Announcing Dynamic Futures Portfolios
We are pleased to introduce a new method of constructing portfolios for futures trading. Along with everyone else, we were frustrated with the standard method of allocation, which worked during the 30 years when interest rates kept falling and interest rate policy created exceptional trends. When professionals trade for themselves they pick and choose their markets and allocate according to their expectations. As is our policy, we do this with an algorithmic model that enables us to cover more markets and removes the error of subjective and random decisions. This method description can be found in the article on this website, “Dynamic Futures Portfolios.” The method replaces the static daily futures portfolios for both the Trend and Divergence programs.
… And Some Additional Stocks and ETFs
Using StockCharts.com as a guide, we’ve added those stocks that have been viewed most often last month, including 3D Systems (DDD), First Solar (FSLR), J C Penny (JCP), Michael Kors (KORS), McEwen Mining (MUX), Plug Power (PLUG), Prana Biotech (PRAN), Qihoo 360 Tech (QIHU), Spherix (SPEX), and Twitter (TWTR). Also added were Gold Miners (DUST), Nasdaq Biotech (IBB), Gold Miners (NUGT), Small Cap (TNA), and VIX Short-Term Futures (VXX). Not all of these will appear in all systems, and some may not qualify for trading signals due to liquidity or not enough data. For example, TWTR may get Divergence signals but not Trend signals. Look for them in the All Signals reports.
May 2014 Overview
Up, down, or sideways? If you watch the financial news, the direction of the stock market could be anywhere. We take this lack of conviction as a sign that it will most likely go up. Uncertainty means that investors are not throwing money at the market, and that often means that they will feed money into it slowly and the bull market may slowly crawl up the wall of worry.
We continue to hear the usual arguments that the Fed plans to reduce purchases, but that policy is flexible. Pundits have switched to stock picking rather than investing in the broad index, under the policy that there is always something good to buy – but which stocks will move?
The chart below shows the three main equity index markets from the beginning of 2014. May saw the SPY and QQQ rally but the small caps are still well off the pace. If we consider the average of all three as most representative of the stock market, then we’re in the middle of the yearly range, a disappointment after the past two years.
Our May Performance
All of our 17 equity programs were profitable in May, not by as much as the S&P but certainly more than the small caps. It argues for consistency.
The new futures portfolios showed one losing item out of 9, but otherwise very nice returns in May, overall an acceptable month.
We find it interesting to look at the number of stocks that have long trends each month. So far, we have March 79.0%, April 74.5%, and May 72.8%, a clearly weakening trend. We don’t have enough data to draw any conclusion but we’ll keep this updated and perhaps add some older data.
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 held the following long positions: Preferred Stocks (PFF), Reits (VNQ), Energy (XLE), Staples (XLP), Utilities (XLU), and Oil & Gas (XOP).
The Timing Rotation program held the following long positions: Preferred Stocks (PFF), Financials (XLF), Utilities (XLU), Consumer Discretionary (XLY), Metals & Mining (XME), Oil & Gas (XOP), and Retail (XRT).
Industry Performance in Futures
To understand our switch to new futures portfolios, the chart below shows the long-term Newedge Managed Account Index. Performance for May, taken from Barclay’s shows the CTA Index up 0.12%, short-term traders up 2.08%, trend traders up 3.07%, and overall systematic traders up 0.15%.
A Standing Note on 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 system, 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.
ABOUT OUR PORTFOLIO SELECTION
Nearly all of our sample portfolios use dynamic allocation, which means that we are seeking to trade those stocks, ETFs, and futures markets that we rank as the best potential performers. We select as many as possible from the highest rank in order to fill the entire portfolio. Sometimes, especially during a bear market, there are not enough stocks that qualify; therefore, there are fewer stocks in the portfolio. In other cases, such as the recent 10-year U.S. Treasury note, there can be a period of poor trend performance that will disqualify that market.
The markets in the portfolio will change because of the underlying trading signals, but just as often one stock will be traded off for another because it drops in the ranking and no longer meets expectations. This process makes the trading signals more active than signals produced by the underlying strategy.
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.
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 holding well ahead of the benchmark indices for this year, although there was a noticeable mid-month profit and drawdown in March. Year-to-date, the 10 stock program is up 11.6% and the 30 stock program up 7.25%. Those bigger gains in the smaller program come with higher volatility due to less diversification. The ETF programs are quieter and, because they are index markets themselves, will perform closer to the broad indices than stocks. They also have far less risk.
Weekly NAVs for the Trend program show a similar performance to the daily version, with the 30 stock portfolio showing a small drawdown. The ETFs are more stable, as would be expected. Because ETFs are an index, which averages a set of stocks, the performance will never be as extreme to either the upside or the downside. In this case, it shows a minor drawdown in March.
The Trend ETF Rotation program above, under “Strongest and Weakest Sectors,” 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.
The Divergence program continues to give steady returns as shown in the chart below. Although not the outperformance of the Trend program, it runs a good second and offers excellent diversification in combination with the Trend program. This program will adapt quickly to changing market conditions and patterns. It is often underleveraged because it is not always possible to find enough trading signals to fill the portfolio. But given that underleveraged means lower risk, the returns from this program have been very good.
The EFT portfolio, which is limited further by fewer liquid markets, has also put in a steady performance, with 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 doesn’t 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.
The Timing program posted modest gains in May, but the overall pattern is sideways recently. We can blame this on the NASDAQ stocks which showed enough of a downtrend to trigger 2 of the 3 legs for hedging. Even now, the shorter term trend of QQQ has turned up but the medium term trend is still down, so that 1/3 of our position is hedged. We see the period when the hedge is active as risk protection, and don’t expect any significant returns. It’s necessary to hedge, although most hedges don’t net a profit, just to be protected against a major decline. Given the risk protection, the performance of the two stock portfolios are good.
The ETF rotation portfolio has a strategy contrary to the Trend Rotation. This one buys undervalued ETFs while the Trend program buys the outperformers. While 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 necessary track any index.
We indicated the holdings of the ETF Timing program earlier in this report, under “Strongest and Weakest ETFs.”
Groups DF1 and WF1: Daily and Weekly 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 interested in lower leverage can simply scale all positions equally in proportion to their volatility preference.
Read the new report describing our dynamic portfolio allocation methodology. This method may solve the problem of over diversification and allocations to markets that are not performing.
The chart below shows the long-term, simulated performance of the trend program using the dynamic portfolio methodology. It is designed for 14% volatility; therefore, you will find at least two drawdowns near 10%. In order to reduce the expected risk, and the expected returns, it is necessary to trade a smaller investment. These portfolios are calculated based on an investment of $25,000 per market. Then the three portfolios are $250K, $500K, and $1M. They only trade the most liquid US and European futures within each sector. As expected, the larger, more diversified 30-market portfolio shows the lowest returns and the lowest volatility, both based on greater diversification. Due to market conditions and changing trader and institutional participation, we fully expect future performance to be good but more volatile than the 1990s.
Daily Divergence Portfolio for Futures
The daily Divergence futures program has been replaced with a dynamic portfolio. In this case, the fixed allocation was performing reasonably well, but used a wide range of world markets. The dynamic portfolio program only trades the most liquid of the US and European futures markets, entering on the open of the US and the close of Europe to limit the time needed to execute the program.
Unlike most other programs, the recent drawdowns are larger in the 30-market portfolio and smaller in the 10-market portfolio. Although difficult to see on the chart, the 30-market program was up 5.5% for May while the 10-market program was down 0.07%. In the long-term we expect the larger portfolio to outperform and be more consistent.
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