Industry Benchmark Performance
Even with early signs showing gains in July, the hedge fund industry is lagging far behind the broad market indices. Most funds are slightly down or slightly up. The biggest problem seems to be the lack of risk control. None of the funds show that they reduced risk during the worst of the Covid decline, a measure that would now put them ahead of the market.
Futures were consistently better, but also show only small gains for the year. But then they are diversified in a different way from equities. They also did not benefit from short sales in the index markets, but may gain on the decline of the dollar.
Blogs and Recent Publications – A New Book on Amazon!
Find this at the end of this report. We post new interviews and reference new articles each month.
We are pleased to announce the publication of Kaufman Constructs Trading Systems, available on Amazon as both an ebook and a print book. It is an excellent complement to Trading Systems and Methods, showing step-by-step how to create and develop a trading system, with many examples. Order it through our website, www.kaufmansignals.com or on Amazon.
Kaufman’s Fast Strike Systems on MetaStock
If you are interested in short-term trading, look at Kaufman’s Fast Strike strategies. Contact MetaStock at 800-882-3040 or go online to www.metastock.com/kaufmana.
July Performance in Brief
We continue to benefit from this extraordinary tech rally, adding more than 7% to our 10-stock trend portfolio, now up 21.6% for the year. The 10-stock Divergence program is higher by 22% and the Timing program by 43%. In an economy that is crippled, stock picking seems to be working.
The weekly and daily trend program have taken different paths. We exited from the weekly portfolios due to extreme risk, while that daily program still holds its positions. The stocks that we are holding are greatly overbought, so exiting would not have been a surprise. Time will tell whether the weekly or daily program is correct.
The daily trend program in futures is also doing well, up 15% in July and 16% to 27% for 2020. The Futures Divergence program lags the others but has modest profits for the year. Overall, we cannot ask for much more except holding on to gains for the rest of the year!
Last month it looked as though the equity index markets were peaking. Not so with Nasdaq (QQQ), which gained another 9.5% in July. But while the S&P and Nasdaq are ahead for the year, the DOW and Russell (small caps) remain lower. We believe that the S&P is benefiting in a smaller way from the tech rally.
There is considerable speculation that Tesla will be added to the S&P soon, and could drive that stock price even higher. Its capitalization is more than 95% of the other S&P companies. Sometimes it is all baked into the price in advance, so we can only wait and see.
The Tech Rally Keeps Going
While airlines, cruise lines, resorts, and restaurants suffer, tech stocks are enjoying windfall gains. The most evident is Apple, which posted an unexpected and huge second quarter profit. Its stock price jumped more than 10%, a difficult gain for a large company. It is now 29% higher than the peak before the Covid crisis began. There must be enough people stuck at home and not spending on restaurants and travel to be able to upgrade they iPhones.
On-line shopping has also gained nicely. Rather than go to a store, if they are open, we are all ordering on-line. We can actually get disinfectant wipes on Amazon when they are not available in the stores. ETSY is outperforming AMZN and EBAY, while Alibaba (BABA) is far behind.
If you use your computer for shopping, you will start with Google (GOOGL) or, if you’re in China, probably with BIDU. While Google has recovered its losses of March, it is sitting at its highs. BIDU is lagging its highs by about 15%.
Then there is social networking. While we are staying home, we are also contacting everyone we have ever known. That may be one of the few benefits of this virus. Both Facebook (FB) and Twitter (TWTR) have been moving higher since the lows of March, with FB on new highs and surging on its latest earnings report.
This is an unusual environment in which the broad index, the S&P 500, presents an average of two extremes. It is the same as having one foot in boiling water and one in ice water and claiming that you have an average temperature. There are those companies benefiting, namely these tech stocks, and others hurting. It is not clear that there are any in the middle.
CLOSE-UP: More Risk Control and Better Returns Targeted in the Weekly Program
As we saw early this year, there are times when exiting our portfolio and standing aside can be a big advantage. Our program looks for a sharp decline in performance combined with high volatility to trigger an exit. But up to now, the risk exit in the Weekly Trend portfolios were triggered by the exit in the Daily Trend portfolios.
Risk Exit and Reentry
Beginning July 15, the Weekly program calculates the extreme exit based on its own daily performance. Even though we only change positions weekly, the strategy tracks the daily returns (of the weekly positions) and triggers an exit any time during the week that the losses and volatility meet our threshold. That threshold is slightly smaller than the one used for the Daily program, although the dates for exiting and reentering the systems are usually very similar.
Hedging with Interest Rates
In an article that I wrote in Technical Analysis of Stocks & Commodities in last November, “Running for Cover,” I looked at whether you could buy bonds after we recognized that the stock market was in a steep drawdown. The article looked at the largest downward gaps in S&P futures and the corresponding returns in interest rates, in particular the Eurodollar, 10-year notes, and 30-year bonds. The results are shown in the table below.
Table 1. Movement of interest rates based on large downward 1-day gaps in S&P futures.
We enter on the close of the day with a large move down, then see if we captured profits on the following two days. On average, all three interest rates were profitable on the day after the downward gap. We would have entered on the close of the gap day, so the day after is the important day. The longer maturity, 30-year bonds, was the most profitable. The results show that, for a 1-day drop, there is immediate opportunity. However, our program will buy bonds after our exit threshold is triggered, not a drop in S&P prices, and hold that position until volatility returns to normal and our underlying strategy is again showing gains. Does that work?
Results of Bond Hedge
We all expect interest rates to drop when there is a financial crisis, but we need to prove that a long position in the ETF TLT is profitable based on our strategy. For that, we look at chart below. The blue line is the program NAVs without the extreme exit; the orange line has the extreme exit but not the interest rate hedge; the gray line has the exit and the hedge.
By the Numbers
A comparison of the three methods, beginning in 2003, shows that the risk of not exiting (first line in the table below) is 5% higher and the ratio of return to risk much lower than the strategy using the extreme exit. Adding a long bond position improves results by almost 1% per year but does not reduce the risk. Even bonds have volatility, especially during times when the stock market is in turmoil.
We were planning to implement this new filter on August 1st , but the market has a mind of its own. The program was ready on July 23 and exit conditions for the weekly program were satisfied for both the 10-stock and 30-stock portfolios on July 24th. We exited all positions on July 27 and are still out of the market.
The daily results are appended to the previous tracking history, so that the old performance numbers do not change, only the returns going forward.
Not all exits and hedges will be profitable. The results depend on the success of the underlying trend system. If it correctly identifies a significant decline, the both the exit and the bond hedge will prove beneficial. But just like a trend system, a fast drop in equity followed by a fast recovery would not be a good scenario. On balance, we expect these changes to improve results, as seen in the 20-year simulated performance chart above.
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 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, including Sector Rotation, Income Focus, and Dow Arbitrage
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.
The Daily Trend program just missed the threshold to exit on extreme risk. Because of that it has benefitted with a gain of 7.5% in the 10-stock program and 5.5% in the 30-stock portfolio. Traders should be prepared for high volatility and some give-back, but the good gains so far in 2020 should help absorb any downturn.
Income Focus and Sector Rotation
A good month for both the daily and weekly Income Focus portfolios, although the weekly has suffered from the inability to change positions quickly. In the long run it will even out when holding through a whipsaw turns out to be the best strategy. Both programs were up by more than 2% and 3% in July.
While still trailing well behind the other strategies, the Sector Rotation program gained 12% in July, cutting its losses in half. This brings renewed hope.
The Dow Hedge program gained 7.2% in July compared to the Dow index (DIA) which gained 3.5%. Again, we see that the best performers are most likely to remain the best. This program has shown that it can recover quickly from a drawdown and move to new highs.
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.
The 10-stock Divergence portfolio is keeping pace with the 10-stock Trend portfolio, although with a very different pattern. The smaller portfolio gained 9.4% in July and the larger portfolio 6.6%. This program has a shorter holding period, looking to profit only from the pause in the trend and exiting when the trend resumes.
Group DE3: Timing Program for Stocks
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.
This is the year when buying undervalued stocks has been the best strategy. The Timing program has small gains but held on to a 10-stock profit of 43% and a 20-stock profit of 54%. The program is very volatilite because high gains do not come without high risk. So far, the program is performing well.
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.”
While the Daily Futures program gained 13% to 16% in July, the Weekly program ranged from a small gain to about 2%. Clearly, the weekly program was performing well up to 2015 and rallied to its highs in 2018, but it has been out-of-phase since then. We would avoid this until it shows signs of life. Meanwhile, the daily program is performing up to expectations, posting new highs for all portfolios.
Group DF2: Daily Divergence Portfolio for Futures
The Futures Divergence program lost 2.6% in the $250K portfolio but gained about the same in the $500K and $1 mil portfolios, showing that diversification has a benefit. Overall, that program is higher by 3% to nearly 10% for 2020. All programs could post new highs with another good month.
Blogs and Recent Publications
Kaufman Constructs Trading Systems
We have posted both an ebook and a print version of Perry’s new book, Kaufman Constructs Trading Systems, published on Amazon. It is a complement to Trading Systems and Methods. It takes you step-by-step through the process of developing a trading system, with many examples. Order it through our website, www.kaufmansignals.com or directly on Amazon.
Trading Systems and Methods, Sixth Edition
The sixth edition of Trading Systems and Methods was released the last week of October by John Wiley. It is completely updated and contains more systems and analyses.
MetaStock issued an upgrade to the Kaufman Fast Strike add-on in late January. This add-on has three short-term trading systems, holding positions for one to three days in two of the programs, and about one week in the third program. They trade noisy markets, including most major index ETFs and futures, plus one program trades the VIX. You can see a description of the programs and a record of past performance on MetaStock. Anyone interested should contact MetaStock at 800-882-3040 or go online to www.metastock.com/kaufmana
Mr. Kaufman will be presenting in a webinar for the Indian Technical Analysis group in Mumbai, during the period from October 2 to October 4. More specifics will follow.
“Fools Rush In,” an analysis of the best time to buy an IPO, will be published in the September issue of Technical Analysis of Stocks & Commodities. There is also a full description of Kaufman Constructs Trading Systems in the “Books for Traders” section.
Mr. Kaufman gave a presentation at Jake Bernstein’s “Cycle” seminar. Anyone interested in a copy of the presentation should send a request to email@example.com.
The June issue of Technical Analysis of Stocks & Commodities published the article “Crashes and Recoveries.” It will help you figure out how the Covid-19 pandemic will play out. It will also have the TradeStation code for the “2nd Cross” strategy, requested by readers.
There are some comments in the April issue and on the current stock market drawdown and a correction to Mr. Kaufman’s article in the March issue of Technical Analysis of Stocks & Commodities
“The 1st and 2nd Cross” was published in Technical Analysis of Stocks & Commodities in the March issue. It is based on an idea of Linda Raschke and captures small but reliable pieces of a trending move.
A new article “Essential Math For Traders” will be published in the Bonus 2020 issue of Technical Analysis of Stocks & Commodities.
ProActive Advisor Magazine (on-line) published “Controlling risk that doesn’t go away,” posted on January 15.
Both of these articles are important for understanding your investment risk.
Technical Analysis of Stocks & Commodities published an interview with Mr Kaufman in the December issue.
MetaStock Seminar held in Sunnyvale
Mr. Kaufman was a keynote speaker at the MetaStock conference in Sunnyvale, November 3. You can hear this presentation by going to the MetaStock website.
Technical Analysis of Stocks & Commodities published “Running for Cover,” an article by Mr Kaufman that looks at whether buying bonds after a sudden drop in the S&P can still be profitable.
“A Simple Way to Trade Seasonality” was published in the September issue Technical Analysis of Stocks & Commodities. Seasonal trades and filters can be a big asset to market timing and put you on the right side of a price move.
Mr. Kaufman appears as a chapter in Mario Singh’s book, Secret Conversations with Trading Tycoons, published by FXI International.
Older Items of Interest
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.
Mr. Kaufman spoke in Tokyo and Osaka to the Japanese association of Technical and was a keynote speaker at the 2018 IFTA conference in Kuala Lumpur, both last October. You should be able to get a copy of the presentations by MATA, the Malaysian Association of Technical Analysts.
“In Search of the Best Trend” was published in Technical Analysis of Stocks & Commodities in July 2019. An article on “Defense is Your Best Defense” will appear in ProActive Advisor Magazine also appeared in July 2019.
Mr. Kaufman was a keynote speaker at a number of IFTA conferences, the most recent in 2018 in Kuala Lumpur, and Milan in 2017. You can find his presentations on their website.
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