Industry Benchmark Performance
CTAs posted another good month, gaining more than the major index markets lost, an argument for diversification. If the hedge funds show results similar to the index markets in February, they will have been flat to down for the month and still down year-to-date. Our larger, more diversified macro trend futures portfolios are tracking about the same as the industry, although the smaller portfolios are profitable but lagging.
February Overview: Mixed results generally better than the market
In equities, 11 of 16 of our programs were profitable, and 5 of 9 futures programs. That’s better than the broad market performance and we hope better than the hedge funds in February. We’re going to need some sustained moves in order to leverage up our positions and produce attractive results. There’s no way to predict when that will happen, so we press forward optimistically. The chart below shows that the recent rally still leaves us 10% below the highs in NASDAQ, slightly less in SPY, and still off 20% in the small caps, IWM.
Energy and the Stock Market – An Unlikely Partnership
By now everyone knows that the stock market is following energy prices. When crude oil falls, it’s interpreted as poor demand because the economy is worse than we expected. Fundamentally, that’s not true. Yes, there is slowing in China, a big consumer of oil, but the biggest problem is an oversupply that doesn’t go away. There’s no doubt that the slowdown in China and other emerging markets caused a back-up in supply, but the OPEC countries have a dilemma: they want to cut production to raise prices but they don’t want to lose the income. So they keep producing. Even during the years when OPEC seems a viable cartel, each country would cheat on its quota. When they loaded a tanker, they would add, say, 10% more crude, effectively discounting the price in order to get the sale.
Now we have Iran moving into the mainstream. They want the income also, even if they have been selling oil to China (just a guess) and undercutting Russia’s price. It doesn’t seem as though there is an end in sight for oversupply unless the world economy improves, which it will do eventually.
How does this affect us?
It used to be that, when oil went up, stocks went down, and when oil went down, stocks went up. That makes sense. Lower oil prices mean lower cost for fuel, which is positive for all businesses and consumers, and only negative for the producers (a much, much smaller group). The typical pattern can be seen on the left in the chart below, when crude went to $150/barrel (the chart is continuous futures, so the prices have been adjusted). Although crude declined after the 2008 mid-year peak, the market took some time to recognize that it wasn’t going back up. That’s the same as a J-curve in economics.
As a trend-follower, when the stock market switches back and forth from tracking crude to not tracking it, prices become erratic. The chart above on the right shows the returns of our smaller Trend portfolio of 10 stocks, of which 5 are related to the energy sector. Up until mid-February the program gained steadily by being long the energy stocks while the overall market sold off. Now that stocks are trying to recover, and crude prices are stabilizing, those companies are losing ground to the broad index.
The table of correlations below show the changing behavior of SPY in relationship to other index markets and some energy stocks. Correlations between SPY, QQQ, and IWM hardly change, indicating that “wherefore goeth the S&P, also goeth QQQ and IWM.” Note the erratic changes in ETR and XOM, usually not correlated to the S&P, but spiking at 0.72 and 0.64 in January. XLE shows a steady increase in correlation, while DTE remains steady.
Can we do anything about it?
Do we want to do anything about it? Looking at the chart of DTE below, we see a very trending market that has had a small pullback on increased volatility. The main advantage of algorithmic, or any systematic trading, is the realization that we cannot predict where prices will go. We do know that, on average, prices will continue in the same direction. It’s a quality called “persistence,” and a successful trader is also persistent when she or he know that the odds are on their side.
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 often do it with 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.
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.
In January the Trend Strength Index shows a likely divergence to the upside. This month the pattern seems complete and the recent low is higher than the previous low, confirming the divergence. The classic case is lower lows for the underlying SPY prices and higher highs for the Trend Strength Index. For anyone trading the long side of the equities market, that would be a very good scenario.
Note that our TSI is still very negative, so a rally here may not be the end of the bear market. For a chartist, we would see another 5% rally in the S&P before any new decision is made.
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. February started long only two ETFs, staples (XLP) and Utilities (XLU).
. During uncertain periods, munis tend to be favored for their stability. In January we switched to consumer staples (XLP) and utilities (XLU), resulting in a small loss for the month. We exited XLP but did not add anything else, given the weakness of the overall market. At the end of the month we held only one position:
The Timing Rotation program began January long
Technology (XLK), hedged 33% (2/6) of the risk using SPY:
During February the overall market sold off and we were fully hedged for most of the time. At the end of the month, the short term trend of SPY had turned up, so we are now hedge 2/3 of our maximum 50%, or effectively 1/3 of the total risk. We added Financials (XLF) and Healthcare (XLV) and are now holding:
Technology (XLK), Financials (XLF), and Healthcare (XLV), hedged 33% (2/6) 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.
The Equity Trend portfolios treaded water in February, with 3 of the portfolios earning less than 1% and 2 of them losing less than 1%. Overall, the results were similar to the broad market indices.
The Trend ETF programs were both profitable, but the sector ETFs, which draw from a much smaller set of markets, had little choice except sectors that were mostly lower, resulting in a fractional loss.
Weekly Equities were a little better than the daily counterpart, with the smallest 10 stock portfolio gaining 1.75% and the 30 stock up 092%. The ETFs were also profitable.
Our newest addition, Sector Rotation, was profitable by being long both interest rate ETFs, certainly not exciting but a necessary defensive posture. For a conservative position, a 1% gain for February looks good.
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 programs had mixed results in February, with the smaller stock portfolio showing a loss, the larger one flat, and the ETF portfolio with a gain. While not an exciting portfolio, the ETFs have been slow and steady, a pleasant change in this volatile market.
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.
In February the Timing Program recovered with a 3.1% gain in the 15 stock portfolio and a 1.5% gain in the 30 stock. The ETF program, which buys undervalued stocks, posted a very small loss, a good showing in a market that has had a serious drop.
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.”
Trend Futures were again the best performers in February, with all daily portfolios gaining between 3% and 4%. The Weekly Trend Futures program gained less and the smallest portfolio posted a small loss. The breakdown of profits and losses by sector is shown below. As you can see, interest rates are again the big winners, which helps most of the larger funds which are overweight in that sector because of liquidity. Index markets, FX, energy, and Ags all flip-flopped from profits to losses or losses to profits, a good argument for diversification. We would like to see all of them on the profitable side.
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 Divergence Program posted small losses in February, but the overall pattern in the chart below looks good. This program does have frequent swings up and down, so we look forward to the next one being to the upside.
©Copyright February 2016, Kaufman Signals. All Rights Reserved.