Industry Benchmark Performance
January was a good month for CTAs with the average returns near 4%, similar to our $1 Million weekly portfolio. Due to the delay in reporting, we now show the previous month’s results for hedge funds and current results for CTAs. Given automation, it’s not clear why hedge funds take so long to report, but we can only show what is publically available.
January Overview: Yuk!
Our programs beat the benchmark in all portfolios, but it’s not the results anyone would want. The chart below shows the steep drop in January, off 9%, 10%, and 11% for SPY, QQQ, and IWM on January 20th before recovering a bit. The reason seems to have been another acknowledgement of a slowdown in China, but better news out of Europe should have been equally important to U.S. investors. The only conclusion we can draw is that investors are nervous. We remain optimistic that there are no serious economic issues and a likely European economic recovery would weaken the dollar, good news for us.
Futures fared much better, with all but the smallest portfolios posting gains for January. Because of the erratic price movement in both equities and futures, the Weekly Futures program was the leader, avoiding many of the whipsaws.
It will be interesting to watch the effects of low oil prices on Russia, Iran, and China. With prices now below $30/bbl Russia will be under even more financial pressure. Iran, coming on line with more oil, has frightened the market. The only winner seems to be China, which has negotiating power. We wonder what will happen to the Russia-China oil deal with Iran also interested in selling to China.
We’re still not sure why the market thinks that low oil prices are negative for the stock market, because we can only see positives for all economies except the mid-East oil producers. Even though economists can’t see that consumer spending has ticked up because of lower oil costs, it must be there. Without the increase in disposable income, we expect that consumer spending would have been lower. It’s the same phenomenon as seasonality. The seasonality in prices is always there, even when other factors overwhelm the traditional patterns.
Sector Rotation – Dead or Alive?
Persistence in the stock market is the tendency to continue doing the same thing, that is, prices continuing in the same direction. We can also call it trendiness. The idea behind classic Sector Rotation is that, if you pick the sectors that were performing best last month, they will continue to outperform this month. Was that true in 2015?
While the technique is always the same, some of the time periods change. Classic sector rotation can look at the returns of the past 1 month to 12, select the three best performers and buy them. You then repeat this process every month. In another version you only buy when the 9-month moving average of the S&P is moving higher. We chose to use the returns of the past 3 months applied to the most active sector SPDRs, shown below:
The next step is to calculate the ETF returns each month for the preceding three months, shown below. We’ve presented them as a heat map to help see how the returns are clustered. Notice how the red months seem to be blocked together. The S&P returns and the 9-month S&P trend are shown in the two right columns.
We pick the best three ETFs each month to use for the following month. The table below shows the S&P trend and monthly selection on the left, the returns for that selection, the average returns for the selection and for all the ETFs (as a benchmark), and the NAVs.
The NAVs on the far right, and the chart below, show that the sector rotation netted a 10.3% gain for the year (no commission costs were used) while the average of all 12 ETFs posted a 33% loss. Granted, there are 3 energy ETFs in the list, so it will be weighted to the downside given the significant drop in oil in 2015. Still, we’re impressed by the ability to make money in 2015 when the SPY posted a loss of 2.67% for the same period. Sector rotation seems to be alive and well.
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 do it will 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.
After leading the SPY to the downside for months, the Trend Strength Index now shows more strength than the SPY, not touching the previous lows of October while the SPY has made a quadruple bottom. Note that our SPY values are adjusted to be continuous, even when the actual SPY is adjusted quarterly. The differences are small but the adjustment is necessary for accuracy.
A Trend Strength value of minus 50 means that our set of markets is strongly trending down, but shows signs of stabilizing. The equity markets traditionally have a pattern of fast drops and slower rallies, although with changing participation we’ve seen much faster recoveries than in the past. A fast recovery would be nice to see.
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. January started long only two ETFs, Municipal bonds (MUB) and Retail (RTH). During uncertain periods, munis tend to be favored for their stability. In January we switched to consumer staples and utilities, another defensive ETF. At the end of the month we held
Consumer staples (XLP) and Utilities (XLU)
The Timing Rotation program began January long
Materials (XLD), Technology (XLK), Staples (XLP), Industrials (XLI), and Consumer Discretionary (XLY), all hedged 17% (1/6) of the risk using SPY:
With the sharp decline in the overall market, we exited all of the beginning ETFs and added only Technology (XLF). We also increased the hedge to 2/3 of our maximum 50% risk protection using SPY, putting us in a very defensive position.
Technology (XLK), 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.
Given the stock market performance of down 5% to 8.5%, our losses of 2% to 3% look much more conservative. One of the advantages of systematic trading is the built-in risk controls. When the market is flopping up and down we tend to lag the major index markets, due to the need for more confirmation before reentering a trend. This is a case where going at a slower pace pays off. By not losing as much, this program is in a better position to take advantage of the next rally.
The Trend ETF program chooses from a much smaller set of markets to trade. Out of 65 candidates, the program could only find 2 that qualified for a long position. Much of that can be explained by looking at the Trend Strength Index, which shows that, on average, equities trends are significantly down.
Weekly Equities performed about the same as the Daily Program, avoiding some of the jumping in and out of some stocks that seemed good one day and bad the next. While the equity curve is drifting lower, it seems very stable compared to the major index markets.
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.
(NOTE: We apologize for last month’s stock chart, which was wrong. It showed performance much worse than it should have been.)
The smallest 10 stock Divergence portfolio, which is more highly leveraged, took a larger loss than the other portfolios. Still, in the performance chart below, it seems well within the historic pattern. The larger 30 stock portfolio has been very steady throughout these volatile price moves. The Divergence ETF program, while always tracking at a much lower volatility, continues to post steady returns.
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.
The Timing program posted relatively small losses this month, similar to the Trend program. It has been hedged 2/3 of its risk for most of the month based on the fairly strong downtrends in the SPY and QQQ ETFs. This program has been showing a drawdown for some time, reflecting the overall equity market. It’s inevitable that buying weakness, even in a sound company, is going to show losses in a bear market. We expect to recover once prices start to stabilize.
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 did the best of all programs this month, even with the smallest 250K portfolio posting a loss. The larger 500K and 1M daily portfolios, and all the weekly portfolios, netting positive returns for January. The weekly program outperformed the daily, with the largest weekly program of $1 million gaining 4.60%, a good start for the year, and good diversification from stocks.
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 new Divergence portfolio had mixed results in January, with the smallest 250K posting a fractional loss and the larger portfolios fractional gains. This program traded mostly Canadian bonds and Long gilt this month, keeping clear of U.S. markets.
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