Before the European Union, the dollar was very strong. It touched a low point as the euro currency was created in the mid-1990s. It rallied during the late 90s when investors ploughed money into the U.S. markets to trade what would turn out to be the internet bubble. Afterwards, the dollar declined with Nasdaq. Where is it now?
For the past 5 years, the dollar has been steady. It has declined slightly with the Covid outbreak but is firm now. It is generally stronger compared to the period following the financial crisis of 2008. That does not indicate that we are paying more for imported goods.
Figure 9. The U.S. Dollar Index.
Then there is a lot of talk about higher interest rate causing inflation and depressing the stock market. Figure 10 is the TNX (10-year note) ETF. Yes, rates have rallied but they are still very low, just over 1% for a Note that you need to hold for 10 years. This maturity is also the basis for most mortgages.
Figure 10. The 10-Year Note ETF (TNX) shows the yield.
Most of the costs we have discussed above look temporary, if they show anything at all. A spike in corn and wheat affecting the price of cattle, a rally in some commodities (such as copper), but not in a basket of commodities. An unchanged U.S. dollar and low interest rates (although slightly higher than a year ago). So where is the inflation that we see everywhere?
I can only conclude that it’s labor. Higher labor costs will keep prices for finished products higher than before, essentially forming a new base price. That is a structural change. It is unlikely that we will see labor costs decline. In my view, that is the root of any lasting inflation.
What Do We Do?
As a trader what does this mean? I am taking the side of the Fed – mostly. Costs will come down, but not completely because labor has caused a structural change and supply is not up to full steam.
As for trading, the stay-at-home stocks are uncertain. They should maintain their current value, but it is not clear if there is a reason for them to move higher. Customers are now split between going to stores and shopping online.
Waiting for a pullback seems to be the best strategy. Demand will ease, many of the costs will decline, and there should be a better opportunity to take long positions in most markets. Remember that we are not forced to enter. We can wait. Once in, it is always more difficult to get out.
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 equity portfolios. Our work over the years shows that downturns in the stock market are most often short-lived and it is difficult to capture with a longer-term trend. The upwards bias also works against shorter-term systems unless using futures, which allows leverage. Our decision has been to take only long positions in equities and control the risk by exiting many of the portfolios when there is extreme volatility and/or an indication of a severe downturn.
PORTFOLIO METHODOLOGY IN BRIEF
Both equity and futures programs 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 on the specific system, 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 outperforming 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 since are simulated but the returns from 2013 are the systematic daily performance added day by day. Any changes to the strategies do not affect the past performance, unless noted. The system assumes 100% investment and stocks are executed on the open, futures on the close of the trading day following the signals. From time to time we make logic changes to the strategies and show how the new model performs.
Groups DE1 and WE1: Daily and Weekly Trend Program for Stocks, including Sector Rotation, Income Focus, and DowHedge
The Trend program seeks long-term directional changes in markets and the portfolios choose stocks that have realized profitable performance over many years combined with good short-term returns. It will hold fewer stocks when they do not meet our conditions, and exit the entire portfolio when there is extreme risk or a likely drawdown.
The charts below show that the Weekly Trend program is recovering, now up by 19% and 16%, slightly better than the major equity index markets. But the Daily Trend program is at extremes, with the 10-stock portfolio off by 8% while the 30-stock portfolio is ahead by 32% this year. Why the difference? Tech stocks!
Three of the four Equity Trend portfolio have returns better than the 21.5% posted by SPY, but the benchmark 10-Stock Daily Equity program is still recovering from its drawdown. Normally, the smaller portfolio has higher returns and more risk. This year is clearly different, but we are still optimistic that we will end the year with a nice profit.
Income Focus and Sector Rotation
Small losses in both the Daily and Weekly Income Focus portfolios shows that the fight with higher rates is not yet over, even while the Fed stands firm on not raising rates.
Performance is stabilizing at a gain of 19.5% this year, after a spectacular run. We have no idea what will happen for the remainder of the year, but this market seems to focus on one sector at a time. That would be good this program.
A gain in the daily program and a loss in the weekly, but both sill hold an 8% to 10% gain for the year. This program has had steady performance for years and is fast to recover from a drawdown.
Group DE2: Divergence Program for Stocks
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.
Another month of gains from about 3% to 4% makes the Divergence chart look like a renewed uptrend. This short-term trading system looks for pauses in an uptrend to take advantage of the continuation of that trend.
Group DE3: Timing Program for Stocks
The Timing program is a relative-value arbitrage, taking advantage of undervalued stocks relative to its index. It first finds the index that correlates best with a stock, then waits for an oversold indicator within an upwards trend. It exits when the stock price normalizes relative to the index, or the trend turns down. These portfolios are long-only because the upwards bias in stocks and that they are most often used in retirement accounts.
Are we about to add another upwards leg to the Timing performance? The program gained 1% to 2% but both the 10- and 20-stock charts looks promising. This program looks for undersold stocks relative to a major index, so it often ahead of the rest of the market.
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 down 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.
Please read the report describing our revised portfolio allocation methodology. It can be found in the drop-down menu under “Articles.”
Good returns for August and all programs ahead by about 20% for the year. As expected, the smaller portfolios are farther ahead but also have the greatest risk.
Group DF2: Daily Divergence Portfolio for Futures
Mixed returns with the smaller portfolios posting modest losses and the $1M portfolio a 1% gain. This erratic pattern keeps going. The swings are due to fewer markets that qualify for a signal, so the program has less diversification and more volatility.
Blogs and Recent Publications
Kaufman Constructs Trading Systems
You will find both an ebook and a print version of Perry’s new book, Kaufman Constructs Trading Systems, published on Amazon. It is a complement to Trading Systems and Methods. It takes you step-by-step through the process of developing a trading system, with many examples. Order it through our website, www.kaufmansignals.com or directly on Amazon.
Trading Systems and Methods, Sixth Edition
The sixth edition of Trading Systems and Methods was released at the end of 2019 by John Wiley. It is completely updated and contains more systems and analyses.
Australia in November
Mr. Kaufman will be speaking to a live group at the TradeView conference in Melbourne, Australia in late November. That is, if they are allowing travelers into the country! He will be covering a wide range of topics and presenting some new strategies.
For those practicing their Spanish, Mr Kaufman has an article being published in Hispatrading, an on-line Spanish technical analysis magazine. It is about how to execute a trend-following strategy.
There are two pending articles to be published in Technical Analysis of Stocks & Commodities. The first, “50 Years On,” is a recap of the most important lessons learned by Mr. Kaufman. The other article, “Trading a Moving Average,” looks at two key moving average rules as well as how to time an entry. We have no dates yet for the publication.
“Playing It Safe with Cryptos” appeared in Technical Analysis of Stocks & Commodities. It’s a challenge trying to trade these markets given their extreme volatility.
Mr. Kaufman gave a 30-minute presentation, “Lagged Trends,” for The Money Show on Tuesday, May 11. You can see it using the following link:
There are new articles being published in Technical Analysis of Stock & Commodities. The next one is “Better Entries,” scheduled to appear in the May issue.
Mr. Kaufman will present to the technical students at the Universidad Politecnica de Madrid on February 3, 11 am CST. He will discuss risk and offer advice that comes from years of trading.
Technical Analysis of Stocks & Commodities published an article on Short-Term Patterns, with lots of computer code so that you could do it yourself.
November 1, he taped a session with Andrew Swanscott’s BetterSystemTrader.com
November 18, he presented a webinar on trading to the Italian bank, Fineco, this time in English.
November 27, he presented another webinar to Fineco subscribers in Italian.
Mr. Kaufman appears as a chapter in Mario Singh’s book, Secret Conversations with Trading Tycoons, published by FXI International.
Older Items of Interest
For older articles please scan the websites for Technical Analysis of Stocks & Commodities, Modern Trader, Seeking Alpha, ProActive Advisor Magazine, and Forbes. You will also find recorded presentations given by Mr. Kaufman at BetterSystemTrader.com, TalkingTrading.com, FXCM.com, systemtrade.pl, the website for Alex Gerchik, Michael Covel’s website, TrendFollowing.com, and Talking Trading.com.
“The 1st and 2nd Cross” has been very popular with readers. It was published in Technical Analysis of Stocks & Commodities in the March 2020 issue. It is based on an idea of Linda Raschke and captures small but reliable pieces of a trending move. You can find it online.
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