Industry Benchmark Performance
Very few funds have reported and mostly those with gains in February, I’m going to guess that results will decline as more funds report. Futures tend to be more current and show typical losses for February. Not a good month, but there is a long way to go in 2025.
Source: BarclayHedge Indices.
Kaufman’sMost Popular Books (available on Amazon)
Trading Systems and Methods, 6th Edition. The complete guide to trading systems, with more than 250 programs and spreadsheets. The most important book for a system developer.
Kaufman Constructs Trading Systems. A step-by-step manual on how to develop, test, and trade an algorithmic system.
Learn To Trade. Written for both serious beginners and practiced traders, this book includes chart formations, trends, indicators, trading rules, risk, and portfolio management. You can find it in color on Amazon.
You can also find these books on our website, www.kaufmansignals.com.
Blogs and Recent Publications
Find Mr. Kaufman’s other recent publications and seminars at the end of this report. We post new interviews, seminars, and reference new articles by Mr. Kaufman each month.
February Performance in Brief
An awful month with only the weekly Income Focus and the Sector Rotation program showing gains. Policies from the Administration are confusing everyone, but tariffs on Mexico, Canada, Europe, and China seem to be in progress. Combined with Federal employee “firings” the market sees lower growth and higher employment. The Atlanta Fed just predicted that our GDP would decline from 2.3% to -1.5%. Not a good sign for the economy and the market.
Major Equity ETFs
The decline in the last few days of February doesn’t look too bad on the chart, but the tone of the market has changed dramatically. Few analysts see upside potential and, as just said previously, the Atlanta Fed is predicting a large drop in GDP. The biggest decline seems to be in the tech stocks, with Nvidia earning somewhat disappointing. At the same time, no one seems to know what the Fed will do next. Lower if they are concerned about employment, and higher if they are worried about inflation.
CLOSE-UP: How Much Diversification is Good?
Diversification is one of the benchmarks of risk control. The more you diversify, the less the risk – or so they say. But there are two areas that are left unsaid:
- 1. When there is an economic crisis, all markets move together.
- 2. Over-diversification will leave you with low returns, a poor trade-off for reducing risk.
How Do You Measure Diversification?
We typically measure diversification using correlation. In futures, it could also be spreading your trades into one of the major sectors, interest rates, FX, index, etc. In stocks there are also sectors, not as easy defined and sometimes overlapping. Where does Boeing go: Defense or Airlines?
If you’re reasonably good at using Excel, you can easily calculate correlations. In the example below, we correlate the S&P ETF with the Nasdaq ETF (SPY vs QQQ) for the past 5 years.
- 1. Put the date in column A
- 2. Put the closing price of SPY in column B
- 3. Put the closing price of QQQ in column C
- 4. Calculate the daily returns of SPY in column D
- 5. Calculate the daily returns of QQQ in column E
In this example, the data starts in row 2 and ends in row 1293. The correlation is then:
=CORREL(D3:D1293,E3:E1293)
Which gives us a value of 0.930, a very high correlation. But this doesn’t tell us as much as we would like. Instead of using all the data at once, we will use a 20-day correlation in column F, starting at row 22:
=CORREL(D3:D22,E3:D22)
Then copy that down in row F. We can then see the range of correlations in the chart below.
Chart 1. 20-day correlations of SPY vs QQQ from 2020.
This is clearly more informative. The correlation using all data was 0.93, and the average of the 20-day correlations was 0.913. Not a lot of difference.
While there are some movements towards 0.80, which might offer a chance for arbitrage, there are a few nasty differences, which don’t last long. We can see that, from 2022, the two markets have moved together.
While arbitrage might be good strategy, trading these two markets using a trend system will not offer much diversification. I prefer correlations below 0.60.
Individual Stocks
We would naturally expect to get diversification from a well-chosen set of stocks. We’ll look at LLY and NDVA as unrelated. I could have chosen dozens of pairs, but these were the first that came to mind. Chart 2 shows that the correlations ranged between 0.80 and -0.40, with an average of 0.21 (the orange line in the middle). I’m not sure if this offers an arbitrage opportunity, but they do offer diversification.
Chart 2. Correlation between LLY and NVDA from 2020.
Although this seems like a good way to limit risk, we need to look at the peaks near 0.80. Those are where the two stocks moved together. We need to be sure that ALL stocks were not doing the same thing. If we look at stocks during the financial crisis of 2008, we find that the correlations mostly went to 1.0 (or -1.0), meaning they all moved together.
Chart 3 shows the decline to -1.0 in correlations during the 2008-2009 financial crisis. In addition, all other assets, including art and gold moved together. Traders liquidated everything to cover margins. So diversification is good in normal markets but bad during a crisis. Is that what you want?
Chart 3. Correlation moved together during the financial crisis (source: Trading Systems and Methods, Figure 24.3).
You’ll also find that volatility occurs in most markets at the same time. So not only do markets move together, but they increase in volatility (or risk) at the same time. This is not good for diversification (see Chart 4, a comparison of volatility of SPY and QQQ). We do expect QQQ to be more volatile, but it will be hard to find stocks with good returns in these sectors that offer diversification.
Chart 4. Annualized volatility of SPY and QQQ.
The conclusion was that it was easy to get diversification except when you needed it most. That was during the Nasdaq decline in 2000 and the S&P in 2008=2009.
How Much Diversification Do You Need in Stocks?
Chart 5 shows the amount of diversification you get from adding another asset. As you can see, when you get to 20, there is only a small change. And that is if the correlations are low. My own approach is to limit a stock portfolio to 10 markets. That offers diversification and the ability to generate outstanding profits. Remember, how are we going to beat the S&P without accepting risk?
Chart 5. Impact of diversification using 1 to 20 assets.
Correlation of Futures Sectors
Futures sectors target different areas of the economy. Even with that, they can be interdependent. For example,
- . Interest rates affect the stock market (and most everything else)
- . Interest rates affect the U.S. dollar.
- . Gold is a hedge against the U.S. dollar
- . Non-ferrous metals are used for housing, which is also affected by interest rates.
- . The health of the U.S. economy affects energy, agriculture, and the stock market.
Of these sectors, interest rates are the most correlated. Fed policies affect the shortest maturities, but all Treasuries are highly correlated. Chart 6 shows the history of interest rate futures. While the longer maturities are more volatile, they ae highly correlated, but volatility increases with maturity.
Chart 6. History of interest rate futures.
FX market, as marked against the U.S. dollar is also correlated. When the U.S. dollar declines, other currencies rise. Well, maybe not the Canadian Dollar, which has trade ties to the U.S. (at least it did).
The agricultural sector is the least correlated but also the least liquid. It contains U.S. grans, cocoa, coffee, sugar, orange juice, and whatever else we can add. Many of those are grown in other countries with different seasonal effects.
The Point of this Discussion
Diversification is good until it’s not. No matter what you do, there will be periods of extreme risk. But let’s talk about how it affects your returns and risk.
If you are looking for stock diversification, you can calculate the correlations and find the stocks that are both uncorrelated and have high returns. Perhaps that will be Nvida, Apple, and Lilly. But if they are all going up, are they likely to come down at the same time? Perhaps.
Whether they do or not, they will be very volatile, and volatile is risk. So most traders, given a choice, are looking for returns and not diversification.
My own theory is that, if you really want diversification, trade the S&P. It is fully diversified. Since 1998 it has had a return of 8.6% and a risk of 19.4%. Unfortunately, it also has had large drawdowns, as shown in Chart 7.
Chart 7. SPY drawdowns.
Then how is diversification helping?
How To Pick the Best Stocks
If you want to beat the market, you’ll need to have a trading system – even a simple trend system, and select the market that it does best. You might need a scanner to apply your system to a list of stocks. Then pick the 10 best over some recent past. “Recent” allows a stock or futures market to start trending when it was erratic before. It also allows you to remove stocks that were doing well but are no longer the best.
Yes, there are times when you will have 50% in tech stocks, perhaps more. But those are the times when they are moving. You may have drawdowns of 25% to 30%, but you should have returns nearly the same. That’s much better than the index.
Diversification comes from using different systems
Just as a note. You can get diversification from different strategies. If both are successful in the long-term, then a trend and mean-reversion work well. Or any short-term strategy with a long-term trend.
Different time periods applied to the same strategy won’t help much. In a crisis they will all move together. Nor will markets with different volatility. We size position based on volatility in order to equalize risk, so volatility is negated.
Think about it. Try selecting the best stocks and futures for your strategy. Avoid the underperformers.
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 equity portfolios. Our work over the years shows that downturns in the stock market are most often short-lived and it is difficult to capture with a longer-term trend. The upwards bias also works against shorter-term systems unless using futures, which allows leverage. Our decision has been to take only long positions in equities and control the risk by exiting many of the portfolios when there is extreme volatility and/or an indication of a severe downturn.
PORTFOLIO METHODOLOGY IN BRIEF
Both equity and futures programs 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 on the specific system, 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 outperforming 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 since are simulated but the returns from 2013 are the systematic daily performance added day by day. Any changes to the strategies do not affect the past performance, unless noted. The system assumes 100% investment and stocks are executed on the open, futures on the close of the trading day following the signals. From time to time we make logic changes to the strategies and show how the new model performs.
Groups DE1 and WE1: Daily and Weekly Trend Program for Stocks, including Income Focus, DowHedge, Sector Rotation, and the New High-Risk Portfolio
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. It will hold fewer stocks when they do not meet our condition and exit the entire portfolio when there is extreme risk or a significant downturn.
Equity Trend
A loss in the Daily Trend program of 2.65% leaves slightly down for the year, but the 30 stock program remains ahead. The Weekly program too the biggest hit, unable to change positions fast enough But we’ve seen this before. The last time Trump imposed tariffs on China the market sold off. He reversed them and the market recovered.
Income Focus and Sector Rotation
Are rates going higher? Are they going lower? At this time no one seems to know. Both of these programs benefit from lowering rates but at this point they are treading water.
Weekly Sector Rotation
This program continues to generate profits. It has been holding three ETFs: Financials, Staples, and Utilities and refusing to be distracted! Higher by more than 3% in February, it is not ahead by 7.4% for 2025.
DowHedge Programs
Small losses in February but still positive for the year, very much like the Dow ETF DIA. The equity is sitting near its highs.
High-Risk Portfolios
There is still a lot of news about DeepSeek, some good, some not so good. But it seems to have dampened the buying of tech stocks. This program has pharma, which might turn out to be the next wave given bird flue and whatever comes next. This program had losses of 3.3% and 6.7% in the two portfolios.
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.
Large losses in the 10-stock portfolio of 6.7% and the smaller portfolio of 3.1%. Still, the 10-stock remains ahead for the year and the 30-stock is fractionally behind. This is all much the same as the equity indices.
Group DE3: Timing Program for Stocks
The Timing program is a relative-value arbitrage, taking advantage of undervalued stocks relative to its index. It first finds the index that correlates best with a stock, then waits for an oversold indicator within an upwards trend. It exits when the stock price normalizes relative to the index, or the trend turns down. These portfolios are long-only because the upwards bias in stocks and that they are most often used in retirement accounts.
While the charts don’t look too bad, buying on a pullback is not working in this market. Returns could jump up if the market decides to rally. One never knows with the market. Meanwhile, this program lost 7.7% in the small portfolio and 6.3% in the larger.
Futures Programs
Groups DF1: Daily 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 down 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. The “US 250K” portfolio trades only U.S. futures.
A losing month much like the other portfolios and the market. The 500K lost 3.5% for a 2025 loss of 4.5%. We always hope that futures will offset equity losses, but for that we need a serious decline in equities. I’m not sure that we want that!
Group DF2: Divergence Portfolio for Futures
Smaller losses than that trend system, but still not the market for this strategy. It buy or sells during a pause in an uptrend. Given that there is no trend, there is no pause.
Blogs and Recent Publications
Perry’s books are all available on Amazon or through our website, www.kaufmansignals.com.
March 2025
Perry looks at an old standard in “Revisiting the 3-Day Trade,” which appeared in Technical Analysis of Stocks & Commodities in the March issue.
February 2025
Another article, “Chasing the Market” appeared in the February issue of Technical Analysis of Stocks & Commodities. It answers the question, “Can you make money entering the market after a big move?”
Perry enjoyed the “Fireside Chat” at theSociety of Technical Analysts (STA) in London on Tuesday, February 11. It should be available for viewing on their website. He also taped another interview and we’ll let you know how to see it when it’s released.
He also posted “If you think the market will tank, here’s a plan” on SeekingAlpha. It has received lots of view and good comments, although it is advising deleveraging.
December 2024
“Overlooked Strategy Rules” appeared in the December issue of Technical Analysis of Stocks & Commodities. We tend to overlook certain rules that can make a big difference to results. This article looks at scaling in and scaling out of a position, delayed entries, correlations, and other simple but important rules.
October 2024
“Trading a Breakout System” was published in Technical Analysis of Stocks & Commodities. It looks at whether it’s better to enter on the bullish breakout, wait for confirmation, or buy ahead of the breakout. It’s a practical look at improving breakout results.
September 2024
Two articles posted by Perry, “The N-Day or the Swing Breakout,” (Technical Analysis of Stocks & Commodities) looking to see which is better. You would be surprised.
A look at deleveraging Artificial Intelligence stocks, a shorter version of the article posted in our “Close-Up” section. It appeared in Seeking Alpha earlier in September.
August 2024
“Theory Versus Reality” was published in the August issue of Technical Analysis of Stocks & Commodities. It discusses price shocks, diversification, predicting performance, and more.
July 2024
Perry posted a new article on Seeking Alpha, “Capturing Fund Flows.” It a good strategy for someone that wants to add some diversification. It only trades 3 days each month!
June 2024
Perry was interviewed on June 27th by Simon Mansell and Richard Brennan at QuantiveAlpha (Queensland, Australia), a website heavy into technical trading. It should be posted in a week or so.
“Trading Extreme Gaps and Extreme Closes” looks at daily patterns in stocks, published in the June edition of Technical Analysis.
May 2024
In the April edition of Technical Analysis, Perry again deals with risk in “How Professional Assign Risk.” It is another chapter in how to protect yourself.
April 2024
Another article in the April edition of Technical Analysis, “Determining Risk Before It Happens.” Perry thinks this is an article everyone should read.
Older Items of Interest
On April 18th, 2023, Perry gave a webinar to the Society of Technical Analysts (London) on how to develop and test a successful trading system. Check their website for more details, https://www.technicalanalysts.com..
Perry’s webinar on risk, given to the U.K. Society of Technical Analysts, can be seen using the following link: https://vimeo.com/708691362/04c8fb70ea
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, Michael Covel’s website, TrendFollowing.com, and Talking Trading.com.
You will also find up to six months of back copies of our “Close-Up” reports on our website, www.kaufmansignals.com. You can address any questions to perry@kaufmansignalsdaily.com.
© February 2025, Etna Publishing, LLC. All Rights Reserved.