Industry Benchmark Performance
A generally good month for all programs, with long equity running ahead of the pack. But that would be expected in 9-year bull market. Even the Fund of Funds are showing gains. Futures CTAs posted mixed profits in July, with trend-following doing the best, and trimming somewhat substantial losses. We’re all waiting for some major trends to develop.
Blogs and Recent Publications
(We’ve moved this section to the end of the report.)
July Performance in Brief
The stock market keeps marching forward, with the Nasdaq 100 leaving the S&P and Russell in the dust. With few exceptions, our portfolios did well, keeping pace with the S&P, both Daily and Weekly Stock portfolios averaging about 10% year-to-date. The ETF portfolios, which tend to have modest returns, show gains of about twice the average annual expectation.
Futures put in an excellent month, averaging about 5% for the Daily Trend program and ranging from 2.4% to 6.0% for the Weekly Trend. The Futures Divergence program, which has had a very good year-to-date, posted fractional losses this month.
Major Equity ETFs. Last month it looked as though the stock market was weakening, but it again posted good gains, with SPY up 2.06% in July and 11.42% for the year, and QQQ up 4.06%, 21.47% for the year. If we only knew in advance! The laggard is the Russell, up 0.86% in July and 5.70% for the year. Still a nice performance. We won’t bother trying to predict if this will continue.
Selecting Markets That Work for Your Trading
Markets that work best for long-term trends are those that are driven by interest rate policy, or macro supply-demand changes. Historically, the best trending market is the Eurodollar interest rates, which closely reflect Fed policy. The worst are the equity index markets, which always have a high degree of backing-and-filling, even in a bull market.
Short-term trading requires the opposite pattern, markets with a lot of noise. They exhibit bursts of price movement, followed by equally sharp reversals, perfect for mean-reversion systems.
It’s one thing to theorize about which markets are better for trend profits or short-term trading, but theory does not always translate into reality. To prove that the concept works, and can be used for market selection, we calculate the rolling 60-day noise and scatter it against the corresponding 3-month net profits and the 10-year net profits, both ending concurrent with the noise calculation.
For those not familiar with the noise calculation, it’s
Noise = Price change over N days divided by the sum of each daily price change, taken as positive numbers.
We use N=60 and average the rolling noise over the past 20 years for stocks and 27 years for futures. When “Noise” is near zero, there is a lot of noise; when it has a higher value, it has more trendiness.
Stocks, Futures, and ETFs
Charts 1 and 2 show there is a clear correlation between noise and profits, based on 275 stocks used in our Equity Trend program, but it would be the same for any long-term trend strategy. Chart 1 uses profits over 90 days (3 months) and Chart 2 shows the same relationship using profits over 10 years.
There is a linear regression line shown on the charts. Both angle up and to the right, indicating that profits get larger as the noise ratio gets larger (less noise). There is a large cluster on the left of each chart, representing many stocks with either little trend or more noise than trend. Either way, they are not good candidates for a trend system. The points towards the upper right are the good ones. The fact that both the 90-day and the 10-year charts both show a similar picture proves that this concept is robust, that is, there is a clear relationship between noise and profits for trend following.
Chart 1 (left) and Chart 2 (right), scatter of 60-day noise vs net profit for rolling 3-month profits (left) and rolling 10-year profits (right). Based on 275 stocks from 1998.
The most liquid 65 futures show the same relationship, perhaps better. The only outlier is one point on the 10-year scatter that belies an otherwise strong correlation between noise and returns (see Chart 3 and Chart 4). Getting the same results when applying noise to a completely different set of markets increases the confidence level.
Chart 3 (left) and Chart 4 (right), scatter of 60-day noise vs net profit for rolling 3-month profits (left) and rolling 10-year profits (right). Based on 65 futures markets from 1990. Note that the one point at the bottom of the right chart distorts the strong correlation.
Not to avoid EFTs, we took 75 of the most liquid, and performed the same scatter, shown in Chart 5 and Chart 6. Because each ETF is an index, prices have intrinsically more noise and the correlation between noise and returns are stronger, as seen by the regression line.
Chart 5 (left) and Chart 6 (right), scatter of 60-day noise vs net profit for rolling 3-month profits (left) and rolling 10-year profits (right). Based on 75 ETFs from 1998 or inception. The correlation is stronger than stocks or futures.
How Do You Apply Noise?
As good as it looks, noise values can jump around. A good correlation does not mean that a trending market will always be a good choice or a noisy one won’t have periods of trend. Whenever there is uncertainty, it is best to limit the use of these relationships to extremes.
Instead of trying to use only the best markets, that is, the ones at the top right of the charts showing the least noise and the most return, eliminate the worst performers. You can see in all the charts that the markets on the far left posted net losses based on high noise. Eliminating a few of the worst, up to 20%, will boost your portfolio returns considerably and still leave plenty of markets to get diversification.
Markets that have a long history of losses based on a strategy, as well as more recent losses, should be avoided. If you run 3-month and long-term noise calculations, don’t trade any market that is in the lower 20% of both charts. That can be done by sorting the markets by their noise values. If you want to use the charts shown above, you can eliminate any markets with noise values below, for example, 0.15 for the 3-month ETFs, and 0.13 for the 10-year ETFs. Those values are very similar for stocks, futures, and ETFs.
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 275 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.
The Trend Strength Index is now tracking the same direction as SPY, although at a weaker level. The recent dip in the Index from about 60 to near 20 was reflected in SPY by a very small, sideways move, not very impressive. In all fairness, the TSI is based on our set of 275 stocks, which are a mix of S&P and Nasdaq members, with a few stocks that haven’t made it into the S&P but are actively traded.
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 June positions:
Preferred (PFF), Industrials (XLI), Technology (XLK), Staples (XLP), Utilities (XLU), and HealthCare (XLV)
End of July positions:
Industrials (XLI), Technology (XLK), Utilities (XLU), HealthCare (XLV), Materials (XLB), and Consumer Discretionary (XLY)
The Timing Program buys 4 ETFs that are undervalued with respect to SPY, in expectation of rotation.
At the end of June positions:
Technology (XLK), Utilities (XLU), and Consumer Discretionary (XLY)
We now hold:
Preferred Stocks (PFF), Industrials (XLI), and Utilities (XLU)
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, Income Focus, and Dow Arbitrage
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.
All portfolios were profitable in July. Stocks gained 0.99% to 1.27% and ETFs from 2.05% to 2.18%. Year-to-date looks good, with the two stock portfolios averaging about 10% and ETFs about 4.25%, all well ahead of their long-term rate of return. Both charts below show steady growth based on a bull market that we thought would end in the first quarter of this year. It’s the benefit of following a system rather than overthinking the decisions.
The Weekly Equity Program was mostly profitable, but less so than the Daily Program. All four portfolios still look strong with the smaller ones continuing to outperform.
Income Focus and Sector Rotation
July saw both Daily and Weekly Income Focus portfolios gain nearly identical amounts, 0.45% and 0.47%, about the long-term average return for this program. It may not be exciting, but it’s steady.
A gain of 1.81% for July puts the Sector Rotation program back in positive territory for the year. It’s been clawing back from a drawdown last year but has been much more inconsistent that we would want. Still, it’s a classic way of trading and offers good diversification.
On the other hand, this new program is outperforming expectations, with July +3.20% and year-to-date +17.67. The run up looks hard to sustain, but then so does the bull market that we’ve seen since 2008. Another good reason to be an algorithmic trader. Rather than deleverage in expectation of the end of the bull market, this program shows that profits are accelerating.
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.
Both stock portfolios posted gains in July, but slightly below the SPY benchmark. The charts below remain mostly the same, with the 30-stock portfolio looking strong. The ETF program was virtually unchanged for the month.
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.
We apologize for printing the wrong charts last month, but this time they’re correct. The two stock portfolios were mixed this month, with the 15-stock up and the 30-stock fractionally lower. The 10-stock portfolio is holding onto nice gains over the past few months. The ETF portfolio gained 2.27%, a sign that the recovery is continuing.
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.”
A good month for both the Daily and Weekly Futures Trend portfolios. The Daily program posted gains from 4.33% to 5.27%, adding to year-to-date profits and hovering near the all-time equity highs. The Weekly program gain from 2.39% to 5.98% giving us hope that we’ve seen the last of the drawdown.
Group DF2: Daily Divergence Portfolio for Futures
Fractional losses in the Divergence program doesn’t change the picture of a strong recovery. The 250K portfolio is up for the year better than 11.5%, while the larger portfolios are higher by 5% to 6%.
Blogs and Recent Publications
Mr. Kaufman will give a 1-day seminar on Developing an Algorithmic Trading Strategy for the Chicago Institute of Investing on Monday, September 4. It will be held in Chicago. Check their website for details.
Mr. Kaufman will be a Keynote Speaker at the IFTA annual conference, hosted by the Swiss technical analyst’s association (SIAT) to be held in Milan, Italy, in mid-October 2017.
ProActive Investor Magazine published Keeping Risk Under Control on June 22. Check their website. It will be publishing other articles later this year.
Seeking Alpha has published a new article, “Living Off Profits,” a help for those investors that plan to withdraw funds from their investment account.
Technical Analysis of Stocks & Commodities has published The Return of High Momentum in the July issue, a new intraday system that combines both high momentum and mean reversion into a single strategy.
Technical Analysis of Stocks & Commodities will also publish “Optimization – Doing It Right,” now scheduled for the September issue
Modern Trader will print Dogging the Dow. It’s a full-length write-up on the new trading program was presented in last month’s report.
The Swiss Technical Analysis Society (SMAT) has published Creating Your Own Sectors in their current quarterly publication. If your focus is higher returns, It shows that simple market selection is far better than a packaged ETF.
Andrew Swanscott at BetterSystemTrader.com (a good source for trading systems) has put up an edited version of an older presentation of Mr. Kaufman’s. It’s all about price noise and the Efficiency Ratio.
Look for past 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.
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