Kaufman Signals

February 2019 Performance Report

Industry Benchmark Performance

Early reporting shows that the hedge fund index is lagging the broad market S&P although the long-only programs are tracking about 3% behind. Most of the other equity funds posted modest gains.

Futures programs, including ours, continue to search for trends that are not there. Many of the funds broke even for February, a better result than January. We keep saying “its time will come,” but it’s clearly not yet.

Blogs and Recent Publications

Find this at the end of this report. We post new interviews and reference new articles each month.

February Performance in Brief

A much better month, with our benchmark 10-Stock Equity Portfolio up by 6.47%. All portfolios except the daily futures posted nice gains. The Equity Divergence program gained the most, up 6.57% for February. As more stocks return to profits, our portfolio has a better pool to chose from, making it easier to exceed the broad market index.

Major Equity ETFs. The broad index ETFs continue to rebound but at a slower rate, and still below the highs of last October. A chartist would say that they are meeting resistance at this level. While the economy is still good, it was good when prices took its recent plunge of more than 20%. Given the sideshow of trade, conflict, and politics, it’s difficult to be as enthusiastic about a new bull market than it was a year ago.

CLOSE-UP: The State of Artificial Intelligence and Other Advanced Techniques, in Brief

I’ve been asked by many members about the state of artificial intelligence in financial markets. Are we about to be replaced by robots? Are they smarter than we are? Maybe, but probably not for a while.

Most people mix many of the advanced techniques into the same pot as artificial intelligence (AI). There are neural networks, expert system, genetic algorithms, and even game theory. None of those qualify. Neural nets and genetic algorithms are very sophisticated ways to optimize a trading system, a portfolio, or anything else that requires number crunching. They are fast and can uncover patterns that could not be found manually. Used correctly, they are powerful tools. Used incorrectly, they are just a more sophisticated way of overfitting the data. We need to be careful when applying these tools to understand how to use them correctly.

Game Theory

Game theory is a fascinating method for finding the solution for a buyer and a seller, each with the purpose of out-maneuvering the other. In a way, it could represent you against the market. It seems that the market always maximizes the number of losing traders, so it may appear to be a life form of its own. In game theory you need to make a table of payouts given certain conditions, those conditions listed on the left and top axes. The left would be the buyer and the top is the seller. Each box represents the intersection and shows the payout for the buyer and the seller. The game is to find which intersection satisfies both buyer and seller. Most often, when the buyer shows a profit, the seller shows a loss. The optimal solution can be that both buyer and seller net zero. Life can be disappointing.

Expert Systems

Expert systems come closest to artificial intelligence. It is based on a set of facts from which you can combine and infer other facts. For example, in my book, Trading Systems and Methods, I show three facts and create a fourth:

FACT 1: U.S. bonds are more volatile than Eurodollar rates.

FACT 2: The S&P 500 is more volatile than U.S. bonds.

FACT 3: Volatility is directly proportional to risk.

then the inference engine, which is the main driver of an expert system, can create the new fact

FACT 4: The S&P is riskier than Eurodollars.

It can then use Fact 4 to create other facts. This could be very useful.

Artificial Intelligence

The methods that are used in artificial intelligence are all statistical, unlike the logic of expert systems. The concept behind artificial intelligence is that it will be self-correcting and “self-learning;” therefore, it will improve over time. Analysts call this “deep learning.” That may be a bit extreme.

As with expert systems, we start with answers that we know are correct. Those are called “known values.” Think of an answer that has two conditions, X and Y. We put X and Y on the axes of a table, and the answer in the intersecting box. In more complicated problems there by be multiple conditions and multiple dimensions to our table. In any case, there are some boxes that hold an answer and many boxes that are empty.

A user now asks a question which contains multiple conditions. The box for that answer is empty. The artificial intelligence engine applies a technique called K-nearest neighbor (K-NN), the most popular solution. It finds the closest answer to the empty box and puts that in the box. If you are more sophisticated, it can find the nearest 3 or 5 answers and use a weighted average, based on how close they are, to fill the box. That method is called K-means. Personally, I think K-means makes more sense. When there is an actual solution for the combination you’ve chosen, that solution will replace the estimate. In that way, the method keeps  getting more accurate.

The interesting point is that it works.

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 rallied sharply along with the market, but is also meeting resistance between 20 and 25, an indication that prices are not likely to continue much higher. This area of 20-25 seems to be a point of equilibrium for the market, showing a modest upward bias that we know exists in the S&P. You can see the clustering at that level when the index retreats from its short-term highs or rallies off the less frequent lows.

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.

Good gains in both Equity Trend portfolios as prices recover and our portfolio selection strategy has more to choose from. The 10-Stock benchmark program gained 6.47% to move ahead for the year by 8.35%. The 30-Stock, more conservative due to greater diversification, gained 3.74% and is now up 4.61% for 2019.

Income Focus and Sector Rotation

Another good month for the Income Focus program as interest rates drop. The daily program was higher by 85bp for a year-to-date of +3.84%. That’s nearly half of the expected annual return for this low risk program. The weekly Income Focus gained 1.58% and is now up 2.77% for 2019.

A gain of 3.09% gives us hope that this classic program is coming out of the doldrums and may make new highs soon.

 DOW Arbitrage

Another gain of 3.27% puts this program up by 10.53% for 2019, only 1% below the S&P. It has a history of recovering quickly and seems to be continuing. Another good month and the equity will be at new highs.

 

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 posted the best gains of all portfolios in February, adding to a good January. The 10-stock portfolio was higher by 6.57%, now up 10.94% for 2019. The larger portfolio gained 6 .03%, up 8.20% for 2019.

 

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.

The Timing program remains hedged more than 50% because the longer trends have not yet turned higher for any of the major equity index markets. While that prevents steep losses, as can be seen in the chart below, it slows down the recovery. While we hope that all trends will turn higher, the purpose of this program is to recognize that there are times when a portfolio should be hedged to reduce risk. Both portfolios gained slightly more than 1% in February.

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.”

There is no doubt that the CTAs are struggling with this sustained period lacking any major trends. Markets continue to flop around. The daily program has a much better pattern than the weekly program, indicating that directional turns are happening mid-week and cannot be caught by the weekly program. These programs have a long history or success and will again do well as trends reappear, as they always do.

Group DF2: Daily Divergence Portfolio for Futures

Perhaps there is something to learn from the gains of the Divergence program compared to the losses of the Trend program. The Divergence program holds trades for 5 to 8 days, looked to take advantage of a pause in a trending move. It enters on a pullback and exits when the trend continues. That seems to be in tune with the market. The 10-stock portfolio gained 5.37% in February, up 10.51% for 2019. The other two portfolios are ahead by nearly 8%.

Blogs and Recent Publications (for the past 12 months)

Changes in the KaufmanSignals.com website

We are still 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.

March

An article will appear in the March issue of ProActive Magazine, targeting financial planners. It is “Let’s Be Realistic About Drawdowns.” Most traders don’t pay enough attention to the drawdown history of their trading, or of any system trading. Large drawdowns are infrequent but can be ugly. This article shows how to assess them and some ideas on reducing drawdowns.

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

Previous Appearances and Publications of Interest

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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