Industry Benchmark Performance
Modest profits for all funds in March, both equities and futures. Equity Long funds are now higher by over 10% for 2021, a good performance given the rotation of the markets out of tech stocks.
Blogs and Recent Publications
Don’t forget our new 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.
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.
March Performance in Brief
The Equity Trend portfolio, both daily and weekly, posted a long overdue drawdown as the market rotated this way and that. It also took a loss in BIDU, the result of liquidation of the Archegos Fund. Drawdowns are a part of trading and this one is well within the normal amount. We take a closer look at drawdowns in our Close-Up report this month.
Our other portfolios were mixed, with Equity Timing and Futures Trend posting gains, and both Divergence programs posting small losses. We have been told that April is a good month for stocks, so we look forward to that.
Major Equity ETFs
The Dow and S&P are still gaining, but the small caps (IWM) and Nasdaq (QQQ) are the weakest of the equity index markets. Investors have turned away from tech stocks but may find renewed strength in microchips. The Administration’s plans to revitalize infrastructure should help many firms, but the long-term effects will take time to surface.
My Take on Archegos
For those of you who were not trading in the late 1990s and do not remember Long Term Capital Management (LTCM), this story has remarkable similarities. It is all about greed. LTCM convinced the banks to extend leverage of more than 50 times value, explaining that they had two Nobel laureates that confirmed the results. Later Lowenstein wrote about it in “When Genius Failed.”
But leverage works both ways. As the story goes, LTCM removed some large losses from their historic performance, reasoning that those situations would never happen again. The banks accepted their results. Instead of the same situations occurring, it was something else. The ruble dropped. It was the hedge that did not work.
When you are highly leveraged, you are at extreme risk. This past week Viacom (VIAC) released earnings and their price dropped nearly 15% on March 24th. That caused a margin call for Archego, but they were so highly leveraged that they had no reserve funds to cover the margin call. They were required to liquidate other stocks, which cause them to liquidate additional positions. It is an ugly scenario, but the result played out much like Long Term Capital. The banks took the losses.
In all fairness, every crisis is different, yet this one could have been avoided. While it is not clear that SEC auditors have a method to find over-leveraged situations, let alone in a timely fashion, extreme leverage can put the entire marketplace at risk.
CLOSE-UP: No Place to Hide
No one likes a drawdown, including me, but you learn a lot about yourself during a drawdown. Mostly about discipline.
No one enjoys watching their equity decline, no matter by how much. However, it is part of the process of trying to outperform the overall market and our competition. Becoming a trader means accepting risk. You do not need to like a drawdown. I certainly do not. But as long as the drawdown is within expectations, you need to stay with your program in order to benefit from the strategy.
Another aspect about the psychology of a drawdown is that it matters when it happens. If you were fortunate to profit from the tech rally last year and were ahead by 50%, then a 15% drawdown is not as painful. Your equity started at $100,000, went to $150,000 and then fell to $127,500. Not pleasant, but still a good gain.
If you just started trading and your equity dropped from $100,000 to $85,000 you feel differently about it. What is going on? Why did I start trading now? One pattern that I have learned over the years, is that most investors start after a big move up. It confirms that there is a bull market or that a trading method works. It is also the most likely time for a drawdown or, as the analysts like to say, a “correction.”
The Drawdowns We Accept
For some reason we tend to overlook drawdowns in the Dow or S&P. Perhaps we accept that it is part of our economy. We also have seen that, regardless of the drawdown, the market makes new highs – eventually. In addition, the S&P is an investment in our economy, so it must be OK.
It is easier to understand drawdowns if you see past patterns. Let’s start with a passive investment in the S&P. We will use SPY because it is not back-adjusted, as are futures, and we can use percentages. We will compare that against one of our benchmark programs, the 10-Stock Trend. Understanding drawdowns is essential for the success of your own trading as well as investments in any managed program. They all have drawdowns.
A trading program is different from a passive investment in the S&P or any broad index. It is not the economy. It is trying to take advantage of trends or some other price pattern. Even if it has a track record of 40 years, the future is still unknown. Technology changes, participants change, patterns change, drawdown can get bigger but so can profits.
History of Drawdowns
Starting with the Dow from 1920, Figure 1 shows that prices are far more volatile than in the past. But that is just the way it is shown on the price scale. The percentages are lost, as we can see because the crashes of 1929 and 1987 cannot eve be seen.
Figure 1. The Dow from 1920 shows volatility now but not larger swings in 1929 and 1987.
If we change the scale to “log,” we are looking at percentage changes instead of price. We can now see the importance of 1929. Today’s volatility is no longer extreme.
Figure 2. The Dow from 1920 on a log scale, showing percentage changes.
Now let’s look at the 10 largest drawdowns, shown in Table 1. The crash of 1929 lasted more than 25 years before there was a new high. We do not think that will happen again because we have a Federal Reserve with the authority and tools to deal with economic downturns. But the next largest drop was the financial crisis of 2008, which all of us should remember. That took five years to recover.
Table 1. The 10 largest drawdowns in the Dow.
Table 2 shows all drawdowns in the Dow from the beginning of 2020. The largest was also the longest, a loss of 37% from February to November 2020. Other than that, drawdowns have been very small. But a 37% loss can be very disturbing.
Table 2. Recent drawdowns in the Dow.
Why We Trade Using a System
The purpose of using a trading system is to increase the chance of profits and, at the same time, use risk controls to avoid catastrophic losses. That is not to say that they can avoid losses, just try to control the size of those losses.
As an example, we will use our 10-Stock Trend portfolio because it is a good representation of a trend program and we do not have access to the detailed returns of other managers. Table 3 shows the largest drawdowns from late 2002. The two of most interest are 2008 and 2020.
Table 3. Largest drawdowns for the 10-Stock Trend portfolio from late 2002.
In 2008 the Dow lost 53% and took more than 5 years to make a new high. In 2020 it was down 37% and took 9 months to recovery. Table 3 shows that our stock strategy was down 31% in 2008 with a recovery of less than 2 years. In 2020 it dropped 26% and recovered in 6 months. You cannot eliminate drawdowns, you can only manage them.
Table 4. All drawdowns for the Trend strategy from 2020.
None of those are overnight recoveries. Large drawdowns take time to rebuild because you are starting the recovery with less money and less leverage. But any trend system will reduce drawdowns and get back on the right side of the market. That is why we invest with a strategy that has a long history of success.
The Odds of Another Drawdown
Table 3 shows that there were 10 drawdowns greater than 13% during the past 15 years. In fact, there were 16 over 10% during the past 15 years. That’s an average of one each year. Table 4 shows all drawdowns, 20 of them, since January 2020. Unlike the 10-year bull market, these drawdowns seem typical of what we should expect in the future. Most of them are small, and a few are larger, and one is 26%. Yet, even with these drawdowns, 2020 was a great year.
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 our current drawdown, a little over 10%. Following the gains of last year, we would expect a drawdown at some point. Now we have it. Both 10-stock portfolios for the daily and weekly trend were caught with BIDU when the Archegos Fund collapsed. We were fortunate not to have other stocks in the Archegos portfolio.
Our portfolios now have a mix of some tech stocks, some energy, some auto. There is no particular sector concentration. That will change when investors decide on the next sector that looks promising.
Income Focus and Sector Rotation
Both daily and weekly Income Focus portfolios gained just over 1%, and are now lower by about 1% for the year. Given the dramatic rise in interest rate futures, we think this is good performance. But then the Fed does not agree with the market price and, as many experienced traders know, the Fed wins. The Fed has confirmed that it will keep rates low. We will continue to watch.
If we only knew in advance wich trading strategy is going to be best, we would all be rich, After a long period of lethargic returns, Sector Rotation is gaining quickly, up nearly 10% this month and 20% for the year. We will not even try to forecast what comes next.
Investors seemed to be favoring the Dow last month. Perhaps it is just safety when you do not know which sector to choose, and those sectors keep changing. Either way, this program is doing well, with the Weekly portfolio ahead of the daily for now.
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.
Mixed returns for the Equity Divergence program in March, but holding onto gains of 2% to 4% for the year. We count on this program to add diversification because of its counter-trend nature and short holding periods.
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 does not depend on market direction for profits, although these portfolios are long-only because the upwards bias in stocks and that they are most often used in retirement accounts.
The market seems to like a strategy that buys pullbacks, then exits with the price recovers. It does not try to turn an early entry into a trend position. Both portfolios posted gains for March and are higher by 27% and 15% for the year, by far the best performance of our programs.
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.”
Futures are continuing to perform well, up about 3% for all portfolios in March. For 2021 the returns range from 11% to 18% with the smaller portfolios doing the best. We expect that energy is driving the performance and the interest rates are both good and bad, depending on the day. At this time the program is short rates, expecting higher yields. No surprise.
Group DF2: Daily Divergence Portfolio for Futures
This program also continues to do well, although it posted fractional losses for March. For the year it is higher by 5% to 6%, is close to its all-time highs, and maintains its strange volatile pattern.
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.
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 new articles being published in Technical Analysis of Stock & Commodities. The next one is “Better Entries,” scheduled to appear in the May issue. Keep checking!
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 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
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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