Kaufman Signals

February 2017 Performance Report

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Industry Benchmark Performance

Hedge Fund early reporting for February shows nice gains in equities, but lagging behind both the broad market indices and our own performance.

The BTOP50, the index of large futures funds, is showing a loss for 2017, similar to our own performance. But with only a modest number of funds reporting, we’ll wait for more information.

February Performance in Brief

It was a good month for equity performance, with only two portfolios posting a small loss in February, and all portfolios ahead for 2017. The 10-stock Timing Portfolio is the leader, up 10.38% in the first two months, followed by the 30-stock Weekly Portfolio, up 6.54%. However, fewer portfolios beat either the S&P or Nasdaq indices in February, with those markets reflecting unparalleled optimism.

In futures, the smallest trend portfolio posted a loss while the large ones were profitable. Trends in interest rates and the U.S. dollar are not materializing, a surprise when the talk is all about higher interest rates, which should strengthen the dollar. Losses are small, so any trend can turn performance to profits quickly.

Major Equity ETFs. After seeing the momentum shift away from the small caps in January, we see a continuation of strength in both the S&P and Nasdaq, gaining 3.93% and 4.38%, but all standards, an excellent start to the year. We prefer to look at the average of SPY, QQQ, and IWM, to represent a more likely return for investors. Those numbers are still good, with a gain of 3.41% in February and 5.92% for 2017.

 

Blogs and Recent Publications

The March 2017 issue of Technical Analysis of Stocks & Commodities will feature a new article by Mr Kaufman, VIX or Historic Vol – Which is Better for Position Sizing? This article shows the effects of using volatility parity based on both historic volatility and implied volatility (VIX) to find the right position size for your trade.

Last month Mr Kaufman posted an article in ProActive Advisor Magazine, “Low Volatilty – High Returns?” This article shows how to turn periods of low volatility into high returns, and why you want to avoid high volatility.

Look for other 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.

High Momentum or Mean Reversion?

A long, long time ago, back in the 1990s, we had a method called “High-Momentum Trading.” It was a short-term strategy that took advantage of overbought and oversold conditions – not by fading them (selling overbought and buying oversold values), but by buying overbought and selling oversold situations. It does seem contrary to the concept of being overbought or oversold, but it’s all about timing.

Rather than use a standard momentum indicator, such as an RSI, MACD, or stochastic, we’ll look at sequences of up and down moves. One of my favorite systems is the 3-day pattern, which works well for equity index markets because they have a history of being noisy. That is, they don’t often continue in the same direction for more than 3 days without reversing. Yes, sometimes they continue longer, but this is all about numbers.

In the classic pattern trade, which I call a “Short Cycle,” you wait for two down days then buy the close of the third day down (see the Figure below). You hold for a profit target, based on a 20-day average true range, or exit on the next close. The trade is held no longer than one day. That approach is mean reversion, and works for both long and short sales, but makes much more on the long side, which should not be a surprise. It does even better if you filter it with a long-term trend, although that reduces the number of trades and increases the correlation to other trend systems. It’s a simple method, but you’ll need to decide on the length of the trend and profit-taking factor. Profit-taking is important for short-term trading, so you want to capture profits often.

The point of reviewing this mean-reversion, short-cycle trade is that the equity markets are noisy and the best short-term trades are counter to the current price move. Then it becomes more interesting that the VIX, the options volatility index based on the S&P, does the opposite.

For this high-momentum strategy, we can use the same basic set-up, two days down as a trigger, but instead of buying the following close, we sell a lower open or sell a lower close, whichever comes first (if at all). Again, we use profit-taking on the first day if we sell the open, and on the second day if we are still holding the trade or entered on the previous close. We use the EFT UVXY for both longs and shorts, but for the volatility index, profits from short sales overwhelm gains from longs. That’s probably why most professionals sell volatility.

I’m not going to show you the results of either of these strategies for two reasons. First, you now have all the rules for implementing this yourself. It’s always best that you test any strategy to be sure it actually works. When you do that, and you are successful, you will be more inclined to trade it.

Second, a more detailed article about these two methods will appear in Technical Analysis & Stocks and Commodities in a few months. This way you have a head start! We’ll let you know what issue.

February Insight: Running on Fumes?

If the new administration implements tax reforms and eases regulations in the financial industry, there is no doubt that it will be good for business. Companies will be more inclined to stay in the U.S., or even move some foreign operations back. They might even repatriate money sitting overseas. The consumers would have more, or better paying jobs, which increases consumer spending and boosts the economy. We can’t find anything wrong in that. But how far can it drive the stock market? Since the election on November 8, the S&P has gained 13% and the Russell 16%.

We don’t think the market has fully discounted the benefits of these policies – if they can be implemented in the most optimistic way. Is the market expecting a corporate tax rate of 15%, or is it 20%? That would certainly stimulate the economy, but is it realistic? Somehow, we would have to find other sources of income if we don’t want to balloon the debt. Then maybe 22% is more reasonable, still a large drop from 35%. Will it disappoint the market? Most likely, yes.

The problem is that we have no way of knowing when reality will strike, or how hard or soft the blow will be. If you can forgive the promotional plug, that’s why systematic trading has become so popular. It’s not impressed by speeches or innuendo, only by price movement.  When stocks start to turn down, it will act and not find reasons to wait.

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 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.

We didn’t expect the Trend Strength Index to break above the last high of 50, but the S&P continues to rally on expectations. Normally, this would be a predictable event, that is, strength fades while traders wait for something of substance to happen, but there is always an exception (or two) to the rule. History shows that 60 is the highest value posted, so we’ll set our sights on that level now, followed by a sell-off.

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.

Strongest

The Trend Sector ETF program buys the 6 strongest sectors of the SPDRs.

At the end of January, we held Oil & Gas Exploration (XES), Materials (XLB), Financials (XLF), Industrials (XLI), Metals & Mining (XME), and Technology (XLK). We exited Oil & Gas Exploration (XES) and Financials (XLF), replacing them with Consumer Discretionary (XLY) and Staples (XLP). We now hold:

Materials (XLB), Industrials (XLI), Metals & Mining (XME), and Technology (XLK), Consumer Discretionary (XLY) and Staples (XLP).

Undervalued

The Timing Program buys 4 ETFs that are undervalued with respect to SPY, in expectation of rotation. We started February with Energy (XLE), Financials (XLF), Metals & Mining (XME), and Retail (XRT). This month we exited Financials (XLF) and entered Materials (XLB).   We now hold:

Energy (XLE), Metals & Mining (XME), Retail (XRT), and Materials (XLB).

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 and Income Focus

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.

Another month of good returns is easy to see on the charts. The ETF programs are still lagging, but the sector ETF program is looking as though it’s turned up. We still in favor of investor optimism, which is always the driving force moving prices higher.

 

The Weekly Equity Trend Program broke its run of outperformance by posting a fractional loss in the 10-stock portfolio and modest gains in the others. Even with the equity index markets making new highs, it has not been done in a smooth manner, making it difficult to capture what we call “price persistence.” The charts still look good and we expect these programs to outperform the market.

 

Income Focus and Sector Rotation

The Daily and Weekly Income Focus programs posted gains of 1.41% and 1.62% in February, bringing 2017 gains to 2.63% and 2.86%. Considering this is looking for interest income as the primary source for returns, it also serves as a hedge against moves in the equities market. Both daily and weekly charts show similar movement, with returns at all-time highs.

 

A small gain in February, added to the nice gain in January, makes the chart below look strong.

 

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 10-stock Divergence portfolio lost nearly 2% in February while the 30-stock portfolio gained almost the same, evening out year-to-date returns at 3.75% to 4%, still respectable. The charts below still look positive. The ETF program gained 0.66%, continuing it’s boring but upward direction.

Meanwhile, the ETF program moves upward, 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.

February saw a 4% jump for the 10-stock Timing portfolio, putting it up 10.38% for 2017. The 30-stock portfolio lags because it can’t find enough stocks that meet the trading conditions. The ETF program gained nicely and continues its recovery.

 

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.”

Another month of waiting for trends to surface. The smallest, less diversified 250K daily portfolio posted a fractional loss, while the other portfolios posted gains of less than 1%. All portfolios show small losses for the year. We still see the new administration as inflationary, so declining bonds and a rising dollar may turn out to be the winning trades. The Weekly futures program is not faring as well, as it continues it’s retracement from the highs of 2 years ago.

 

Group DF2: Daily Divergence Portfolio for Futures

Although the Divergence program posted losses for February, it had half the days with no positions. This program is proving to be volatile because it leverages a few trades and has less diversification that other programs. That will turn out to be good when the patterns favor this program.

Insert Futures Divergence charts

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