Industry Benchmark Performance
With only about 25% of the equity and commodity funds reporting, we see small gains in all sectors, even while the BTOP 50 (Futures CTAs are posting a small loss. Our performance in the Trend Equity portfolios far exceeded the industry, and the returns for Futures were generally better, although not by the same margin.
This is shaping up to be a good year for equities and a lethargic year for most futures funds. This happens often. It’s in the years when stocks take a plunge that investors regret not having futures as diversification. Those interested should read articles on “Crisis Alpha.”
Blogs and Recent Publications
(We’ve moved this section to the end of the report.)
May Performance in Brief
The daily and weekly stock trend portfolios surged up this month, posting an average of 5%, and now have year-to-date returns exceeding the S&P, up about 11% to 12%. The other equity programs are positive, but still lagging their average performance. But then it’s only May.
Futures put in a mixed result, with the Divergence program, mostly a forgotten strategy, now up from about 10% to 14.5% for the year. The daily Trend Futures program had modest gains, while the weekly program is steadily recovering from losses.
Major Equity ETFs. It seems hard to stop NASDAQ from rallying, and our own stock portfolio benefited from that this month. Tesla (TSLA) has gone up, regardless of news about that company or the economy. The company seems to be gearing up for a broad move into diversified products, mostly related to electricity supplies, without considering SpaceX. We see a general shift away from the small caps (IWM), with a decline of 2% in May. Even the SPY gain of 1.41% is enough to keep it looking like the bull market is intact.
Flight to Safety
Is it true that when the stock market turns down, investors and traders shift from more speculative to less speculative stocks? When the market turns up, do they again seek more risk? If this does happen, how long does it take before investors make the switch?
I always like to prove to myself that these old adages are true or false. Sometimes they were true at one time, but evolving investor personalities and technology could easily change the patterns. When I looked at the 3-day cycle, originally introduce by Taylor in the 1950s, I found that it was greatly intact. There is only a slightly increased price bias to the upside.
Volume Versus Returns
How do you identify the shift from one market to the other? We’ll say that investors look at the returns of the major equities indices and chase profits. We’ll decide when they do this by looking at the relative change in volume. To make it easier, we’ll use the ETFs IWM (small caps), QQQ (Nasdaq), SPY (S&P 500), and DIA (Dow Industrials).
This study look at only one interesting time period, from July 2, 2007 through December 31, 2008. That will include the lead-up to the financial crisis, the worse part of the crisis, and the beginning of the recovery that would last more than five years.
Because volume is an erratic statistic, we’ll use a 20-day average to smooth it out. We’ll also look at the returns over the same 20-day period to be consistent and to avoid the same erratic changes in price.
Now comes the math. Unfortunately, it can’t be avoided when trying to find whether price and volume are moving the same direction (meaning that traders are buying an increasing number of shares) or the opposite direction (traders are abandoning that ETF).
To find how long it takes traders to switch from one index to the next, we need to lag the volume when comparing it against the price changes. For example, if prices rally this week and volume increases next week, we can say that it takes traders one week to react. If volume increases after two weeks, then it takes two weeks for traders to recognize the shift in performance and move to the new ETF.
Because don’t know how long it takes for traders to recognize and change their positions from one ETF to another, we’ll look at the relationship between price and volume with no lag (meaning they change instantly), 10-day, 20-day, 30-day, 40-day, and 60-day lags. After 60 days, we think that any trader would have missed the opportunity.
Using the data interval from July 2007 through December 2008, we plotted the rolling 20-day correlations of returns versus lagged volume. In Chart 1, we see the no-lag case, which shows most of the correlations less than zero (slightly negative, meaning generally going the opposite way, or no identifiable pattern). Even the peaks only rarely reach above 0.20, which is a poor correlation, So, we can conclude that there is no obvious relationship between increases and decreases in volume compared to increases and decreases in returns when compared with no lag, that is, on the same day.
Chart 1. Correlation of price versus volume with no lag.
When we lag the volume by 40 days (the bet result), we see that the patterns are both more consistent and the majority of the points are above zero, with more frequent occurrences of much higher correlations. Note that, in Chart 1, IWM is at the top right, while it’s at the bottom right in Chart 2. This can be interpreted as running for cover. After a nasty period in the market, traders have moved away from IWM and now favor the Dow. That’s what the textbooks tell you to expect, moving from high risk to stability, from small caps to large caps.
Chart 2. Correlation of price versus volume with a 40-day lag.
Why 30-40 Days?
Chart 3 shows the direction of prices before, during, and just following the financial crisis of 2008. There was a slight rally from July 2007 through October 2007 before things turned ugly. In Chart 4, we see the lagged market reaction to the crisis. With no lag, volume declines as prices rise, and rise when prices decline, producing a strong negative correlation. But when we lag the volume 30 days or 40 days, we get a noticeable positive correlation. That means volume is increasing when prices rise 30-40 days earlier.
Chart 3. Prices of the ETFs, July 2007 through December 2008
Chart 4. Shifting correlations of volume versus returns.
Do investors really wait that long to change positions? We think it’s because of the large influence of investment funds that have macrotrends as their basis. A macrotrend can be a moving average, and a typical calculation period is 60 to 80 days. Then the average of those periods is 30-40 days. Voila! It appears that the funds are driving the change. Their size would overwhelm a lot of the individual trader patterns.
Can We Exploit Our Knowledge?
I’m not offering a specific strategy to take advantage of this shifting landscape. It does confirm that volume chases profits, but we should already know that. If more volume also tends to drive prices up, then acting at the front end of the shift, which would be less than a 60-day trend, might gain from being ahead of rest of the pack. On the other hand, the macrotrend calculation periods of 60 to 80 days were chosen because they were reliable. Acting sooner might produce some trades that were too soon.
Our philosophy is that, the more you understand, the better you trade, but you’ll need to figure out how to use this yourself.
May Insight: Staying with the winners and taking advantage of surprises
There is always a temptation to cash in your profits, but it usually turns out to be a bad idea. Winning stocks tend to persist, that is, they keep going up, as you can see in the chart above. These stocks gained 5% to 6% this month, except for Marriott, which gained 10%. If you have time to watch the market, as I do, you can add to your gains during earnings season.
Because the trend is most likely to be on the side of any price surprise, I often exit the trade in the morning (sometimes in the aftermarket before the official open) when I see prices jump 5% or even 10% or more, after an earnings report. Most of the time, these jumps are overdone. I can then wait and reenter after a pullback, often an hour later (but it varies a lot), gaining anywhere from 2% to 5% for that stock. I always reset the trade so I am fully in-line with the portfolio positions at the end of the day, even if I made a mistake in my day trade. Mostly I reset around midday, because prices are more likely to trend in the afternoon. It takes time and practice, so start small.
Portfolios Selected by Performance are High Beta
As a reminder, our automatic portfolio selection process uses past performance to select stocks and futures. Markets that are outperforming the averages tend to continue to outperform, but they also have higher volatility than the broad index. Outperformance means that profits on any day are higher, which also means that on a losing day, losses will usually be larger. It’s the basic principle of volatility and risk: you can’t achieve higher returns without higher risk.
Smaller portfolios that are less diverse are more likely to generate higher returns during “good” markets (the ones that work well for the strategy) and larger losses during “bad” markets. More diverse portfolios will have smaller gains and losses. To decide which is best for you, you must determine your risk tolerance and how much capital can be put at risk.
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 250 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 confirms what we all believe, that the underlying tone of the market is weak. Unfortunately, the market itself doesn’t seem to know that, and keeps going up. If this index doesn’t drag prices down by the time it gets to the previous lows of about zero, we should get another rally. It’s difficult to believe that the little dip we saw at the top of the TSI at near 60, is all we’ll see.
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.
Strongest and Most Undervalued 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. The new Sector Rotation program also buys the strongest sectors and is reviewed with the Trend Equity Program.
The Trend Sector ETF program buys the 6 strongest sectors of the SPDRs.
At the end of March, we held Industrials (XLI), Technology (XLK), Consumer Discretionary (XLY), Staples (XLP), Utilities (XLU), and Materials (XLB). We exited Industrials (XLI) and Materials (XLB) and added Preferred stocks (PFF) and HealthCare (XLV).
We now hold:
Preferred (PFF), Technology (XLK), Consumer Discretionary (XLY), Staples (XLP), Utilities (XLU), and HealthCare (XLV)
The Timing Program buys 4 ETFs that are undervalued with respect to SPY, in expectation of rotation. We started May with only Financials (XLF), and Oil & Gas Equipment (XES). We are still holding XES but have exited all other sectors.
We now hold:
When an ETF appears in both the Trend and Timing programs, it means that market is very strong but is in a short-term retracement.
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 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, 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 and ETFs, including Sector Rotation, Income Focus, and Dow Arbitrage
The Trend program seeks long-term directional changes in markets and the portfolios choose stocks and ETFs that have realized profitable performance over many years combined with good short-term returns.
A strong performance for both stock portfolios, gaining 4.5% to 5.5% and are now 2% to 3% ahead of SPY for the year. Both small and large portfolios are tracking each other, although normally the larger portfolio lags because the added stocks are not as volatile as in the smaller portfolio.
The ETF programs are not as exciting, but are steadily gaining ground. The Sector portfolio, with 6 ETFs, is now looking much stronger, no doubt a reflection of the stock market as a whole.
A similar move up in the Weekly Stock portfolios. In this case, the smaller 10-stock portfolio gained more that the larger portfolio in May, but the larger one is up 12.2% for the year, while the smaller is only up 7.6%. History shows that the smaller one will usually catch up and exceed the larger portfolio.
The ETF portfolios gained nicely as well, and are well off their drawdown lows. Continued upwards momentum would be well-received.
Income Focus and Sector Rotation
Both daily and weekly Income Focus programs are chugging away, posting small gains but offering good diversification to equities.
The Weekly Sector Rotation had a nice 2% gain for May, putting it positive for the year and not too far off its highs.
This new program was up 2.07% in its first month of official tracking. We expect it to consistently outperform the S&P and the Dow. So far, so good. As a reminder, this program buys the 10 best performers in the DOW, then reduces exposure and hedges them with the 10 worst performers when the market turns down. Based on that approach, it has avoided many of the minor drawdowns since 2008.
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.
Mixed results in the Divergence Stock portfolios, with the 10-stock portfolio falling 1.6% and the 30-stock gaining 1.1%. For the year, the 30-stock is up 4.5%, while the smaller portfolio is not quite up 1%. As the chart below shows, the larger portfolio continues to outperform the smaller one and is near all-time highs.
The ETF portfolio has been one of the steadiest performers, and added 1.15% this month, keeping it on track for its small, but consistent annual returns.
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 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 buys undervalued stocks so that it will buy the weakest even in a declining market until that stock shows that it is not expected to rally. Risk is protected with an absolute stop of 15% and also by hedging the broad index.
The Timing Program for both stocks and ETFs holds the distinction of being the only group to post, loses, even though they were fractional. The 10-stock portfolio remains up over 4% for the year. The pattern of performance for the 30-stock portfolio is smoother than the smaller one, with the long-term returns slightly lower, typical of what we would expect from the nature of diversification. The ETF program continues to languish in a slight recovery mode.
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.”
Both daily and weekly Trend Futures programs did better this month, with the daily program continuing a nice pattern in returns, but the weekly program still not having a noticeable recovery from its drawdown. It’s unusual to see the daily and weekly performance diverge by this much, but we have every expectation of fortunes returning to normal. This year, losses in the weekly program are similar to the industry, but we would like to do better.
Group DF2: Daily Divergence Portfolio for Futures
Last month’s recovery continues with gains of 2% to 3.5% for the Divergence program. That brings the smallest 250K portfolio up 14.5% for 2017, and the other portfolios close to 10%. These programs clearly have a mind of their own and refuse to be told when to make and lose money.
Blogs and Recent Publications
Mr. Kaufman will be a Keynote Speaker at the IFTA annual conference, hosted by the Swiss technical analyst’s association (SIAT) to be held in Milan, Italy, in mid-October 2017.
Technical Analysis of Stocks & Commodities will publish The Return of High Momentum in the July issue, a new intraday system that combines both high momentum and mean reversion into a single strategy.
Technical Analysis of Stocks & Commodities will also publish “Optimization – Doing It Right,” in an upcoming issue, not yet assigned.
Modern Trader will print Dogging the Dow. It’s a full-length write-up on the new trading program was presented in last month’s report.
The Swiss Technical Analysis Society (SMAT) has published Creating Your Own Sectors in their current quarterly publication. If your focus is higher returns, It shows that simple market selection is far better than a packaged ETF.
Andrew Swanscott at BetterSystemTrader.com (a good source for trading systems) has put up an edited version of an older presentation of Mr. Kaufman’s. It’s all about price noise and the Efficiency Ratio.
Look for past articles by Mr. Kaufman on Seeking Alpha (www.seekingalpha.com), Forbes (https://www.forbes.com/sites/perrykaufman). www.equities.com, Modern Trader, Technical Analysis of Stocks & Commodities, and Proactive Advisor Magazine. You will also find many articles posted under Articles on our website, www.kaufmansignals.com. You can address any questions to firstname.lastname@example.org.
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