Industry Benchmark Performance
As of April 1, the Hedge Fund Industry posted losses varying between -7% and -10% for March, and slightly worse for year-to-date. Those are excellent given that SPY peaked on February 19, up 5% for the year, then had collapsed 33.7% by March 23. It has now recovered about 11%. The Performance Summary above shows losses in the major equity indices of 18% to 30%.
Kaufman’s Fast Strike Systems on MetaStock
MetaStock has posted an upgrade to Kaufman’s short-term trading systems, Fast Strike. Contact MetaStock at 800-882-3040 or go online to www.metastock.com/kaufmana.
Blogs and Recent Publications
Find this at the end of this report. We post new interviews and reference new articles each month.
March Performance in Brief
This is the first month since 2008 that our stock program has been completely out of the market. We took the first loss on January 24th and the system triggered an extreme risk exit for the next open. Because of that, our daily 10-stock portfolio remains up by 4.9% for the year, and our weekly program up 11.4% for the year.
Other strategies were not as fortunate, but all are far better than the major equity index markets. The Divergence program is down 7% and the Timing program down over 4%.
Daily Futures posted a large gain of 15% for the small portfolio and 10% for the large one, but the middle 500K portfolio is lagging.
Our equity trend programs will reenter the market when the volatility drops and our stock selection is showing gains. That could be in another week or another month.
Major Equity ETFs
By now we all know this picture. The equity markets have plunged, then bounced back slightly. Our “Close-Up” report that follows gives the history of large drawdowns. At the moment, NASDAQ is holding up better than the other markets, down only one-half of the S&P and one-third of the small caps. Typically, investors shy away from small caps during a crisis. They see them as higher risk.
CLOSE-UP: What We Can Learn from Past
Drawdowns and Recoveries
In early 2000 when the Internet bubble peaked, there were a lot of traders who entered NASDAQ stocks late in the 1990s because it seemed as though prices would never stop going up (see Figure 18.1). When the decline started, many, if not most, financial advisers said, “Stay with it, it’s just a correction.” When the index had to 3500, they said, “We expect prices to stabilize here.” But that stabilization was short-lived.
In November 2000 the prices broke down again. By April 2001, the NASDAQ had moved below 1500 (Figure 1). “Why get out now, we must be near the bottom?” Finally, in August 2002, NASDAQ had lost 82% of its value. What responsible investment advice or financial planning could allow you to hold those positions through an 82% decline? That’s not risk management, that’s wishful thinking. It’s also unprofessional. It would never happen with a systematic trading strategy.
Figure 1 NASDAQ 100 (NDX) Index.
History is filled with large drawdowns and different recovery patterns. We’re now in one caused by covid-19. We may not be able to figure out the exact pattern of recovery, but past patterns will help us understand our risk. Let’s start with 1929, shown in Figure 2.
The decline from about 375 to under 50 took more than two years, followed by a very long recovery period, only ended by World War II. That’s not the scenario we want now. Although the Federal Reserve was formed in 1913, it was decentralized and required the agreement of many parties to enact anything. They did nothing to help.
Some traders will look at the 50% bounce following the first drop, but you would have had to have been very aggressive to buy at that point. We always see opportunities in the past, but at the time it would have been a very difficult decision.
Figure 2 Dow Industrials, crash of 1929
It is interesting that the Federal Reserve caused the 1929 crash by continuing to raise interest rates in order to slow speculation. That turns out to be the same scenario that caused the 1987 crash. You would think they would learn. They also failed to act to save the banks, a lesson remembered when the Fed acted in 2008. Thank goodness Bernanke remembered.
Investors would like to think that all crashes have a “V” bottom. That investors are so clever that they know the market is oversold and plow money into it. Was there a V bottom in 1987? There was a bounce of about 16%, not much compared to the decline of 34%, shown in Figure 3.
Figure 3 A “V” bottom in S&P futures during the 1987 crash.
Then we have the financial crisis of 2008, shown in Figure 4. You may call the absolute bottom a V bottom, but it was a long time coming. The bounce was modest and the recovery into 2010, almost 3 years on, was still only about half the drop.
Figure 4 A bounce but a slow recovery for the 2008 financial crisis.
The only V bottom that is easy to remember happened in December 2018 (Figure 5). The S&P dropped from 2800 to about 2350, about 16%, over tariffs with China. Then the administration “delayed” those tariffs and the market rallied. News that disappears is the best chance for a V bottom and a quick recovery.
Figure 5 The S&P falls on expected tariffs and recovers when they are postponed.
What about the corona virus (Covid-19)? While our expectations can be completely wrong, a V bottom is an unlikely path, even with the Fed pumping trillions of dollars into the economy. Markets just don’t recovery quickly, especially when the threat is still out there. Given the Fed action, when the fear of the virus subsides, the market should make a steady recovery – not a fast one because there should be a lot of residual pain. Many small businesses will not be helped by the bailout. They will have gone bankrupt. It will also take a resurgence of confidence to see vacationers taking cruises or even get on airplanes at the rate they did prior to the outbreak. Figure 6 shows the price movement so far.
Figure 6 The decline due to the corona virus pandemic as of March 31.
I have to conclude that a V bottom is caused by unexpected news, often temporary, and generally short-term. All of the big sell-offs were economic events, or caused economic pain. They are slower to recover. This one seems no different, hopefully not worse.
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 350 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.
It would be nice to say that the Trend Strength Index anticipated this drawdown, but it clearly moved along with it. It has not recovered as much as the SPY at this point, and it stopped very near the previous lows of -50, a point that we had identified last week. However, we don’t see this as over, and expect another test of the lows, even more likely new lows. Because the Trend Strength Index is a momentum, it may not make new lows. That does not mean that the market is not declining, it is just declining at a slower rate.
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.
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.
Based on our extreme risk control features, we exited all positions in both the daily and weekly equity trend portfolios on the open of February 25th, a slight rally before the market collapsed. That left all the portfolios with positive year-to-date returns, now 20% to 30% better than the broad equity indices.
Our exit conditions are a combination of extreme volatility and losses in the underlying stock portfolios. The reentry is the opposite, a decline in volatility to a near-normal level and stock positions that are showing profits. We expect volatility to decline to our level in 1 to 2 weeks, and that there will be enough stocks doing well to find a profitable portfolio.
Income Focus and Sector Rotation
A large loss for the weekly Income Focus program shows the risk side of a weekly program. In the case of the Trend programs, we exited the weekly positions based on the signal from the daily program. The Income Focus program does not have that feature, normally benefiting from not responding to short-term wiggles in prices. This was not one of those times.
Income Focus still remains a conservative program, down 3.3% this month in the daily version and 6.7% in the weekly. As you can see in the chart below, 2008 also saw drawdowns followed by years of steady gains. We expect to see that again.
The Sector Rotation program shares the honors with the Dow Hedge program for the worst results in March. Neither program has a risk exit rule, so it’s a matter of getting into the right sectors and switching to safer ETFs and stocks. That’s difficult to do when you assess the market weekly and all sectors are collapsing. This program lost 12% in March.
The Dow Index has been hit particularly hard during this crisis, and it is reflected in the performance of the Dow Hedge program, which lost 15% in March, leaving it down 10.5% for 2020. Still, it is far better than the overall market which is down 20% to 30%. During a crisis, investors tend towards larger, safer companies, and away from smaller start-ups. We can see that in the IWM returns, down 30% for the year. We expect the companies in the Dow, and our Dow Hedge program, to show early signs of recovery.
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.
No program is immune to this market crisis, but the Divergence portfolios have held up nicely. The 10-stock program was down fractionally and the 30-stock program higher by 2.6%. Year-to-date for both programs are down 5% to 7.5%. Normally that would be poor, but it looks far better than the overall market.
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.
The new Timing program had mixed results in March, down 5% in the 10-stock portfolio and up 1.0% in the 20-stock portfolio. Both are down a little over 4% for the year, still far better than the overall market. This program waits to select undervalued stocks but only when the trend is up, so it benefits from both selection and risk control.
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.”
The Futures Trend program is another example of needing a faster response to a crisis. The daily program gained 5% to 15% in March and is higher by varying amounts for the year. The weekly program cannot change positions quickly and is lower by 6% to 10%. The daily program shows what is meant by “crisis alpha,” the situation where futures are profitable when the stock market is in a sharp drawdown.
Group DF2: Daily Divergence Portfolio for Futures
Another month of small changes but mixed results for the Divergence program, up 1% to down 1%. Compared to the stock market, that seems good. Year-to-date remains at a loss of 7% to 10%. The chart below shows that returns are near the low of the volatile historic pattern. We hope this is a sign of a pending reversal!
Blogs and Recent Publications
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
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 new book, Secret Conversations with Trading Tycoons, published by FXI International.
A second part of the interview with Caroline Stepan at TalkingTrading.com was just posted.
Mr. Kaufman was interviewed by Caroline Stephen at TalkingTrading.com. It covered a wide range of topics. It has not yet been posted but should be available soon.
We thought the article in ProActive Advisor Magazine would be in March, but it should appear any day in April. It is “Let’s Be Realistic About Drawdowns.” Most traders don’t pay enough attention to the drawdown history of their trading, or of any system trading. Large drawdowns are infrequent but can be ugly. This article shows how to assess them and some ideas on reducing drawdowns.
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, and Michael Covel’s website, TrendFollowing.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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