Industry Benchmark Performance
Barclays CTA Index showed a preliminary loss of -0.34% for systematic traders in December, and a loss of -1.68% for 2015. Long bias hedge funds show a gain of 0.19% for December and 2.84% for 2015. Fund of Funds posted a loss of -2.07% in December and -1.55% for the year. We were unable to capture the Futures performance as of this date.
December Overview: What Happened to the Christmas Rally?
Our forecast of “more of the same” seems to be depressingly correct. The expectation of a Fed rate hike was in the market, so there has been only a slight move to higher yields (see the Crude and Bond chart below). If you use a ruler and a magnifying glass, you can see the slight decline in the 30-year bond futures. Crude, said to be driving the market (although it’s hard to understand why), is looking for a bottom somewhere under $40 per barrel. It’s still too early to predict the bottom, but we don’t expect prices to go much lower. At some point even the Saudis, who have raised gas prices 50% locally, to just under $1 per gallon, will find low prices unsustainable for the Mideast economies. The Saudis posted a $98 billion deficit this year, and expect a similar one next year, all because of lower oil prices. The combination of rising energy costs and higher yields seem to be enough to offset the positive news in the U.S. economy, and we expect a continuation of the sideways equity markets. Investor sentiment has the final say. The highly reliable Christmas rally just never happened.
Throughout 2015 we have traded in and out of the “FANGs,” Facebook, Amazon, Netflix, and Google (or “Alphabet” if you prefer). The chart below shows the long-term history on the left and 2015 (rescale and indexed to start at 100) on the right. Note that we’ve separated Amazon and Google (using the left scale) from Facebook and Netflix (the right scale) so that we can see the similarity of the rallies in the past few years. Our portfolio selects candidates by performance, and these four markets have clearly performed, that is, up until the past few months.
In the right chart below, all of the FANGs are creeping higher, but certainly not at the rate of the past few years. Netflix has shown high volatility, making it difficult to sit tight and hold that position through ups and down. Even Google and Facebook are tracking quietly, which may cause them to be replaced by other more aggressive stocks. All in all, it’s made for a bumpy performance over the past few months, but the net result was similar to the broad market indicators.
Can we expect these four stocks to outperform in 2016? Trying to view this with a simple concept, we ask ourselves “Why isn’t Apple part of this group?” It wasn’t long ago that Apple was the main focus. Our conclusion was “maturity.” As companies mature in both products and price, they have a harder time maintaining the flow of new products and continuing to produce returns at the same rate. We see that as a problem for Amazon and Google, although not as much for Netflix and certainly not for Facebook. Facebook is still in the development stage. Although there are rumors that Amazon plans to take over the world, we think that the boulder they are pushing uphill will get bigger and bigger. While it may be difficult to see it now, competition inevitably dilutes, as it has with Apple. As good as the iPhone is, Samsung and other competitors will gain market share, slowing Apple’s growth. It will happen to Amazon, although there are no immediate threats.
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 do it will volatility that his higher 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.
December System Performance
December was a pivotal month, and for the majority of portfolios the loss turned year-to-date profits into year-to-date losses. While a losing year is part of the process, we would rather have profits all the time.
It wasn’t all bad news. The Daily Stock Divergence program posted returns of 7.44% and 1.80% for the 10 and 30 stock portfolios; The small Timing portfolio netted 4.30% for the year, and the Weekly Stock Trend program posted 3.14% and 0.16% for the 10 and 30 stock portfolios.
Futures didn’t fare as well, losing about 7% in December, turning all portfolios negative. The CTA industry also posted negative returns for the year, but that followed an exceptionally strong 2014, so that a small loss doesn’t change the big picture of long-term success
We’ve always stressed strategy diversification over market diversification. The major broad market indicators, SPY, QQQ, and IWM show how closely equities track. Even unrelated stocks will move together after a surprising economic report or geopolitical event. If we take our three equity strategies, Trend, Divergence, and Timing, and combine the smallest portfolios equally, this year would have returned 3.38%, somewhat better than the SPDR SPY of 1.24% or even the average of SPY, QQQ, and IWM, which was 2.06%. Not enough to retire on, but still a gain for 2016.
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 bigger picture for 2015 shows the equity trends weakening from a peak above 60 in May 2014 to near -60 in September/October 2015. That led the SPY by nearly one year and continues to show a neutral weighting for stocks trends, indicated by a value of zero for the Trend Strength Index. We use that to confirm our view that the overall equity markets will continue sideways.
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 Trend Sector ETF program buys the 6 strongest sectors of the SPDRs. December started long Preferred Stocks (PFF) and Consumer Discretionary (XLY), and Technology (XLK). We’ve switching in and out of Technology all month, and ended December with only Munis and Retail, hedged 1/6 because the short-term trend for SPY is still down.
Municipal bonds (MUB) and Retail (RTH)
The Timing Rotation program began December long
Preferred (PFF), Reits (VNQ), Oil & Gas Service (XES), Technology (XLK), Staples (XLP), Utilities (XLU), and Consumer Discretionary (XLY), all hedged 17% (1/6) of the risk using SPY:
It exited Preferred (PFF), Reits (VNQ), Oil & Gas (XES), Staples (XLP), and Utilities (XLU). It now holds only 4 positions, and is still hedge 17% (1/6) using SPY.
Materials (XLD), Technology (XLK), Staples (XLP), Industrials (XLI), and Consumer Discretionary (XLY), all hedged 17% (1/6) of the risk using SPY:
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.
Our hopes for new highs in December didn’t materialize and we posted losses, most of them small, for all Trend portfolios, resulting in small negative returns for 2015. The smaller 10 stock and 10 ETF portfolios fared better than the bigger ones and the sector ETF program lost the most. This past year has been one of sharp drops followed by sharp recoveries, a pattern not compatible with trend following. The sharp drop cause positions to be closed out but there is a lag in resetting those positions in order to control the risk. We consider small losses as a good outcome in this type of market, even though we would all prefer profits.
The Weekly Stock did much better than the daily program, with both the 10 and 30 stock portfolios posting gains for the year. In this case, the Weekly program avoided reacting to some of the erratic, volatile price moves, resulting in smoother overall performance. The ETF programs posted modest losses, working with a much more limited set of products.
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 posted a small gain in the 10 stock portfolio and a small loss in the 30 stock, but both returned net gains for 2015. The 10 stock was up by 7.44% for the year, the best of all our portfolios, while the 30 stock was higher by 1.80% for 2015, beating the SPY benchmark. The ETF portfolio was quiet, returning a loss of 2.92% for 2015, net of fees, but continues to look slow but steady.
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 Timing portfolio netted a 1.30% gain in December and 4.30% for 2015, even though the past few months were hedged from 17% to 66% using SPY and QQQ. Neither the 30 stock portfolio nor the ETF Sector Rotation portfolio did as well. Remember that the Timing program buys undervalued stocks compared their benchmark index and when prices continue to fall those stocks may not rebound as quickly.
December showed another reversal in the Trend program, posting losses in all portfolios and turning a profitable year into a modest loss. While the Divergence program did much better in December, it also returned losses in all portfolios. While the strength in the U.S. dollar and weakness in the energy markets provided good returns during the year, those markets turned sideways in the past few months, leaving very few long-term trends anywhere in the futures markets.
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 would normally expect the larger portfolios, which are more diversified, to do best, but this year the smaller portfolios posted the smallest losses. The charts below show a common picture in trend following, a very large gain in 2014 followed by a drawdown in 2015. The benefit of systematic trading is that it keeps these drawdowns to a minimum even though they can’t be avoided.
Group DF2: Daily Divergence Portfolio for Futures
The performance in the chart below represents the historic returns of the new portfolio. The performance shown in the Summary Table at the beginning of this report is performance tracking, which posts the daily returns of the current positions. The tracking will reflect the new portfolio performance going forward.
The new Divergence portfolio held up nicely in December with a modest loss in the smallest, less diversified portfolio, and small gains in the larger portfolio. The returns for the year were still losses but within expectations for futures. The overall picture, as seen in the chart below, shows that there is a volatility, but a tendency to move higher.
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