February 2020 Performance Report

Please note that there are two versions of the weekly stock trend portfolios.

Explanation of New Weekly Stock Trend Portfolios

On Monday, February 24th, we advised our subscribers that we were exiting all positions in both the Daily and Weekly Stock Trend Portfolios due to our extreme risk rules. Those rules combine a drop in equity value with extreme volatility. As of today, we are still standing aside with no positions.

While the Weekly Stock Trend Portfolios have performed much the same as the Daily program over many years, it cannot respond in a timely way to all extreme situations. Therefore, we must use the trigger from the daily price action to manage the risk of the weekly program. We know that subscribers did not expect this, but circumstances dictate that more risk control is better than less risk control.

We also understand that not all subscribers will want to close out their entire portfolio; therefore, we will now post the results of the Weekly Stock Trend portfolios with and without the extreme risk control (market “XRC” on the performance summary above).

There have been other crises that have shown larger losses than our current drawdown and the market always recovers. There is no reason to believe this will be any different. Investors can now choose to follow either version of the weekly program.

Additional descriptions of this and other strategy changes can be found in the “Close-Up” a few sections below.

Industry Benchmark Performance

February industry returns reflect the start of the coronavirus decline (we are posting this comment on March 10th). Long equity funds are taking the brunt of the losses while futures should offset that once the downward trend becomes clear. It is a case of “crisis alpha.” Futures can profit from being short the index markets, but that takes time before it kicks in.

Kaufman’s Fast Strike Systems on MetaStock

MetaStock has posted an upgrade to Kaufman’s short-term trading systems, Fast Strike. Contact MetaStock at 800-882-3040 or go online to www.metastock.com/kaufmana.

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

The coronavirus and high volatility triggered a full exit of our daily and weekly stock trend portfolios on the open of Tuesday, Feb 25th. Whether this turns out to be a net gain or a lost opportunity, the system is based on the idea the less risk is best during a crisis. Not all of these risk events will be profitable, but in the big picture, controlling risk is vital.

After holding a 10% year-to-date gain in the benchmark stock program on February 19th, we ended the month higher by 3.92% and the year up 4.90%. The 30-stock portfolio was just slightly lower. The weekly program can only trade on the Monday open, but subscribers were told of the full exit on Tuesday and would be notified of the reentry positions. Those that exited their 10-stock portfolio on Tuesday are higher by 6.65% for February and 11.40% for 2020.

Other programs do not have the same risk controls and suffered from the collapse. However, most of them are doing better than the benchmark broad market ETFs.

Futures have also taken a loss. Although we like to count on futures offsetting losses in equities, a sudden change of direction will catch these long-term trends off guard.

Major Equity ETFs

A nasty drop from the highs in just seven trading days wipes out 13% across the board in all the major equity ETFs. Systems and traders will have a difficult time reacting to this fast change of direction. Some analysts are trying to forecast the bottom, but we prefer to wait and react to change rather than anticipate. We may be a little late getting back in, but waiting has less risk.

CLOSE-UP: Strategy Changes – More Volatility Control – More Panic

Over the past few months we have been reviewing the strategies that underly our portfolios. For the most part we are happy with the performance. The Trend Stock programs, daily and weekly, have been outstanding. But there is always unknown risk. To try to reduce the possibility of a large drawdown, we added risk controls based on extreme volatility to three strategies: Equity Trend, Equity Timing, and Dow Arbitrage. We wanted to be proactive.

We cannot guarantee that we can avoid all large drawdowns, but we hope that these changes will significantly reduce the size of those drawdowns and, at the same time, increase the returns. This past week’s experience in the equity trend programs shows that extreme risk can occur at any time.

Let’s take a look at the changes for each strategy.

Daily and Weekly Equity Trend

This program has been successful for many years, yet we always have a chance of suffering another 2008 drawdown. It’s best that we try to control that in advance rather than explain the problem afterwards.

Realistically, we can’t eliminate drawdowns completely. Anyone would recognize that the rules for doing that would be hindsight and overfitting. But we can reduce the impact of most drawdowns by monitoring the volatility of our performance. When volatility becomes extreme and we are in a drawdown, we can go to cash by exiting all positions. When volatility returns to normal and our system starts to produce profits, we can reset the new positions. Therefore, our added risk control is simple: it is a matter of volatility causing prices to move in the wrong direction. Not all volatility is the same.

Timing

We like this strategy because if buys dips within a trend, a method that has been used successfully for years and is often the basis for day trading. To find these pullbacks, we compare the stock price with its correlated index ETF, which could be SPY, QQQ, or IWM.

In the original version of this strategy, which is only long stocks, we hedged with the correlated ETF when the trend turnd down. That seemed to work well for a number of years, but recently the hedge has not offered the protection that we expect from it.

Instead, we now take positions in proportion to the strength of the system trends. This prevents overexposure. Unlike our other portfolio methodology, which can switch stocks at ant time based on ranking, once we are in a trade using the Timing strategy, we hold that trade to completion. As with other mean-reversion approachs, the price often flops between profits and losses until the new direction is established. Because this strategy has a high percentage of profitable trades, holding the position is the best choice.

Dow Hedge

This strategy buys the 10 strongest performers of the 30 Dow companies. In the original strategy, when volatility reached an extreme, we sold one-half of our long positions and used those funds to go short the 10 weakest stocks as a hedge.

We found that the hedge was not always enough risk protection because the 10 weakest stocks might not be moving at all, while the strongest stocks were quite volatile. Instead, we applied a combination of system performance volatility and Dow volatility, measured using the ETF DIA. When either one exceeded an extreme, we exit our entire portfolio. We reenter when both revert to normal levels of volatility. The result is seen in the comparison of the old and new returns (see the Figure below).

You’ll note that the new program has a lower return than the old one, but it is far smoother, indicating less risk. The long-term return of the old program was 22% and the new one is 19%, not that much of a difference. The newer Dow Hedge program responds better to market patterns over the past few years.

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 350 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.

This week’s sharp decline in stocks is easy to see on the Trend Strength Index. It’s an unprecedented sell-off. We can’t predict that the sell-off will stop at the -50 level shown in January 2019 because this event is unique (as are all crises). While the TSI showed declines ahead of this crisis, we don’t think the overbought condition of the indicator had any forecasting qualities.

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.

Please read the new risk control features, discussed earlier, added to both the daily and weekly trend programs.

The daily Equity Trend portfolios exited all positions on the open of Tuesday, February 25th. That resulted a net gain for February of 3.92% and 4.90% in 2020 for the 10-stock portfolio. The 30-stock portfolio has similar results but slightly lower. This compares to SPY that lost 11.71% in February and is now off 9.93% for the year.

As of the last trading day of February, these portfolios had no positions. It will be necessary for the volatility to drop and the underlying trend system to show profits before we reenter the market.

To see the difference between the portfolio returns with and without the extreme risk control (XRC) feature, the chart on the left below compares the system returns for February. Looking at the 10-stock Weekly Trend portfolio, applying the risk feature turned a loss of -5.66% to a gain of 6.65% and shows a net gain for 2020 of 11.41% (see the performance table at the beginning of this report). Overall, the risk control saved about 12% in both the 10 and 30-stock portfolios. We still recommend no positions and will notify subscribers when to reenter the market.

Income Focus and Sector Rotation

The Income Focus program took a surprising loss this month, given its steady performance recently. The culprit is JNK, the high-yield stock ETF that has a tendency to track the stock market, even though greatly subdued. Preferred stocks, PFF, also posted a loss while the municipal bonds, MUB, showed gains. In the big picture this program is doing very well and provides a much more conservative investment option.

Sector Rotation

February posted the worst performance of all portfolios. It is exiting the four sectors, Home Builders (XHB), Financials (XLF), Technology (XLK), and Health Care (XLV) in favor of interest rates (AGG and IEF). While this reflects the shift in investor sentiment, it also comes late. Technical programs often tend to lag market action, and this strategy is a classic example of that.

DOW Hedge

As discussed early, this program has been changed to avoid short sales in Dow components that may not act to offset losses in a declining market. The new program gained 3.3% in February and is higher by 5.2% for 2020. That compares to the SPY loss of 11% in February, down 9% for 2020. We expect these changes to show more stable returns as we go forward.

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.

After a nice run up last year, this program took a loss of about 7% in both 10- and 30-stock portfolios, still less than the 11% loss in the overall market. This nets a loss of about the same 7.5% for 2020. We have no way to forecast the end of this move but we expect the strategies to all take a defensive posture in selecting stocks to trade.

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 is another program that has had changes. The underlying strategy remains the same, but we have removed the ETF hedges that seem to have stopped working during the past two years. We expect returns to be steadier and higher now. It also allows us to use 10- and 20-stock portfolio that will be more attractive to investors.

In February, this program was able to hold onto a gain of 2.3% in the 10-stock and a small loss (all things considered) of 3% in the 20-stock. Overall, the chart still looks good.

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.”

Compared to the stock market, futures performance is much better even with losses in the Daily Trend portfolios of 1% to 4%. It’s disappointing because futures can sell the equity indices, but that’s not enough to offset losses from the fast change of direction in other products. The Weekly Trend portfolios did worse, down from 6% to 9% in February because they are unable to change positions as quickly as the daily program.

Futures program will reduce exposure based on volatility but will not exit the entire portfolio. If performance is bad, it will not select those markets to trade.

Group DF2: Daily Divergence Portfolio for Futures

Mixed results in February added to losses of 9% to 11% for 2020. As with the Futures Trend we would like to see gains in futures offsetting losses in equities, but futures reflect many sectors. Some of these sectors are reacting in the same way a equities, changing direction quickly. We can only wait to see how this develops.

Blogs and Recent Publications

Trading Systems and Methods, Sixth Edition

The sixth edition of Trading Systems and Methods was released the last week of October by John Wiley. It is completely updated and contains more systems and analyses.

MetaStock Strategies

MetaStock issued an upgrade to the Kaufman Fast Strike add-on in late January. This add-on has three short-term trading systems, holding positions for one to three days in two of the programs, and about one week in the third program. They trade noisy markets, including most major index ETFs and futures, plus one program trades the VIX. You can see a description of the programs and a record of past performance on MetaStock. Anyone interested should contact MetaStock at 800-882-3040 or go online to www.metastock.com/kaufmana

February 2020

“The 1st and 2nd Cross” was published in Technical Analysis of Stocks & Commodities in the March issue. It is based on an idea of Linda Raschke and captures small but reliable pieces of a trending move.

January 2020

A new article “Essential Math For Traders” will be published in the Bonus 2020 issue of Technical Analysis of Stocks & Commodities.

ProActive Advisor Magazine (on-line) published “Controlling risk that doesn’t go away,” posted on January 15.

Both of these articles are important for understanding your investment risk.

December 2019

Technical Analysis of Stocks & Commodities published an interview with Mr Kaufman in the December issue.

MetaStock Seminar held in Sunnyvale

Mr. Kaufman was a keynote speaker at the MetaStock conference in Sunnyvale, November 3. You can hear this presentation by going to the MetaStock website.

November 2019

Technical Analysis of Stocks & Commodities published “Running for Cover,” an article by Mr Kaufman that looks at whether buying bonds after a sudden drop in the S&P can still be profitable.

September 2019

“A Simple Way to Trade Seasonality” was published in the September issue Technical Analysis of Stocks & Commodities. Seasonal trades and filters can be a big asset to market timing and put you on the right side of a price move.

Book Interview

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

May 2019

A second part of the interview with Caroline Stepan at TalkingTrading.com was just posted.

March-April 2019

Mr. Kaufman was interviewed by Caroline Stephen at TalkingTrading.com. It covered a wide range of topics. It has not yet been posted but should be available soon.

We thought the article in ProActive Advisor Magazine would be in March, but it should appear any day in April. 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.

Older Items of Interest

For older articles please scan the websites for Technical Analysis of Stocks & Commodities, Modern Trader, Seeking Alpha, ProActive Advisor Magazine, and Forbes. You will also find recorded presentations given by Mr. Kaufman at BetterSystemTrader.com,  TalkingTrading.com, FXCM.com, systemtrade.pl, the website for Alex Gerchik, and Michael Covel’s website, TrendFollowing.com.

Mr. Kaufman spoke in Tokyo and Osaka to the Japanese association of Technical and was a keynote speaker at the 2018 IFTA conference in Kuala Lumpur, both last October. You should be able to get a copy of the presentations by MATA, the Malaysian Association of Technical Analysts.

 “In Search of the Best Trend” was published in Technical Analysis of Stocks & Commodities in July 2019. An article on “Defense is Your Best Defense” will appear in ProActive Advisor Magazine also appeared in July 2019.

Mr. Kaufman was a keynote speaker at a number of IFTA conferences, the most recent in 2018 in Kuala Lumpur, and Milan in 2017. You can find his presentations on their website.

You will also find many articles posted under Articles on our website, www.kaufmansignals.com. You can address any questions to perry@kaufmansignals.com.

© February 2020, KaufmanSignals. All Rights Reserved.

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