Are the negatives beginning to outweigh the positives? Can a better GDP offset the underlying concerns of the market that’s inundated with Gaza, Ukraine, Argentina’s default, Portugal’s new banking issues, the end of Fed easing (eventually), and a 5-year stock market rally? We’ve always believed that, as long as the broad investing public remains on the sidelines, stock prices will rise. History reminds us that there are no hard and fast rules.
Due to popular demand, we are now posting the Weekly Trend Futures program. For technicians, weekly data tends to showthe trend more so than daily data, because it has the extra smoothing as a result of only using one day each week (in our case, Friday). Odd price moves during the week are ignored. The downside is that a weekly program will be slower to react to a real trend change, but there are trade-0ffs in any strategy, and this one is acceptable to many long-term investors.
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. 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, EWX is the equally-weighted 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 TSI started down on July 7, well ahead of the SPY, indicating a classic divergence. All of our programs react to a change in trend. The Trend strategy will start to reduce position size and may trade fewer stocks; the Divergence strategy will find fewer new signals, and the Timing program will begin to hedge its exposure. We offer this Index for those investors select their own trades rather than following our sample portfolios. Daily Index values are available to subscribers.
The last day of July was sad for both equities and futures, sharply reversing the gradual upward trend in performance and netting a loss for SPY. NASDAQ is holding up best, but the small caps, IWM, dropped 6%. Traditional analysis says that investors are becoming more cautious when they switch out of small caps. We see each of our trading programs taking defensive action. See the comments at the beginning of each section.
All of our daily stock and ETF programs posted losses in July. Most of the stock programs lost slightly more than the benchmark SPY because they are high-beta portfolios. The YTD returns for all three stock strategies remains nicely positive, ahead of the SPY in all but one smaller portfolio. The Weekly Trend stock program gained a small amount in all portfolios.
In futures, the Trend program showed net gains in all portfolios, but the Divergence program reversed its steady climb, posting its worst monthly loss in some time. The larger $500K and $1M portfolios remain profitable for the year. The benchmark Indexes published by Barclays and Newedge show overall fractional losses in July and fractional gains for 2014. The BTOP 50 also showed a loss of -0.51% in July and -0.13% YTD. No one is finding this market easy to trade.
Strongest and Weakest 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 Rotation program (buy strong) removed Oil & Gas (XOP) and Oil & Gas Exploration (XES). Financials (XLF) and Consumer Discretionary (XLY) were added. Exposure to XLB was reduced by about 1/3, indicating overall weakness in the market. Current positions are:
Materials (XLB), Energy (XLE), Financials (XLF), Technology (XLK), Heath Care (XLV), and Consumer Discretionary (XLY)
The Timing Rotation program (buy low) exited more ETFs than it entered and now holds only 6 of 8 possible positions. Instead of reducing its position in XLB, as did the Trend, it removed it completely. Its current positions are:
Oil and Gas Equipment (XES), Energy (XLE), Industrials (XLI), and Staples (XLP), Utilities (XLU), Oil & Gas (XOP)
This month we only see Energy in both groups. That means Energy has a strong long-term trend but is now oversold relative to SPY. We see those as particularly opportune trades.
A Standing Note on Short Sales
Note that the “All Signals” reports show short sales in stocks and ETFs, even though shorts are not taken in the portfolios. Our recent 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 a welcome risk reduction. In this case we prefer paying for risk insurance, even without the expectation of any significant gain from it.
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, the current signal, and, with futures, 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 had profitable performance over many years combined with good short-term returns.
The Trend program chooses the best performers for the portfolio. These stocks have the strongest trends and are fully committed. On the last day of July, some of the stocks added to the portfolio were underleveraged, that is, if you were trading $10,000 per market, the program only wanted an investment of about $6500. That represents “scaling down” as the trends weaken. It is also reflected in the Trend Strength Index.
A little rain must fall. Even with a modest loss in July, the overall picture of the stock and ETF portfolios is strongly positive. Our tracking shows that the 10 and 30 stock portfolios are positive by 15.8% and 7.7% for the year, while the EFT portfolios are now flat for the year. While a stock market rally is the best scenario for the future, the Trend program is on the verge of scaling down on its holdings as its way of reducing risk.
Both Weekly Trend programs showed positive returns this month, contrary to most other portfolios and the benchmark index markets. The stock portfolios are still well ahead for the year, and the ETFs are adding to small gains. In both cases, the smaller, higher beta portfolios of 10 are well ahead of the more diverse portfolios. The downside is that they will risk faster losses when the overall market turns.
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.
Divergence patterns can occur in bull and bear markets, but our program will find fewer bullish divergences and more bearish ones as the market rolls over. Portfolios will have fewer positions; therefore, they will be less exposed as a bear market move develops.
Even with small losses in July, the Divergence program for stocks has strong returns for 2014. As a pattern recognition program, it offers excellent diversification for portfolios using any type of momentum strategy. While trades of the underlying system are held for about 5 to 8 days, signals are selected for the portfolio a day or so after they have been initiated. Because the pattern of a mean-reversion trade often shows starting losses, this method actually selects a more profitable part of the trade. It is frequently underleveraged because it is not always possible to find enough trading signals to fill the portfolio. But because underleveraged also means lower risk, the returns from this program have been very good.
The ETF portfolio, which is limited by the lower volatility of an index and by fewer liquid markets, is far less volatility than the other stock programs. It posted a loss for July but is holding on the profits for the year. The long-term pattern of returns is excellent.
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 the 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 will hedge the risk of the stocks in the portfolio in three parts, based on the strength of a developing bear market. As of August 5, the program began hedging stocks that track the SP, reducing risk in the portfolios. Note that during the upward trend in the market the hedge has lost money, which means the trend resumed giving us greater profits on the upside. But it is important to follow a sound plan and protect the downside.
This program gave back a small amount after a strong June and remains well ahead for the year. The slow, steady move upward all month kept the program from setting hedge positions, and the drop in the S&P on the last day was not enough to trigger any medium to long-term downtrends. A few more days of decline should see the program begin to hedge.
The ETF rotation portfolio has a strategy contrary to the Trend Rotation. This one buys undervalued ETFs while the Trend program buys the outperformers. While the Trend program can achieve high returns with high risk by selecting from a broad range of stocks, the Timing program targets moderate returns with low risk. Not all stocks qualify because they do not necessarily track any index.
We indicated the holdings of the ETF Timing program earlier in this report, under “Strongest and Weakest ETFs.” All of our ETF programs tend to be less volatile, with lower returns that the stock programs, by the very nature that ETFs are an index. In July, buying the weakest stocks (with a good long-term record of recovery), can produce larger short-term losses.
Because of the high leverage in futures trading, we’ll take a closer look at short-term performance this month. We also see the combination of Trend and Divergence Programs as good diversification. The Trend is primary, targeting macroeconomic trend, based mostly on world interest rates. Divergence is a short-term program based on pattern recognition; therefore, the two programs have little relationship to each other in the way they choose to take trades.
Comparing the sector performance of the two programs for July and year-to-day, we see some common ground and some differences. Both programs reduce leverage in short-term interest rates when those yields fall to low levels. Our analysis shows that there are poor trends during those times, and the low volatility results in small profits and larger risk for both programs. The Divergence chart on the left shows no trades for “Rates” (short-term maturities), and very small returns for the Trend (in this program, “Rates” include but short-term and long-term maturities).
For Divergence, the bonds (long-term) still give the best returns, with FX and Equity Index net losers for the year. For both programs, the interest rates and agricultural markets are the best performers, although in very different percentages. Remember that, even with “uncorrelated” programs, profits or losses can occur at the same time.
Group DF1: Daily Trend Program 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 to execute for U.S. investors.
Please read the new report describing our revised portfolio allocation methodology available under the drop-down menu “Articles.”
The Trend program added to gains this month, holding a diversified position in 12 markets out of a possible 30 for the largest $1M portfolio. Although the portfolio leverages up when it holds less than a full portfolio, it remains at a lower leverage than if it were fully committed.
The chart below gives a long-term and short-term view of performance. The long-term shows a strong upward breakout of returns, confirmed by the new highs for the year that occurred in May. You can also see that the last day of July was as negative for futures as it was for equities. Reversal days can affect all programs the same way.
The $500K account is outperformed the others in July, but for the year the $1M portfolio is ahead. We still expect that the smaller accounts will have higher returns and higher risk than larger accounts, due to less diversification. This in no way to predicts what combination will produce the best year end results.
Group DF2: Daily Divergence Portfolio for Futures
The Divergence futures program paints an extreme picture of long-term versus short-term performance. In the long term it shows a sharp breakout to the upside, but July posted a large reversal, affecting the smaller accounts more than the larger. We can blame that on the lack of diversification in July. During the last week of trading, the program held from 1 to 6 positions on any one day. Few positions will result in higher volatility, both positive and negative. With a pattern recognition program, such as Divergence, it is not always possible to find a large number of trades in a set of liquid world futures markets.
To keep it in perspective, in the past there have been many situations like this. Part of the portfolio profile is a “target volatility,” which allows the program to take a specific risk to gain a good return on investment. Investors looking for lower risk can either select a smaller portfolio or scale down the size of the positions in any of the portfolios.
Group WF1: Weekly Trend Portfolio for Futures
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.
Because of the recent sideways price activity in many futures markets, in particular equity index, interest rates, and energy, this program has avoided some false signals and held onto gains for the year. Two of the three portfolios posted gains for July and the YTD results are the best of all our programs.
In the charts below we can see an upside breakout of the larger portfolios, but a steady rise in the smaller, 250K portfolio. These portfolios trade only the main U.S. and European futures markets, with orders entered on the open for the U.S. and the close for Europe. The chart on the right is a better view of 2014 returns, showing a significant pull back midmonth, followed by a partial recovery.
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