June 2014 Overview
Our programs performed well in June, with all of them profitable, and all but one stock portfolio nicely outpaced the SPY. The S&P is finally moving to the upside – good news because most investors are long and our equity programs only take long positions in the portfolios. As long as the news networks express confusion about the sustainability of this bull market, prices keep going up. That’s good for all of us. The performance table above shows NASDAQ leading this year, up nearly 8%, followed closely by the S&P, up nearly 7%, with the small caps trailing a bit more than 3%. We think this is typical of uncertainty, where the S&P is considered more conservative than the small caps.
Our new dynamic futures portfolios had an excellent month, even better when compared to the Newedge CTA index, gaining from 4.17% to 8.72% in June. Newedge shows a gain of 0.48% for June and 1.06% year to date (as of their June 30 posting). The benchmark BTOP 50 was down -0.04% for June and up 0.44% year-to-date.
Everyone now seems to agree that the Fed will end tapering as planned, and the big talk is that inflation can’t be far behind. Of course, ending buy-backs has been interpreted by the market as the same as raising rates, and the economy is strong on paper but not on Main Street, so we question how soon inflation will emerge. In the meanwhile, rates stay low and the market plods higher – just what we want.
Our Trend Strength Indicator, shown at the bottom of each of the All Signals daily reports, took a big jump up last month. It turns a slow downtrend into renewed uptrend, with a June value of 81.6% after May at 72.8% (April 74.5% & March 79.0%). We may track this daily and use it for a market overview.
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.
At the end of this month, the Trend Rotation program (buy strong) held the following positions:
Oil & Gas (XOP), Heath Care (XLV), Technology (XLK), Energy (XLE), Materials (XLB), and Oil & Gas Exploration (XES). It removed Preferred Stocks (PFF), Reits (VNQ), Staples (XLP), and Utilities (XLU).
The Timing Rotation program (buy low) held the following positions:
Preferred Stocks (PFF), Reits (UNQ), Materials (XLB), Energy (XLE), Industrials (XLI), and Staples (XLP), removing Financials (XLF), Utilities (XLU), Consumer Discretionary (XLY), Metals & Mining (XME), Oil & Gas (XOP), and Retail (XRT).
It is interesting to see Energy, Oil & Gas, and Material in both groups. That means those three ETFs have a very strong long-term trend but are now oversold relative to the SPY. We see those as opportune trades.
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 stock portfolios are recovering nicely from the recent downswing, with the smaller portfolio up 18% for the year and the larger portfolio up 11%. Naturally, the smaller portfolio has higher risk, posting an information ratio (annualized return divided by annualized risk) of 1.10 compared to 1.25 for the larger portfolio.
The ETF programs are quieter and, because they are index markets themselves and will perform closer to the broad indices than stocks. They also have far less risk. Performance was slightly below the SPY this month, but nicely positive. They are also lagging in the recovery from their recent drawdown, but positive for the year.
As expected, the Weekly NAVs for the Trend program show a similar performance to the daily version. The 10-stock portfolio show similar new all-time highs, and the Weekly 10-ETF program has a much smaller drawdown than the daily counterpart. When comparing both the 10 and 30-stock portfolio, the weekly remains a slightly better performer with more consistency.
We showed the holdings of the Trend ETF Rotation program above, under “Strongest and Weakest Sectors.” This program continues to produce steady returns.
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.
Similar to the Trend program, the Divergence program continued its recovery and all three portfolios posted new all-time highs. 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 further by fewer liquid markets, continues to put in a steady performance, and is far less volatility than the other stock programs.
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 does not 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.
A breakout to the upside is always good news, and the Timing program gained 4.5% and 6% in the stock portfolios, posting new all-time highs. Unlike the previous month, the trends for the broad index markets, used as a hedge, were all up, so there were no hedges to reduce returns. While we captured some outstanding moves, this program will usually benefit from buying oversold stocks in a rising market, or even a sideways market.
While the underlying technique used in this strategy is a variation of pairs trading and high-frequency trading, the average holding time for a trade in this portfolio is about 17 days. Some call that “medium term.”
The ETF rotation portfolio has a strategy contrary to the Trend Rotation. This one buys undervalued ETFs while the Trend program buys the outperformers. 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.
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 interesting 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 new portfolio allocation methodology available under the drop-down menu “Articles.”
June is the first full month of live tracking for the new Dynamic Portfolios for futures, and it was outstanding, adding from 4.17% to 7.84% and turning an uneventful first 5 months into a profit. It must be pointed out that the smaller $250K portfolio is the least diversified; therefore, it is likely to have the greatest profits and the greatest risk. We use the larger $1 million portfolio as representative.
The chart below shows the long-term, system performance of the trend program using the new portfolio methodology with June as the first out-of-sample period for the portfolio (the underlying trend program has been running for nearly five years). Trades are held in the portfolio for an average of 19 days.
It is interesting to see the sector breakdown, remembering that the portfolio is seeking those markets that a trending best. For 2014 interest rates and ags are the only two sectors that are profitable, in contrast to the past few years when equity index markets have been the success stories. FX, in particular the EURUSD, has been caught in a narrow range. Even though the near high of 150 seems attractive, it did not stay at that level long enough to capture the “macrotrend” returns. This month does show good returns for equities, which relates to the steady grind upwards.
The $500K account is outperforming the others, but that’s really just a matter of good fortune. Typically, the smaller portfolios will outperform with greater volatility, while the larger ones are more diversified and more stable. We can see that more in the Divergence results.
Group DF2: Daily Divergence Portfolio for Futures
The daily Divergence futures program has also posted a breakout month, with returns from 5.68% to 8.72% and reaching new all-time highs. This can be seen the left chart below. Up to now the smaller portfolio has been very steady, with the two larger ones stuck in a sideways pattern for about two years. June changed that.
When we look at the sector returns we see that there are no trades in the short-term interest ‘RATES’. Profits in the longer-term ‘BONDS’, unlike the Trend program, performed nicely this month. ‘AGS’ are the next best group for the month. Equity ‘INDEX’ is clearly more volatile, posting a good return in June but still down for the year.
Similar to the stock Divergence program, this holds trades for an average of only 4 days, so costs and execution matter.
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