Even the good equity performance pales next to futures for 2014, proving that economic forecasts are not as good as diversification. Was it possible to predict the drop in oil prices? Even with pundits talking about a strong dollar, no one could put a time frame on it. Then there’s sugar, a drop from 22 cents to nearly 14 cents, about 28% from the first of the year. With a contract value of more than $16,000 and margin of $800 (5%), that’s a big drop for the trend followers. In 2008, the futures industry had their best year by shorting equity index markets and buying interest rates, but 2014 did not have a crisis, so these returns are appreciated, but they were truly unexpected.
Equities were more complicated, upsetting algorithmic trading programs with the sharp drop in October, causing most systems to go on the defensive, including ours. The results were more evident in the ETF programs, which do not have the flexibility of choosing stocks that might remain strong during a short panic attack. We should also note that the internals of the stocks that we track are showing lethargic movement, as seen by the Trend Strength Index (further below).
With all that, the three major ETFs, SPY, QQQ, and IWM, averaged about 12% last year. Both of our Trend stock portfolios beat the SPY and the averages, although the ETF program did not. While the stock market was having a sustain rally futures were not stellar. The chart below shows how all the portfolios fared for 2014. The futures returns dwarf everything else.
So, what do we expect for 2015? If we listen to the news, we expect the bull market to continue for another five years. That’s fine with us because we take only the long trades in the equity markets. But is it realistic? We seem to forget that the unexpected event is a periodic occurrence in all markets. It’s easy to explain afterwards, a specialty of the business news shows, but not likely to be predicted. The only choice for an investor is to diversify, preferably into something algorithmic, but not to over-diversify. Spreading an investment over too many markets, or too many strategies, is more than diminishing returns, it may result in underperformance. Then choose carefully, choose wisely, stay engaged by monitoring the results, and remember that even the best traders can have a disappointing record when it comes to prediction. With our eyes wide open – it’s a new year.
Trend Strength Index
The Trend Strength Index is our measure of market strength. 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.
Even while the stock market struggles higher, the Trend Strength Index has stalled out at 30, still showing a weak sign of divergence. Yes, we’ve seen this before and the market continues higher. Timing is not easy, but there seems to be underlying weakness in the market that requires caution. Fundamental forecasts are all modest for 2015, with the best just over 10%. In a market where traders are carefully watching for signs of weakness, we are likely to see another sharp sell-off. It seems unlikely that each sell-off will have such a dramatic recovery.
We offer this Index for those investors who select their own trades from the All Signals Report rather than following our sample portfolios. The daily Trend Strength Index values are available to subscribers.
OVERVIEW OF DECEMBER
From the bar chart shown earlier, overall performance for December was very good and similar to the 2014 total performance. The smaller, more aggressive stock portfolio returned over 20% for the year, the best of all the equity portfolios. The Weekly Stock portfolios were more consistent, with both small and large portfolios showing nearly the same 17% returns. ETFs have mixed profitability for the year.
The Divergence program for equities posted respectable 5.6% and 7.5% returns for the year, while the Timing program had losses in all three portfolios. The Timing program buys weaker stocks and can be very profitable, but it also has greater risk than trading the trend. For most investors, the Timing program offers excellent diversification that can smooth out portfolio returns. We expect it to have a disappointing year from time to time.
Futures, on the other hand, posted the best returns since 2008, when shorting the equity index markets and buying interest rates produced another 50% year. These are the years when investors should think carefully about the alternative investment space. Most futures programs, as shown by Newedge, have had a sideways three years. During that time, investors drift away from them in favor of the equity markets that keep rising. We admit, it is difficult to be enthusiastic about an investment that takes a lot of money and goes nowhere. But then we have the notable exceptions of 2008 and 2014. A 50% return, spread back across the past three years is 12.5% per year, very acceptable. It has also been shown that the best years in futures are when stocks are doing badly. The fact that both returned gains in 2014 is an unusual bonus. The chart below shows that both the SPY and IWM have reached new highs but the QQQ is still hovering below its previous high. Analysts have always said that a shift to the small caps is a sign of investor confidence. We’ll see.
STRONGEST & WEAKEST 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 strongest sectors of the SPDRs. This month the program removed Preferred Stocks (PFF), and added Financials (XLF) and Retail (XRT).
Current positions are: Preferred stocks (PFF), *Heath Care (XLV), Staples (XLP), Utilities (XLU), Vanguard Reits (VNQ), and Retail (XRT).
The Timing Rotation program (buy low) exited Financials (XLF), and entered Preferred Stocks (PFF), Energy (XLE), and Technology (XLK). There is no doubt that energy is oversold, so now it’s a matter of timing.
Current positions are: Preferred (PFF), Energy (XLE), Technology (XLK), Staples (XLP), and *Health Care (XLV).
*Note that Health Care is in both programs, indicating that it has been very strong but had a pullback in October that allowed it to be bought and held by the Timing Rotation program as still undervalued.
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.
Small gains for stocks, small losses for ETFs were still better than the benchmark SPY performance for December. For the year, the aggressive 10 stock portfolio finish up more than 20% and the larger 30 stock portfolio up 13%, both very much in line with the 12 year average returns. The ETF program, which attempts to select the strongest sectors, finished the year up over 5%. These returns are particularly good if you consider the defensive action necessary when the market sold off sharply in October. It is always easy to say in retrospect that the fast recovery means that trading programs should have been fully committed again, but that’s not realistic. We should remember that the index market recovered all its losses from the 2008 subprime crisis, but many individual investors reduced their positions during 2008 and never saw the recovery. Theory and reality often diverge.
The Weekly Trend Program performed better than the Daily Program in stocks, finishing the year up about 17% in both smaller and larger portfolios. The ETFs did not fare as well, both portfolios up for December but slightly down on the year. We need to point out that weekly trading signals have both advantages and disadvantages. During the October sell-off and rally it did better than the daily program by holding many of the positions. On the other hand, weekly signals will be late for a sell-off that continues. In the long run, equity markets are very noisy, and do not continue in one direction long without a correction. If you look at our sector performance for the Trend program using futures, you will see that the equity index sector is one of the few that did not post large profits in 2014. We attribute that to the underlying level of noise (volatility) in those markets.
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 was profitable for the year, but did not reach its average returns. It does offer excellent diversification because it does not track the trend, so its benefit in a portfolio is greater than the returns. All three portfolios were positive for the year. One reason for lower performance is due to lower exposure. It is not always possible to find enough divergent signals, even out of the large set of stocks that we track for this program. Therefore, the risk is also lower. This is especially true for the ETF program, which draws from a much smaller set of about 70 ETFs. Still, the ETF returns have moved steadily higher on low risk.
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 does not 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 is our one disappointment this year, returning losses in all portfolios. A downturn in the SPY generated a hedge position in December, which then dampened performance when the market failed to continue lower. At the very end of December we set one leg of a hedge in QQQ. While we hope that stocks rally and we take a small loss in this hedge, risk protection is an integral part of the Timing program. During a sustained downturn it will hold losses to a minimum compared to other program.
One of the issues with algorithmic trading is that it can be frustrating when it’s not making money, and requires discipline to consistently follow the trading signals. It is not possible to predict when the system will turn and returns will improve, and not possible to select when to trade and when not to trade. Case in point is the Trend Futures program this year. No one would have expected a 50% return after three years of sideways performance for the Industry.
We’ve been amazed at the consistency of the futures performance all year, and those returns continued into December, finishing the year 40% to 55% higher for the daily program and 42% to 60% higher for the weekly program. We admit that it’s not likely to continue, but we would have said that earlier in the year as well.
Looking at the sector returns for the Trend program below, only Equity Index shows a loss. That’s actually consistent with the long-term performance of equity futures. While they serve as excellent diversification and occasionally have a good positive run (remember the short positions of 2008?), they have too much noise for a trend program to identify turns in a timely fashion. Still, a small loss in equities during 2014 did little to dampen overall performance.
We can see that interest rates were profitable due to the Fed driving yields lower all year, FX due to a stronger dollar, energy because of a major drop in oil prices, metals because of the continued slide in gold (also due to the strength in the US dollar and weak oil), and ags because of continued lower prices. It is only when long trends occur in (nearly) all sectors that the program can post such high returns.
DF2 Divergence Program
The Divergence program was mixed for the year, with the larger portfolios doing well, but the smallest posting a net loss. In terms of sectors, the chart below shows that gains were limited to bonds and ags. Again we see the equity index markets posting the largest loss.
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 are not the only futures program doing well. Newedge shows that the CTA index rose more than 15% with trend followers up 19% for 2014. The BTOP 50 represents the top 50 CTAs, with an average of 12.4%.
The charts below show the daily and weekly Trend program performance. We recognize that the extreme move that we see for 2014 won’t be sustained, but we have no way of knowing when it will end. The advantage of an algorithmic system is that it will exit when the trend turns and will not make excuses for holding the positions “just in case” it rallies again.
Group DF2: Daily Divergence Portfolio for Futures
The Divergence program did well in the larger portfolio and maintains a nice upward trend in equity. It may be overlooked this year as the Trend program continues to post outstanding returns, but it is a sound program on its own. We’ll revisit this as the year takes shape.
Copyright 2014-Kaufman Signals December Performance Report-All Rights Reserved