Industry Benchmark Performance
A nasty month for most equity programs, but year-to-date returns are still positive. Futures are mixed with smaller losses but smaller 2019 gains. Bonds have had the biggest rally, but it’s not enough to offset all the other uncertainty.
Blogs and Recent Publications
Find this at the end of this report. We post new interviews and reference new articles each month.
MAY Performance in Brief
It may have been frustrating posting profits that lagged the broad index markets, but May posted one of the largest single month drawdowns for all equities. The year-to-date returns are still positive for nearly all our portfolios, but the recent downturn in sentiment means that the system will need to do a clever job of selecting stocks that want to go higher.
Futures are a brighter spot, driving by the sharp decline in yields, the market telling the Fed what it should be doing. Daily and weekly portfolios gained as much as 4% in May, and the Futures Divergence program remain up 24% for 2019.
Major Equity ETFs. A sharp and deep sell-off in May, reaction to the lingering trade issues with China and the new tariff to be imposed on Mexico this week. Costs haven’t shown up yet for most consumers, but they will. With China it would be electronics, machine parts, and clothing. With Mexico it will be food, autos, and about 15% of all our imports. The markets anticipate as we saw these past few weeks. Note that the small caps (IWM) never made new highs. Investors concerned with the economy opt for safer places to put their money.
CLOSE-UP: Alternative Position Sizing
In the June issue of Technical Analysis of Stocks & Commodities there is an interview with John Bollinger. I have the greatest respect for John. He’s thoughtful, smart, successful, and has done this for a long time. He talked about how he thinks we should size our positions – larger when there is high volatility and smaller when there is low volatility.
He explains this very logically, observing that volatility is “extreme-seeking.” If you take a large position when volatility is high, volatility will fall and your risk will drop. If you take a small position on low volatility then volatility increases and so does your risk. It does seem sensible and I think it applies to options trading and mean reversion, but most traders and funds favor trend following, as do we. I have always sized positions in the opposite way, larger when volatility is low, so I needed to look at this carefully. Perhaps I’ve been doing it all wrong?
Setting Up a Test
Without making this complicated, I decided to test the following:
- A trending market, the ETF TLT (the long bond), and a noisy market, the sector SPDR SPY.
- Data from 2007 to now, which includes the financial crisis of 2008 and the following bull market.
- A 100-day moving average to represent a long-term trend.
- Three rules for position sizing:
- A $10,000 allocation divided by the closing price.
- A $10,000 investment divided by the annualized 20-day volatility
- A $10,000 investment times the annualized 20-day volatility
- The position size is set on entry and held for the entire trade.
Different Rules Have Different Investment Sizes
Rule (a) is the easiest allocation. Every trade has the same $10,000 exposure.
In rule (b), the position size gets smaller as the volatility gets larger. Then very low volatility will use need a larger investment. For example, if volatility is 15% we will use $10,000/0.15 = $66,666. But on October 19, 2017 volatility touched a low of 3.21%, so the investment would have been $10,000/0.0321 = $116,822. We will adjust the final returns based on the largest investment that was needed.
In rule (c), the position size gets larger as the volatility gets larger. At a volatility of 15% we have $10,000 x 0.15 = $1,500 and at 60% volatility will need an investment of $6,000. In our test, the maximum volatility was 93.5%. We will adjust the returns to reflect a maximum investment of $9,350.
There is always an exception. This test is for trend following. If we are trading a mean-reversion strategy, we would be more interested in situations where there is high volatility because we could set our position farther from the norm, the level where we expect prices to correct. On the other hand, very high volatility can be dangerous regardless of the system you are using.
Results of SPY
Recognizing that the S&P is not normally a trending market, and this is a trending test, the results of the three rules applied to SPY (long-only) were:
Our simple allocation in Rule 1 gave a much higher return than the other tests, but also the highest risk. Rule 2, which needed a much larger investment, had a medium return, lower risk, and the best payout ratio of 0.509. Rule 3, which had larger positions when volatility was higher, had the lowest returns, much lower risk, but also the lowest payout ratio.
While we would like to get the higher ratio of Rule 2 (using annualized volatility to decide the position size, favoring larger positions when risk is lower), we don’t know what our investment needs to be at any time, making it impractical.
Results of TLT
While interest rates are generally very trending, bonds have a longer maturity and prices have the ability to move around more. About one-half of this test period represents the end of the long bull market in interest rates. These tests traded only on the long side.
As with SPY, the simple allocation of Rule 1 gave the highest return and the highest risk, netting a payout ratio of only 0.132. Using historic volatility in Rule 2 resulted in both lower returns and lower risk, but a slightly higher ratio. Again, the problem with Rule 2 is that we don’t know our maximum investment until after-the-fact. Rule 3 had the lowest return and the lowest risk, but a ratio the same as Rule 1.
What Can We Conclude?
Granted, this is a small test. Results could be different using other markets or different trend speeds. But I don’t think so.
Some years ago, when interest rates were near zero, futures funds held gigantic positions in Eurodollar rates in order to attempt to have equal risk in each sector. That presented a real possibility of event risk – a geopolitical situation where rates might suddenly rise, even temporarily – would result in huge losses. But that never happened. Still, holding large positions when volatility is low comes with a certain amount of risk. For that reason, our program does not trade the very short-term rates when yields are very low.
These tests confirm my own belief that larger positions should be taken when volatility is low in order to equalize the risk of each trade. That maximizes diversification. It gives each trade an equal say in the outcome. To take larger positions (uneven allocations) under any circumstance means that those larger positions must outperform the others, something I don’t believe we can predict.
For those who would like a more sophisticated way of calculating position size, use the method most common to futures, an equal allocation divided by the dollar value of the average true range. But then all assets in the portfolio need to be scaled down to the investment size. For the exact way to do this, you’ll need to go to my book, Trading Systems and Methods. The downside is that each time you change assets you’ll need to rebalance the portfolio. There is always a downside.
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 275 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.
A sharp turn-around in the Trend Strength Index indicates that the SPY sell-off is stronger than it seems. Although it is now sitting in a neutral zone, near zero, we expect it to drop to -20, the most likely support level.
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.
The daily Trend portfolios are holding up much better than the weekly, but neither are putting in a cheerful performance. Trends have started to turn down again after an attempt to rally. If that continues, the programs will again take defensive action. We hope for a recovery, but we don’t see much in the way of hopeful signs in the near term. We’ll let the system decide.
Income Focus and Sector Rotation
Interest rates are the beneficiary of uncertainty, and we seem to have plenty of that. While the Income Focus program trades preferred stocks (PFF) as well as munis and other rates, it benefits from the flow of interest income and now also from they expectation of lower rates by the Fed.
Last month’s gain was too good to be true. This month we gave it back, but not as much as the S&P.
This program had a smaller loss than the S&P and is still up more than 7% for the year. It’s had a good history of recovering quickly from drawdowns. It will also benefit from a flight to safety where investors move their money to the more conservative stocks during uncertainty. That would be the DOW.
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.
Losses of 6% and 5% in the portfolios leave the year-to-date still higher by 11% and 6%. It is interesting that this program trades the turns in the trend but stays only for a few days. That seems to be a better approach during the current uncertainty.
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. 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 buys undervalued stocks and hedges with one of the major equity ETFs when prices turn down. During the recent rally, it still maintained a small hedge, preventing it from fully benefiting from the rally. Now it has set a larger hedge, which should allow small profits but good protection from another major sell-off. Losses this month of 4% to 5% put this program flat for the year.
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.”
Another month of profits for all Trend portfolios, and certainly better returns than equities. Still, gains in bonds are not enough to drive a big return for futures, and the up and down pattern of stocks reflects in other sectors. Still, we’ll take profits at a time when equities are in the decline.
Group DF2: Daily Divergence Portfolio for Futures
Losses of 1% to 4% seem modest while gains for 2019 are still up 15% to 24%. While this program tends to have larger equity swings, the current swing looks good.
Blogs and Recent Publications (for the past 12 months)
MetaStock will be offering a program with four of Mr. Kaufman’s short-term trading strategies for ETFs, stocks, and futures. They should be available now but are running late. We’ll have a video presentation by the end of June.
“A Simple Way to Trade Seasonality” will be published in Technical Analysis of Stocks & Commodities. We’ll let you know when we have a date.
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.
Technical Analysis of Stocks & Commodities will publish “Volatility: What They Don’t Teach You In Grad School,” in the January edition.
An article appeared in ProActive Advisor Magazine looking at all calendar patterns, including the Santa Rally, the Presidential Cycle for 2019, the January and May effect, and seasonal patterns in ETFs.
In January Technical Analysis of Stocks & Commodities will publish an article showing the real relationship between price and volatility, which will surprise you. It should change the way you size your positions.
Mr. Kaufman spoke in Tokyo and Osaka to the Japanese association of Technical Analysts on various techniques for trading Japanese markets. You can contact the organization for a copy of the presentation. Mr. Kaufman was presented with a Japanese translation of his newest book, A Guide to Developing a Successful Trading Strategy.
He also spoke about “Making Volatility Work for You” at the 2018 IFTA conference in Kuala Lumpur. It was an excellent conference with many good speakers. You may be able to get a copy of the presentation by contacting MATA, the Malaysian Association of Technical Analysts.
“In Search of the Best Trend” will appear in Technical Analysis of Stocks & Commodities this month.
A new article on “Defense is Your Best Defense” will appear in ProActive Advisor Magazine this week.
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 has been a keynote speaker at a number of IFTA conferences, the most recent this year in Kuala Lumpur, and the previous year in Milan. You can find his presentations on their website.
© May 2019, KaufmanSignals. All Rights Reserved.