Kaufman Signals

December 2018 Performance Report

Industry Benchmark Performance

Early reporting shows that hedge funds, in general, performance on a par with the SPY, the broad index. Long-only equity programs, similar to ours, fared worse, although our benchmark 10-stock portfolio netted a gain for 2018.

Futures did better, with the CTA index posting fractional gains. The SG Trend Index, a more realistic measure, shows trend systems down 7.82% for 2018, the bulk of what is being traded by the large CTAs. Short-term did better, but lack of liquidity makes it difficult to put enough funds into that strategy to affect the final performance.

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

No one is immune to a fast, steep market correction, especially if you are long stocks. Our programs did better than the broad market indices, but only one program ended up for the year.

Our futures divergence portfolios all showed gains, but overall futures performed only slightly better than stocks. This is the year we would  hope to see “crisis alpha,” where futures gained enough to offset the loss in equities, but patterns are all different and futures were not able to capitalize on the downturn.

For 2019, most of our portfolio did better than the S&P, and our benchmark 10-stock Trend program ended with a gain of 4.72%. Weekly futures had modest gains in 2 of the 3 portfolios.

Major Equity ETFs. History did not prove to be on the right side of the December equity move. Losses ranged from -8.5% in the DOW (DIA) to -12% in the small caps (IWM). When investors exit the market, they tend to start with the small caps, then NASDAQ (QQQ), then the S&P, and finally the DOW. That was the pattern in December. For the year, QQQ was essentially even after testing the highs on October 1st, when it was up 20% for the year.

The VIX index jumped as prices started falling. In December it peaked at 36%, much the same as at the end of January. While it is now declining, it is symbolic of the nervousness in the market.

The VIX Index for 2018

CLOSE-UP: First, a Look Back, Then a Look Ahead

We’ve seen worse, a lot worse. Look at the crash of October 1987, the end of the internet bubble January 2000 through 2002, the financial crisis of 2008. For the past 10 years we have had one of the most sustained bull markets of all time. We can get complacent and see corrections as disasters instead of opportunities, given some systematic rules that help confirm our timing.

Last month we emphasized that letting the price tell you what to do was the safest plan. We showed that the emerging markets could have given buy signals throughout the year, but there was really no confirmation of an upturn. We’re still waiting, as seen in Figure 1.

Figure 1. Emerging market ETF EEM from January 2018, now through December

The problem with bottom-picking is that you are wrong far more often than right. Trend following has a very similar pattern with some exceptions. It provides discipline, so that it will wait for a new uptrend but get out with a small loss if the uptrend doesn’t develop. And, it will keep trying and not get discouraged until it captures that new trend. Discretionary traders find it more difficult to do that. Long-term trend following has a low percentage of good trades, but a very big payout when it’s right. That’s a profile you’ll need to learn to live with for long-term success. So, are we ready to buy EEM? Not yet.

And Facebook (FB) was in a decline. It still has lots of customers and may be undervalued by some measures, but it shows no sign of a turn up. We’re still waiting.

Figure 2. Facebook is still declining

On the other hand, interest rates told a different story. Yields had already reflected the trader sentiment that the Fed was near the end of their tightening. First there was increased volatility following a rate hike, then there was a clear disagreement between the Fed and the market. Interest rate futures were all moving higher while the Fed still pondered raising rates. Figure 3 shows that the market is still pressuring the Fed to stop, even after the recent hike. As a trader, a move from 138 to 148 is good. It may be time for a pause. If the stock market recovers, the Fed may raise rates one more time; otherwise, not likely.

Figure 3. Eurodollars versus 30-year bonds futures.

The Year that Was

Without trying to make light of a losing year, Figure 4 shows four years before the start of the bull market. While 2008 was nasty, combining 2000, 2001, and 2002 totaled a loss of 43%, even larger. So, a loss this year of less than 5% isn’t impressive. If we can recover from those other losses and even put them out of our mind after the 10-year bull market, we can survive 2018. It’s time to think about 2019.

Figure 4. Losing years since 2000.

Looking Ahead

The one thing we know about 2019 is that the politicians will be trying to convince the voters that the economy is thriving. The year before the election year is traditionally the best year for the stock market, even though it has not been quite as strong since 2000. Elections are won and lost on the economy, a lesson learned by Bush senior. We would hope there would be positive moves on both sides, each taking credit for good things rather than blaming the other for bad things.

The biggest factors will be a resolution of the trade war with China and the action or inaction of the Fed. There are dozens of social issues, immigration, and defense alliances, but those we see as relatively minor for voters. It’s what goes into and out of their pockets that are most important. “It’s the economy, stupid!”

It would be nice for us regular people if the politicians tried to out-do each other to bring about good things. Trying to stop the other party from succeeding doesn’t satisfy anyone. But perhaps I’m too optimistic.

Look for a positive year, although not anything unusual. There are possibilities for high volatility from time to time, most likely around current government shut-down, then the vote on the debt ceiling (silly because we’ve already spent the money we didn’t have), and then if Mueller releases a report on his investigation. But those should be short-lived because they are not about the economy.

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.

Volatility at the end of December matched the late January sell-off, but the Trend Strength Index shows that the SPY is far weaker now than in January. The low reading of about -50 matches the historic low of the index occurring in the Fall of 2015 on much smaller reversals. This indicates the depth of the downturn, affecting many more stocks now than in the past. As it stands, the index should stabilize here. Unfortunately, we don’t have more actual history, so we’ll need to keep monitoring it. It’s never good to buy as prices drop, so missing a small rally to get a confirmation of an upturn is always a better plan.

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.

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 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, including Sector Rotation, Income Focus, and Dow Arbitrage

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.

A sharper decline in December turned all major index markets negative, but the 10-stock Daily Trend held on to a gain of 4.7% for 2018. Other equity portfolios netted a loss for the year, but most did better than the broad market. While not the result we want, it puts us in a position to recover sooner.

It is worth mentioning again, that during a downturn, the portfolio strategy seeks stocks that perform better in these markets, which are usually conservative companies. In this case we are holding Coca Cola (KO), McDonalds (MCD), and Merck (MRK) among others. If the market recovers quickly, our performance will lag as well, but we feel that it is a better trade-off for losing less.

Income Focus and Sector Rotation

Fighting a market of rising interest rates is not a good scenario for this program, but keeping losses small is a good outcome. We expect this program to be back on track as interest rates stabilize.

While not posting impressive returns for a while, the Sector Rotation program gained 2.2% in December, offering some diversification. With a little consistency in the market, this program could move higher in 2019.

DOW Arbitrage

There is no place to hide when the market sells off. Traditionally, investors seek the “blue chips” when there is risk or uncertainty. In this case, the DOW performance tracked the S&P very closely in 2018. This program has a pattern of recovering faster than the overall market, so we’ll be watching in the next few months.

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.

The Equity Divergence program didn’t do any better or worse than the other portfolios, losing in December and posting losses for 2018. The larger 30-stock portfolio is looking much smoother than the smaller portfolio. We’ll see what pattern shapes up during a recovery.

Group DE3: Timing Program for Stocks

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.

This program hedges a maximum 50% of the exposure in three steps as prices turn down. During December if was short two of the three legs for SPY and QQQ, and all three legs for IWM. Even with the hedge, it seeks out trades that have a history of being profitable. The result is that the system lost slightly more than 2% this year and does not show the big drop in equity seen in the other portfolios.

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.”

We like to think that “crisis alpha” means that whenever the stock market goes down, futures go up. That may be for the equity index futures, but a diversified portfolio of futures, no matter how cleverly constructed, will dilute the equity results. Both daily and weekly Futures Trend program lost less than the stock market, but also had mixed results for 2018. The daily program had net gains in the $500K portfolio, and the weekly program gained 4.8% and 9.2% in the $250K and $500K programs. The largest portfolios netted a modest loss.

Group DF2: Daily Divergence Portfolio for Futures

All three Futures Divergence portfolios posted gains from 1.4% to 3.5%, a pleasant change to the equity results. Even with that there was a modest net loss in all portfolios. We look forward to better performance in 2019.

Blogs and Recent Publications (for the past 12 months)

Changes in the KaufmanSignals.com website

We are in the process of a long overdue upgrade to our website. We will regroup our daily and weekly products, and add short-term strategies, and make it easier to navigate. Stay tuned.

MetaStock Strategies

MetaStock will be offering a program with four of Mr. Kaufman’s short-term trading strategies for ETFs, stocks, and futures. They should be available now but are running late.

Book Interview

Mr. Kaufman appears as a chapter in Mario Singh’s new book, Secret Conversations with Trading Tycoons, published by FXI International.

January

Technical Analysis of Stocks & Commodities will publish “Volatility: What They Don’t Teach You In Grad School,” in the January edition.

December

An article appeared in ProActive Investor Magazine looking at all calendar patterns, including the Santa Rally, the Presidential Cycle for 2019, the January and May effect, and seasonal patterns in ETFs.

In January Technical Analysis of Stocks & Commodities will publish an article showing the real relationship between price and volatility, which will surprise you. It should change the way you size your positions.

October

Mr. Kaufman spoke in Tokyo and Osaka to the Japanese association of Technical Analysts on various techniques for trading Japanese markets. You can contact the organization for a copy of the presentation. Mr. Kaufman was presented with a Japanese translation of his newest book, A Guide to Developing a Successful Trading Strategy.

He also spoke about “Making Volatility Work for You” at the 2018 IFTA conference in Kuala Lumpur. It was an excellent conference with many good speakers. You may be able to get a copy of the presentation by contacting MATA, the Malaysian Technical Analysis organization.

July

“In Search of the Best Trend” will appear in Technical Analysis of Stocks & Commodities this month.

A new article on “Defense is Your Best Defense” will appear in ProActive Investor Magazine this week.

March

Mr Kaufman spoke to the Austin chapter of the CMT Association (previously the MTA)

He was interviewed by Jacek Lempart for his blog systemtrade.pl, serving the European Polish investors. The interview will be posted soon.

February

A new interview with Mr Kaufman has been posted on the FXCM website (Forex Capital Markets) as of a few days ago.

 

Mr. Kaufman spoke at the Trader’s Expo in New York on Monday, February 26th. His presentation was on ways to reduce risk that traders forget to use.

There is an interview on YouTube conducted by Alex Gerchik for his Russian audience. We think you will find it enjoyable and helpful. The link is:

https://www.youtube.com/watch?v=TznkQtPQXgM&t=3s

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 posted 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 (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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