Industry Benchmark Performance
Another good month for the hedge fund index, but lagging 10% behind the S&P. Long-only equities did a bit better while other equity funds posted good, but lower returns. We understand that the purpose of the funds is to have steady returns and protect against drawdowns. If that works, then a lower profit in 2017 is easy to accept.
CTAs ended, on average, fractionally ahead this year. It frequently happens that a good year in the equities market doesn’t follow through into futures. Futures are best when the stock market sells off because it can leverage the downward move into sizable gains.
Blogs and Recent Publications
Find this at the end of this report. We post new interviews and reference new articles each month.
December Performance in Brief
All 28 of our portfolio finished 2017 with profits ranging from less than 1% to 32%. The average was 13.46%. We consider that an excellent year. Our daily 10-stock Trend portfolio posted 21.62% compared to SPY with 21.70%. By group, the best returns were Futures Divergence, then Daily Equity Trend, followed by Daily Timing. For those of you that follow “crisis alpha,” it was unusual for both stocks and futures to have a good return in the same year.
Even with good performance in our Trend program for stocks, we have upgraded the ranking part of our program to provide, what we hope, will be better returns with less stock turnover. The performance chart shown in that section reflects the new program.
Major Equity ETFs. A little fade in QQQ mid-month, but stocks finished strong in 2017. Nasdaq, up a remarkable 32%, followed by SPY up 21%, and IWM up 14.5%. A good year for all investors and hope that next year will also be positive.
Major Market Events of 2017 and a 2018 Forecast
This past year was filled with major events that moved the markets. We’ll review some and see if the initial reaction and subsequent price moves reflected those events. The table below gives an overview of them.
Trump Presidency, the economy, and real estate
Even with the economy doing well before the election, the major index market continued their unprecedented rise, ending with returns of 21% for SPY, 32% for QQQ, and 14% for IWM. Eliminating some regulation and anticipation of cutting the business tax, added to global optimism, kept the bull market intact. The passage of the bill in December is considered good for business but bad for real estate. Limited deductions of real estate taxes, interest on loans, and state tax may have a depressing effect on housing. The chart of two real estate ETFs since November shows weakening. Expect that to continue.
Increased tensions between the U.S. and North Korea has kept everyone on edge. While the chance of an outright conflict seems small, any chance worries people. Defense stocks, Lockheed-Martin (LMT), Northrop-Grumman (NOC), and Raytheon (RTN) show the concern. Expect this to continue.
Raising Interest Rates
The Fed raised rates three times in 2017 and expectations are for three more in 2018 and two more in 2019, yet the market is slow to react. Fed Funds rate (left below) shows that while rates are rising, they are still very low. On the right, Eurodollar futures are reflecting the rising rates, but the longer 30-year U.S. bonds and the Eurobund haven’t seemed to notice. Perhaps the economy is not as strong as the newpaper headlines indicate. With problems down the road in real estate, we don’t think the Fed will raise rates as quickly as the economists believe. Being either short or long interest rate futures could be risky. Expect more volatility than movement.
Unemployment at Record Lows
Unemployment is at the lowest level in memory, but wage growth is not impressive. Cutbacks in the financial industry and more automation are forcing workers into lower paying jobs. Still, more works with more money means they buy more as a whole. The chart below shows that retail, even as physical stores are closing, gained steadily in 2017. We expect this to flatten at the beginning of 2018.
We all know that our aging population is a boon for health care in the long term. But in the immediate future there is consolidation and concern that the elimination of the health care mandate will force a large number of people off Obamacare and back to the emergency rooms. But that’s not until 2019. The healthcare ETF HLV in the chart above shows some decline as the new tax bill becomes a reality. Certainly, the health care industry isn’t going to collapse, but we are likely to take a break from it’s steady rise. Consolidation, such as CVS buying Aetna (below) should improve margins, although investors seem to think it was a better deal for Aetna than CVS. We don’t recommend health care now because there are too many confusing factors.
Brexit and the European Economy
Brexit may turn out to be a disaster for the U.K., but it’s hard to tell yet. The drop in the British pound immediately after the exit vote marked long-term lows against the dollar. Activating Rule 50 caused another dip, but overall the British and European currencies have been stronger since June 23. The elections of centrists, Macron in France, Rutte in the Netherlands, and the reelection of Merkel in Germany has had a stabilizing effect on the European economy, a contrast to the feeling that the U.S. is not as unified. That feeling of optimism may help the U.K. get past it’s negotiation with the EU without as much blood as originally expected.
Elan Musk, Tesla, and Technology
Elan Musk represents all that is good about technology. He finances green projects, helps the poor, advocates space exploration. Most important, as Sir Richard Branson has said, “He puts his money where is mouth is.” (We’re not sure that’s an exact quote, but it’s close.) While Tesla has continued to disappoint in their schedule deliveries (as has Apple), we cannot underrate his ability to surprise. We would continue to hold companies where he is a significant participant.
Life is changing. There will be driverless cars, more online shopping, more medical innovation, more robotics. There may be fewer jobs for the less skilled, or lower pay, but there is no way to stop progress. But not all technology is equal. Amazon continues to thrive, but Alibaba is more hype than return. We continue to be concerned about Chinese companies, and the possible lack of control over their method of operation and their disclosures. We would stay with Amazon and Facebook, not Alibaba or Bidu, but they could be very volatile.
Finally, we come to irrational exuberance in cryptocurrencies. Below are charts of stock prices and volume in 2017, plus volume in the new CBOE futures contract. Buying BTC-USD when futures began would now show a 30% loss on declining volume. But that’s not the point. If you bought when BTC was listed, you are up at least 17,000%. Not too many investors did that.
Should you invest now? We don’t think so. We’re concerned about the lack of regulation, the counterparty risk, and the fundamentals in general. We understand the argument that some people feel that our currencies are manipulated by the Fed, and for sure that’s true. But our currency is also based on our balance of trade, rate of inflation, and political stability. Those factors attract foreign investment that strengthens the dollar, or, if we’re not competitive with some other countries, our dollar weakens. But what is the basis for Bitcoin? It seems to be simply a speculative item, not tied to anything physical, and cannot be arbitraged. Can we actually buy a shirt at Wal-Mart for $14.99 using a Bitcoin? Not really. We would recommend avoiding any cryptocurrencies until we understand more. Yes, you may miss a return of 1000%, but you may also miss losing your entire investment.
Top: BTC-USA, Center: Bitcoin volume, Bottom: futures volume
We think 2018 will be a good year for the stock market, based entirely on the reduction in the business tax. Earnings should increase, and companies will buy back stock. Workers should see some benefit, although the “trickle-down” approach has a poor history of success. We don’t see as many interest rate hikes as the economists, but if they do occur, it will be because the economy looks strong. The weakest sector we see is housing, the result of changes in taxation. The riskiest is Bitcoin, but you know that.
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 remains strong, so there is no ominous sign that the broad market is about to crash. On the other hand, the TSI is nearing all-time highs, so an upwards surge in prices isn’t likely. We could see the Index decline as momentum stabilizes, without indicating a stock market reversal. Because this index leads the market, we would expect a clear drop of 40 points in the TSI to indicate a sizable reversal in stocks will follow.
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 November we held:
Materials (XLB), Industrials (XLI), Technology (XLK), Utilities (XLU), HealthCare (XLV), and Consumer Discretionary (XLY)
At the end of December we held:
Materials (XLB), Industrials (XLI), Technology (XLK), Consumer Discretionary (XLY), Financials (XLF), and Metals&Mining (XME)
The Timing Program buys 4 ETFs that are undervalued with respect to SPY, in expectation of rotation.
At the end of November we held:
Energy (XLE), Technology (XLK), Healthcare (XLV), and Metals & Mining (XME)
At the end of December we held only two positions:
Reit (VNQ) and Utilities (XLU)
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.
PLEASE NOTE: As mentioned earlier, we have changed the ranking algorithm for the Trend Program for Stocks with the goal of increasing returns and reducing the switching of stock positions in the portfolio. We do this as part of our continual research and monitoring effort.
Gains in all portfolios, with the 10-stock up 3.2% and the 30-stock up 1.7%, both beating SPY. Returns for the year were in excess of 21% for both portfolio, in-line with SPY returns but with more risk control. The ETF portfolios were up 10%, beating their long-term expectations. Even the portfolio that buys the 6 strongest sectors was up over 14%. By all standards, a good year.
In a normal year we would be please with the 11% and 19% returns for these weekly equity portfolio, but this year it seems disappointing. We expect it to make it up during a year when the overall market is not strong, but stock selection can still show outperformance.
Income Focus and Sector Rotation
A disappointing year for Income focus, with the Weekly program gaining only 3.12% and the Daily program, less than 1%. This program does depend on the income being greater than a negative move in rates, which it did achieve. If rates drop, then this program benefits both ways.
The classic Sector Rotation program had a rough year recovering from an early drawdown. It does seem to be back on track and posted small gains for the year. We’ll see if it can continue the uptrend in 2018.
Our second best portfolio this year, the Dow Arbitrage gained 30% and is clearly in an uptrend. We’re going to allow alternative hedging using SPY and DIA, which would be more efficient even if not necessarily as profitable. We should have that by next month.
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.
Although slightly underperforming this year, the Equity Divergence program continues to look good. It’s unusual that the larger, 30-stock portfolio has outperformed the 10-stock portfolio, but this is a case where more diversification was better. The ETF program continues to creep higher, 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.
The Timing Program finished the year with the 15-stock portfolio beating all other programs that we offer, up 32%. The larger 15-stock portfolio lagged with nearly 16%, mostly due to the lack of additional markets to trade that satisfied the conditions. The 4-ETF program, that buys oversold ETFs, finished the year up 5.8%, higher than it’s long-term average return. Overall, a great year for Timing.
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 Futures Trend programs all finished well ahead of the Industry, as seen in the Benchmark Performance earlier in this report. The Daily Program varied considerably from one portfolio to the other, due to an increasing number of markets being traded. The $250K portfolio returned the most, at 18%, the $500K returned the least, at 7.9%, and the largest $1 mil returned 12%. Overall, a good year and good diversification for equity portfolio.
The Weekly Program struggled all year, after a poor 2016. It did finish higher, from fractionally for the $1 million portfolio, to 4.3% for the $250K portfolio. We would like to think that the turn up in the past few months will continue into the new year.
Group DF2: Daily Divergence Portfolio for Futures
A quiet month for the Futures Divergence program, with all portfolios fractionally higher and lower. This program had the most consistent returns across the three portfolios, up 18% to 24%, an outstanding year and well above the long-term average. It continues to be volatile but offers excellent diversification.
Blogs and Recent Publications
There is a new interview on YouTube conducted by Alex Gerchik for his Russian audience. We think you will find it enjoyable and helpful. The link is:
Mr. Kaufman is participating in Jack Schwager’s FundSeeder webinar, which should be aired in January.
Mr. Kaufman will be a speaker at the Money Show Expo in New York at the end of February.
He will give a 3-day seminar in Chicago, March 5-7, on developing a successful trading strategy, sponsored by the Chicago Institute of Investing. It will be in English and Chinese. For more information contact Katie.Tian@chicagoii.com.
Technical Analysis of Stocks & Commodities published Part 1 of a two-part article on profit-taking and resets, in their January issue. The first part looks at trend following and the second at short-term trading. Part 2 is scheduled for the February issue. Before that, they published “Optimization – Doing It Right,” in the September issue.
Mr. Kaufman was a Keynote Speaker at the IFTA annual conference, hosted by the Swiss technical analyst’s association (SIAT) held in Milan, Italy, in October 12-16, 2017. A video of the presentation has been posted on the IFTA website.
“Portfolio Risk in Uncertain Times” was just posted on Seeking Alpha. It shows a better way to structure your portfolio. Prior to this, you will find “Living Off Profits,” which shows how much you can safely withdraw from your account without seeing spiral down out of control. Before that Seeking Alpha published “What Are the Odds?” a look at how to assess the risk of loss for any investment.
Modern Trader published “Dogging the Dow in the current edition, and a new article “Trading Opening Gaps” in stocks, scheduled for January 2018.
The IFTA Journal published an interview with Mr Kaufman in the most recent quarterly issue.
The broker FXCM will post a live interview with Mr Kaufman, taped on October 30.
ProActive Investor Magazine published Keeping Risk Under Control on June 22. Check their website. It will be publishing other articles later this year.
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 (https://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 email@example.com.
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