Industry Benchmark Performance
Hedge Fund early reporting for January shows good gains in equities, with multi-strategy programs gaining more than 3%. Early reporting of Barclays benchmarks show mostly flat returns for January, but the BTOP 50, which should be more current, shows a loss of 1%. Stocks have been doing better than Futures for the past year.
January Performance in Brief
A profitable month for all equity programs, and small losses for all futures programs. We expect that all the good news is in the market, and now everyone will be waiting for actual policy changes, or at least more news of policy changes that will be positive for business.
The equity Trend program had the smallest gain, while the Timing and Divergence programs posted near 6% in the smallest portfolios, and 2% to 3% in the larger portfolios. A good start for the year.
All weekly equity programs got off to a good start, with the larger stock portfolio and Sector Rotation leading.
In futures, the smallest portfolios are still struggling due to lack of diversification; however, when a trend starts, it will make up ground quickly. The other portfolios posted smaller losses while the market regroups, waiting for the new administration to clarify its positions.
Major Equity ETFs. Momentum has shifted from the small caps (IWM) to Nasdaq (QQQ), greatly due to Apple, which gained nearly 5% in January. The S&P crept higher by 1.78% and the small gaps posted a gain of only 28 basis points (0.28%). The small caps remain very volatile and have been higher and lower than the S&P by double the return.
Blogs and Recent Publications
The next 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.
Also, this month will see 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 (https://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 firstname.lastname@example.org.
January Insight: Exploiting Confusion
It’s all about the dollar. The EURUSD (the euro) shows that the dollar has been strengthening since last September, increased more in December following the election, and has now been weakening slowly. At the same time, metals are moving with the dollar, silver is twice as volatile as gold, and even copper is now moving in the same direction. Perhaps that’s not surprising because metals are quoted in dollars.
Metals normally hold a steady international value, that is, neutral to all countries, then the gold price should fall when the dollar rises. That seems to be the case shown in the chart above. And it’s the same for agricultural products that we export. When the dollar rises, the price of wheat for export falls, so the importer still pays the same price. Otherwise, they would buy from someone offering a cheaper price.
Now consider interest rates. The chart below shows that rates have risen steadily through the end of 2016, but have now stalled. When interest rates rise, the dollar rises as money flows into the US to take advantage of higher rates. We also see crude oil rising while the dollar strengthened, and falling now that the dollar is weakening. Crude oil is also quoted in dollars internationally, so this move is opposite of what we would expect. Then it must be caused by tightening of supplies following the last OPEC meeting.
Now, let’s start by being as logical as possible about what might happen in the next few months. The Fed is expected to move rates higher very slowly. That would continue to strengthen the dollar. If money flows into the US and finds its way to interest rates, that tends to push rates down (demand for bonds). A stronger dollar means weaker metals prices and some pressure on crude oil. Nothing wrong with that, and it’s not inflationary.
The missing factor is instability. When you move money into a country to take advantage of higher rates, the biggest other component is the stability of the government and the rate of inflation. If the dollar weakens, then the loss in value of the dollar, as seen by a foreign investor, can be more than the interest income they are trying to earn. It would certainly be more than the difference between what they could earn at home and what they can earn in the U.S.
Then there is stability. We wouldn’t invest our money in Argentina even though interest rates are 24.75% because inflation is averaging 200% and the government is in chaos. Strictly from an investor’s viewpoint, rate of inflation exceeds the return you would get from your investment (without even considering the credibility of the government), so you would come out behind. That may not be on the horizon in the US, but the possibility of a trade war with Mexico, and even China, is not out of the question. We have no idea how that would play out. The new policy of “everyone for themselves” is unsettling for an investor because they have no way of knowing how it will affect them. The result is that many investors, from all countries, will run for cover. They will take the safe route, whatever that is. One thing for certain, it will mean less investment in the US in all forms. Reluctance to invest in the U.S. may counter the positive effect that a decrease in tax rates and regulation was supposed to generate.
How do we take advantage of this uncertainty? First, interest rates should rise, a combination of Fed action, new administration spending, and expected tax reductions for corporations. Tax reductions will stimulate spending unless there is too much uncertainty. Even then, there will be a lag between easing regulation and corporate spending. We could hold on to any savings until the dust settled. Even with higher rates, there will be a reluctance to move money into the US to take advantage of higher rates (not quite like Argentina, but still uncertainty). So, the typical response of lower gold prices should be tempered. Finally, the value of the dollar will not follow interest rates higher because uncertainty makes it necessary to offer a lot more to attract buyers and large funds.
The internet, high-tech companies seem undeterred by anything going on in politics. Since the election, they have moved sideways at first, then started a steady climb. Business keeps growing, with Facebook, just today, announcing an increase in ad revenues by more than 50%. We’ll see if that encourages investment across their industry, for lack of other places to place funds.
The sector ETFs that we normally track are looking tentative at best. Despite the rise in crude prices, energy stocks (XLE) are falling. Health Care (XLV), normally a reliable sector, is also reacting to uncertainty with some moderately volatile sideways movement. Financials (XLF) seem to be holding up. The only sector that shows some upward movement is Emerging Markets (EEM). Why is that? It seems contrary to normal, when money should be moving into US markets and away from the riskier emerging nations, given that interest rates are rising. There seems to be a yellow flag there.
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.
The Trend Strength Index continues to track SPY but is well below its previous highs. By any chart interpretation, it looks as though the equity index has stalled and is ready for a retracement.
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.
The Trend Sector ETF program buys the 6 strongest sectors of the SPDRs.
At the end of December, we Oil & Gas Exploration (XES), Materials (XLB), Energy (XLE), Financials (XLF), Industrials (XLI), and Metals & Mining (XME).
We held all the same positions except replacing energy (XLE) with Technology (XLK). We now hold:
Oil & Gas Exploration (XES), Materials (XLB), Financials (XLF), Industrials (XLI), Metals & Mining (XME), and Technology (XLK),
The Timing Program buys 4 ETFs that are undervalued with respect to SPY, in expectation of rotation. We started January with only two positions, Preferred Stocks (PFF), and Financials (XLF).This month we exited Preferred and added Energy (XLE), Metals & Mining (XME), and Retail (XRT). We now hold:
Energy (XLE), Financials (XLF), Metals & Mining (XME), and Retail (XRT).
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.
The Trend Equity Program continued to perform well, adding 1% to about 2.5% to all its portfolios, and posting new high equities. The ETF programs gained nicely with the Sector ETF program looking as though there is an uptrend in returns.
The Weekly Equity Trend Program continued to outperform the daily program in all portfolios, this month returning between 2% and 5%. The 10-stock portfolio is holding onto a nice upside run, while the 30-stock is now just making new highs. The ETF portfolios still need a few good months to recover, but this month helps.
Income Focus and Sector Rotation
The Daily and Weekly Income Focus programs both posted gains of 1.2% for January, an excellent return for this program. It appears as though the correction is over and the program is approaching new highs
The Weekly Sector Rotation moved up nicely, gaining 3.5% in January and looking positive on the charts.
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.
A continuation of good performance for the Divergence program, with the 10-stock portfolio gaining more than 5%, the 30-stock close to 2.25%, and the ETF program just under 1%. We expect the smaller stock portfolio to outperform, even though it might have higher risk than the larger portfolio. 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.
Another good month for the Tmiing Program, gaining 6.13% and 3.03% in the small and larger portfolios. That put them up 14% and 10% in the past two months. Both programs are on new highs, but the smaller portfolio is on a run, even if volatility is higher. The ETF program posted small gains, but the pattern clearly looks to be one of recovery.
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.”
We keep waiting for trends to develop in the futures markets, but so far, pickings are sparse. We posted losses in the daily program from 3.25% to 1.85%, and from 1.80% to 0.14% in the weekly program. Looking at the brighter side, the program continues to beat the CTA Index, which has survivorship bias, so we’ll be ahead of the Industry when trends show up.
Group DF2: Daily Divergence Portfolio for Futures
Small losses in all portfolios leave the Divergence program hovering near its pullback lows. Looks like it’s time for a run of profits, much like the Timing Program.
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