Industry Benchmark Performance
Positive results for all equity and futures funds is a good year for investors. The summer months tend to be quiet but there have been exceptions. Everyone is back in front of their computers in September, so we expect volatility to increase then. Meanwhile, the long equity funds are tracking the S&P closely, while the other portfolios are lagging.
Blogs and Recent Publications
Don’t forget our latest book, “Kaufman Constructs Trading System.” You can find it on Amazon or on our website, www.kaufmansignals.com.
Find recent publications and seminars at the end of this report. We post new interviews and reference new articles each month.
July Performance in Brief
Mixed performance in July, with the 10-stock Equity Trend Portfolio still trying to recover from a drawdown, while the Weekly Equity Trend portfolio posts gains. The program moved to mostly tech stocks as news of Covid got worse, then tech stocks reversed along with our gains.
Our other portfolios were all up or down small amounts, with the Divergence strategy in equities and futures doing the best. Except for the frustrating returns in the Equity Trend program, an altogether uneventful month.
Major Equity ETFs
July shows some flattening of the long bull market, and Nasdaq (QQQ) has been both volatile and erratic. The small caps (IWM) are no in the sixth month of a sideways move, showing that there is little interest in more speculative stocks when the basic ones are doing well.
The SPY is leading the other indices, but all are in a tight range from up 13% to up 18%, and outstanding performance, more than twice the long-term average of those markets.
CLOSE-UP: Unnecessary Risk
If we are trading stocks, futures, art, or even buying a house, we are taking risk. But there are risks that go along with higher returns, and risks that overwhelm returns.
When you buy bonds, you can see the incremental risk associated with moving away from U.S. Treasuries, which have no risk. There are municipal bonds, corporate bonds, bank CDs, and other choices that span the range from somewhat more return for somewhat more risk.
Then there is unnecessary risk, where the returns do not justify the risk. They fall into three groups:
- Stocks, ETFs, and futures with exceptionally high volatility
- Countries and groups that manipulate prices
- Hidden risk
Overall, the volatility of most stocks are manageable, but the equity index is a composite of many stocks that offset one another. The volatility of an index will always be less than the volatility of some of its components.
Take Tesla as an example. Using the standard 20-day rolling volatility measure, Figure 1 shows that TSLA volatility can peak over 100%. During the first half of April 2020, TSLA prices gained and lost between 5% and 13% each day! Of course, that is good if you are long and it only goes up, but it never works that way.
If the prices go up 8%, down 6%, up 5%, down 7%, and up 5%, you have netted 5%. You need to ask yourself, “Is that 5% worth the risk?” I don’t think so.
Figure 1. Tesla annualized volatility.
Of course, we all know about Bitcoin (BTC-USD), which has volatility far exceeding any other market. It is not a surprise to see a 10% or even 15% change in one day.
More interesting is the volatility of leveraged ETFs. The most popular, the triple-leveraged SPY, the SPXL, is shown in Figure 2. I call this “self-imposed risk.” While the unleveraged SPY has normal volatility of about 15.3%, SPXL has volatility of 46% (see Figure 3). That means, on average, you can expect the price of SPXL to move in a range of 46% over 20 days. Wow! You can make a lot or lose everything in a few days.
Figure 2. Comparison of annualized volatility of SPY and SPXL.
To give an example, in early 2020, SPXL dropped from 75 to 18 in one month (Figure 3), then recovered to 30 in about 2 weeks. A move from 18 to 30 may sound small, but it is a gain of 60%. That’s nice, but a gain of 60% from the lows does not offset a loss of 76% from the highs.
Figure 3. SPXL Drawdown 60% after recovery,
The risk of leverage is not a surprise. These examples are just to remind you that leverage is both good and bad. If you plan to trade a long time, then it’s best to avoid leverage and concentrate on steady returns.
Newer traders may not have experienced market manipulation, but it is always hiding in the shadows. Sometimes it is as clear as Enron, the guys that were cooking the books at the energy company. There is always OPEC, but they are a cartel, and we know their objective is to manipulate oil prices. Over the past 50 years we have gotten used to them and accept them for what they are. They are good about announcing their manipulation in advance. It is the surprises that are a problem.
The most recent show of force is China. We thought they were promoting limited capitalism, encouraging entrepreneurship, even if they often hold 50% of the ownership in both domestic and Chinese divisions of foreign corporations. Within the past few weeks they seem to have decided that super-large tech companies have too much pricing power, causing lower and middle class citizens to pay too much. So they are in the process of a regulatory crackdown.
Disfavor with the Chinese government is not a good thing.
As an example, Figure 4 shows three important Chinese stocks, TAL Education (TAL), Tencent (TCEHY), an entertainment company, and Alibaba (BABA), an Amazon competitor. TAL has dropped from 90 to 4, while Alibaba is off more than 30% and Tencent by 40%. TAL has been a main focus, driving up the price of on-line learning for Chinese students.
Figure 4. Chinese stocks decline on increased regulation.
It is likely that, if you had been trading a moving average, you would be out because the trend durned down. As a value trader, you might still be holding those positions.
It has always been a concern that we, in the U.S., have no control over the accounting of the Chinese companies. Even if they are subject to the rules of the NYSE, it is not clear that we audit their returns, or do anything to verify them. The Chinese government now promises to comply “more closely.” What does that mean?
Given past volatility, combined with the uncertainty of whether the numbers are correct, we at KaufmanSignals removed all Chinese stocks from our candidate list months ago. We suggest that you do the same, if you have not yet already done so.
In the Financial Times last week, Mohammed El-Arian said that Chinese stocks are becoming “uninvestible.” We would say that they were already too risky.
Emerging market ETFs have always been popular because they offer unique opportunity. But looking at the components of the most popular, the EEM (Figure 5), we see that Asia is 79% of the portfolio. Near the top, are 10% in Tencent and Alibaba. Because China is squeezing large tech companies, any company in the EEM is likely to be hurt. We would avoid emerging market ETFs.
Figure 5. Components of the Emerging Market ETF, EEM.
Every rule has an exception. This one is the Taiwan stock index, shown in Figure 6. I would have thought that all of Asia would be affected by a decline in Chinese tech stocks, but that is clearly not happening. Something good is going on and we expect it has been driven by Taiwan Semiconductors (TSM), but that turns out not to be in the top 30 components. Also, India’s Nifty 50, their equity index, is also near its high. Therefore, China’s impact does not go as far as we thought.
Figure 6. The Taiwan equity index futures.
All traders should be concerned with risk. Our returns each year will vary, but we can still keep trading; however, a large risk can be fatal. Those risks can be stock or index volatility, or manipulation in different ways. Some manipulation, such as our Federal Reserve “managing” interest rates is acceptable, but surprises are not good and often costly.
High risk does not translate into high returns. Steady returns and manageable risks are the key to sustained success.
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 equity portfolios. Our work over the years shows that downturns in the stock market are most often short-lived and it is difficult to capture with a longer-term trend. The upwards bias also works against shorter-term systems unless using futures, which allows leverage. Our decision has been to take only long positions in equities and control the risk by exiting many of the portfolios when there is extreme volatility and/or an indication of a severe downturn.
Portfolio Methodology in Brief
Both equity and futures programs 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 on the specific system, 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 outperforming 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 since are simulated but the returns from 2013 are the systematic daily performance added day by day. Any changes to the strategies do not affect the past performance, unless noted. The system assumes 100% investment and stocks are executed on the open, futures on the close of the trading day following the signals. From time to time we make logic changes to the strategies and show how the new model performs.
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. It will hold fewer stocks when they do not meet our conditions, and exit the entire portfolio when there is extreme risk or a likely drawdown.
The charts below show that the Weekly Trend program is recovering, now up by 19% and 16%, slightly better than the major equity index markets. But the Daily Trend program is at extremes, with the 10-stock portfolio off by 8% while the 30-stock portfolio is ahead by 32% this year. Why the difference? Tech stocks!
The daily program focused on tech stocks while news of the Delta variant of Covid was getting all the attention. However, they reversed sharply. It’s not clear why any of this is happening. The only important thing is that we need some persistence, rather than this indecision by investors. We expect that will come soon. In the meanwhile, it is frustrating!
Income Focus and Sector Rotation
Nearly unchanged this month in the Income Focus program, but the chart pattern shows a steady, if small, uptrend in the daily program and a back-to-normal pattern in the weekly program. A typical month.
A loss of over 9% in July is not surprising after nearly doubling in value over the past few months. This portfolio is still ahead by nearly 20% for the year.
Both the Daily and Weekly Dow Hedge programs posted fractional gains in July and are ahead by 6% in the daily program and 11% in the weekly program. This confirms that moving in and out too quickly have hurt most of the portfolios lately. The charts show that the upward trend of the program is still intact.
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.
Gains of about 2% in July bring the year-to-date to 2.4% and 9.8% for the 10- and 30-stock portfolios. The smaller portfolio is in a sideways pattern but the larger on is gaining slowly.
Group DE3: Timing Program for Stocks
The Timing program is a relative-value arbitrage, taking advantage of undervalued stocks relative to its index. It first finds the index that correlates best with a stock, then waits for an oversold indicator within an upwards trend. It exits when the stock price normalizes relative to the index, or the trend turns down. These portfolios are long-only because the upwards bias in stocks and that they are most often used in retirement accounts.
This is the first month for the upgrades in the Timing program. Although we enjoyed the large gains last year, we added some risk features to prevent giving that back. This month was flat, with the 10-stock portfolio gain less than 1% and the 20-stock portfolio losing less than 1%. We look forward to these changes having a positive effect on performance.
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 down 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.
Please read the report describing our revised portfolio allocation methodology. It can be found in the drop-down menu under “Articles.”
A mixed month for the Futures Trend program, with the two smaller portfolios posting small losses and the larger one higher by 2%. Performance looks good even while there seems to be a struggle going on between the Fed and the interest rate traders over inflation. We do not trade agricultural products due to the liquidity, and these past few months have been very volatile, especially for lumber.
Group DF2: Daily Divergence Portfolio for Futures
The Futures Divergence program has edged to the top of its volatile pattern, gaining 2% to 4.5% in July, now up by 10% to 13% for the year. It is an interesting pattern caused by fewer positions due to the nature of the divergence rules. It still seems to be going strong after more than 10 years.
Blogs and Recent Publications
Kaufman Constructs Trading Systems
You will find 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 at the end of 2019 by John Wiley. It is completely updated and contains more systems and analyses.
Australia in November
Mr. Kaufman will be speaking to a live group at the TradeView conference in Melbourne, Australia in late November. That is, if they are allowing travelers into the country! He will be covering a wide range of topics and presenting some new strategies.
There are even more articles are scheduled for Technical Analysis of Stocks & Commodities. We don’t have a date yet, but keep checking!
“Playing It Safe with Cryptos” appeared in Technical Analysis of Stocks & Commodities. It’s a challenge trying to trade these markets given their extreme volatility.
Mr. Kaufman gave a 30-minute presentation, “Lagged Trends,” for The Money Show on Tuesday, May 11. You can see it using the following link: https://youtu.be/bh2fA8oBwBk
There are new articles being published in Technical Analysis of Stock & Commodities. The next one is “Better Entries,” scheduled to appear in the May issue.
Mr. Kaufman will present to the technical students at the Universidad Politecnica de Madrid on February 3, 11 am CST. He will discuss risk and offer advice that comes from years of trading.
Technical Analysis of Stocks & Commodities published an article on Short-Term Patterns, with lots of computer code so that you could do it yourself.
November 1, he taped a session with Andrew Swanscott’s BetterSystemTrader.com
November 18, he presented a webinar on trading to the Italian bank, Fineco, this time in English.
November 27, he presented another webinar to Fineco subscribers in Italian.
Mr. Kaufman had a full schedule in October and November. You can find videos and recording of the following sessions:
On October 3 he addressed 1,000 members at the Indian Technical Analysis group You can find more at https://www.algoconvention.com/schedule
On October 10 he recorded a session on volatility and risk for TopTradersUnplugged.com
On October 22 he addressed another large group for the Italian bank Fineco (in Italian).
“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 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.
“The 1st and 2nd Cross” has been very popular with readers. It was published in Technical Analysis of Stocks & Commodities in the March 2020 issue. It is based on an idea of Linda Raschke and captures small but reliable pieces of a trending move. You can find it online.
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