Industry Benchmark Performance
Equities and futures continue to have an excellent year, with early reporting showing gains in nearly every category. Equity Long Bias posted returns that are better than SPY, a rare occurrence. Futures, especially trending systems, are higher by nearly 10% this year.
Money Show Presentation
On May 11, Mr. Kaufman gave a presentation on “Lagged Trends” for the Money Show. It is available using the following link: youtu.be/bh2fA8oBwBk
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.
May Performance in Brief
Our benchmark 10-stock Trend portfolio is recovering nicely from its drawdown, while the larger 30-stock portfolio has avoided the problems with more diversification. Nearly all of our portfolio are having a good year with the exception of Income Focus, which is fighting increasing interest rates. History shows that rates rise quickly then spend much longer coming down. We expect that pattern to continue.
Futures are outperforming expectations this year, benefiting from rising prices in copper, yen-based currencies, and some energy movement. Copper has moved straight up in the past month, now above historic highs in the cash market. At some point, high prices will dampen demand and we could expect a decline to $350 from nearly $500.
Major Equity ETFs
May shows a flattening of the upwards trend in the major equity index EFTs. Perhaps the anticipated “opening trade,” where shoppers rush to the stores, has come and gone. Economists still forecast a very strong GDP, but that may already be in the market. Buy the rumor, sell the news. The S&P remains higher by 12.7% and Nasdaq up by 6.5%.
CLOSE-UP: Sector Rotation
We hear a lot about “rotation” in the news. It seems to happen when the stocks that were previously making money for us are now losing, and some other stocks that we are not trading are moving higher. If you are confused, you are not alone. “Sector rotation” is easy to see after-the-fact. It is tricky to recognize the right stocks at the right time. As with most trading systems, there is a lag, and as with most trends, they do not last as long as we would like.
What is a Sector?
Some sectors are easy to identify, such as energy, which include the major oil companies, and financials, which include the big banks. There are ETFs that define these broad areas and track them as subsets of the S&P or Nasdaq, or a combination. They are passive indices.
But other sectors are not as clear. The SPDR ETF for technology is XLK and has the major components as AAPL (21.7%), MSFT (20.2%), V (4.2%), and NVDA (3.8). Would you have put Visa into technology? With banking now mostly online, perhaps I have overlooked the transition.
There are also narrower sectors, such as the Philly semiconductor ETF called PHLX (on the NYSE) or SOXX (on Nasdaq) made up of 30 large companies. Its top components are NVDA (8.7%), TXN (8.36%), QCOM (7.75%).
The bottom holdings in SOXX are Monolithic Power, IPG Photonics (added in 2021), Cree, and MKS, all less than 1% and not contributing much to the value.
Then there is ARKK, which includes technology in the form of whatever Kathy Wood decides. Sometimes Tesla, sometimes Bitcoin. It’s called an actively managed ETF but it is a sector if you define it as “innovation.”
New sectors also include green energy, cybersecurity, and artificial intelligence, which we will discuss later.
Sectors can range from broad to narrow, defined by whomever grouped them together.
Trading Only the Largest Components
About 5 years ago I did a study of sector ETFs. My thought was that the largest components drive the market and there are many smaller stocks that do nothing but drag down the performance. Results showed that this premise was true.
I took no more than 10 of the largest sector components, equally-weighted them, and plotted the returns against the full sector index. Health care (XLV) is shown in Figure 1. Equally-weighting has slowly gained over the full XLV index.
Figure 1. Health care ETF (XLV) compared to a smaller, equally-weighted combination.
This was not the only test. Figure 2 shows a similar test for the energy ETF XLE.
Figure 2. Energy ETF (XLE) compared to a smaller, equally-weighted combination.
If you are looking to profit from a sector and are willing to trade individual stocks rather than an ETF, then you can expect to be rewarded.
How Does Sector Rotation Happen?
Now we get to the more difficult question of sector rotation.
Events shape stock movement. When there were heated exchanges between the U.S. and North Korea or Iran, defense stocks rallied. When Covid was first announced, pharmaceutical and research companies rallied. When the lockdown began, stay-at-home stocks rallied. Of course, “stay-at-home” is not a sector, but we all know the stocks that belong to that group, AMZN, NFLX, even PTON.
Now there is green energy, a reaction to our environmental problems.
What is common is that government policy and major events drive groups of stocks. The standard “sectors,” such as manufacturing and utilities are too broad, include too many stocks, and do not reflect what we are looking for, a narrow group of stock targeting one concept.
We look at electric vehicles and not auto manufactures. We look at Kathy Wood’s ARKK Innovation rather than technology. We look at cryptocurrencies and not foreign exchange.
How Long Can a Sector Be the Leader?
Even when a company does everything correctly, competition will dilute their future. While Apple (AAPL) is still doing great, if Samsung were not there, it would be better. For Google there is Bing, for Amazon there is Alibaba. There are countless other companies that are small but eat away customers at the edges.
It is one reason why mature companies cannot maintain the growth of new companies. Competition.
A sector such as Defense can last a long time. A sector such as wind farms may not. A company that appears with a new way of solving artificial intelligence, stopping global warming, delivering packages faster and cheaper, or curing the common cold, will disrupt the competition. Then good “sector” performance will not be sustained, even if we do not know how long it will survive.
How can we take advantage of sectors that are outperforming?
Anticipate or Follow?
Sector Rotation has been a classic strategy for a long time. The rules are:
- Create a list of sectors
- Once a month calculate the monthly returns of each sector
- Buy the 3 sectors with the highest returns.
This approach depends on the best sectors continuing to be the best for a few months. It uses the broader sector definitions, which at best do not make big moves.
There are also many services online that will tell you the best trending stocks and ETFs. However, most have a very short lookback. Some are 1 day, another 8 days, and some 1 year. Those may not match your time horizon.
You can enter “Best trending sectors” into your browser, short-term and long-term recommendations appear. Everyone has an opinion and advice. We did not see where anyone showed how successful this advice has been.
The reality is that there is a lag to identifying the sectors that are now profitable. You get in late and you get out late. The way to succeed is to anticipate the next good sector or find one that has longevity.
Our own Sector Rotation program uses mostly the SPDR sectors, which are very liquid but, admittedly, very broad. We rank the sectors by their returns over the past 3 months and reassess weekly. We filter it with the direction of SPY and only take long positions. The history of performance is shown in Figure 3.
Figure 3. The KaufmanSignals Sector Rotation program.
This is not a sales pitch to use this program. The performance gains slowly and only recently benefited from stay-at-home stocks and technology. Had there been narrowly defined sectors, it might have done better. It may give you ideas for your own program.
What Sector is Next?
After the hacking of the Colonial Pipeline we would think that cybersecurity would advance. It did for some companies but not for all. The two main ETFs, CIBR and HACK, shown in Figure 4, show a minimum move higher, if at all. That leaves you wondering if traders have any confidence in the ability of cybersecurity firms to stop Ransomware, or if the problem is that these ETFs have too many stocks doing nothing.
Figure 4. Two cybersecurity ETFs, CIBR and HACK
If we look at individual companies, the pattern is different. Fortinet (FTNT) has moved sharply higher and CACI (CACI) and CrowdSource (CRWD) have stayed strong, shown in Figure 5.
Figure 5. Individual cybersecurity stocks.
This reinforces the conclusion that ETFs are too broad and contain stocks that are not performing; therefore, they drag down the index. It is better to trade the most liquid stocks.
Robotics and Artificial Intelligence
Another area that is not going away is the advancement of robotics and artificial intelligence. We see it in everything from production of cars and microchips to vacuum cleaners. While CGNX is the leader, most other companies show steady gains. We are not sure where to find an ETF that reflects these gains (see Figure 6). It does not appear to be ARKK.
Figure 6. Individual stocks that specialize in robotics and artificial intelligence.
As much as we might think otherwise, we are a warrior planet. There is hardly a time when some countries are not at war or threatening to go to war. Defense is the largest part of the U.S. budget as it probably is for Russia, China, Iran, Israel, and many other countries. Sad, but true.
Then we can expect the major defense stocks to trend higher. As we can see in Figure 7 (taken from an article that I wrote at the end of 2017), they do not disappoint. During a crisis, such as 9/11/2001, stocks plunged except for defense stocks. At the same time the S&P sank to lows (the black line in Figure 8), the three major defense stocks, Lockheed-Martin (LMT), Raytheon (now RTX), and Northrop (NOC), all rallied. Boeing, of course, is both commercial and military, so it had a subdued reaction.
Figure 7. History of major defense stocks.
Figure 8. Defense stocks compared to SPY during the 9/11 attack.
Defense stocks are not immune from all economic events. All stocks were initially hurt by the Covid pandemic, including defense stocks, shown in Figure 9. They have had a bumpy ride in the past year but are still far ahead of the S&P. Stocks trading has risk.
Figure 9. Raytheon stock prices drop during the first part of the 2020 pandemic.
Some trading opportunities require thoughtful research to decide what sectors will benefit next and sustain their performance. Technology, in the broad sense, seems to be a lasting success. But a technology sector is too broad to capture large returns, that is reserved for smaller sectors.
We have suggested that cybersecurity and robotics are likely candidates, as well as defense stocks. Can you find others?
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.
This is a clear case of the benefits of diversification. The Daily 10-Stock Trend portfolio gained 2%, recovering from the recent drawdown, while the 30-Stock portfolio gained 12% and is now up by 37% in 2020. In the long run, the smaller portfolio finds the most aggressive stocks, but then it also takes a larger loss when those stocks turn down.
The 10-Stock Weekly Trend program shows similar results, with a sharp rally followed by a drawdown. The 30-Stock Weekly portfolio did not rally as far and has no sold off as much.
Income Focus and Sector Rotation
This month small losses in both the daily and weekly Income Focus program as it continues to fight against rising, then falling, then rising interest rates. Although the Weekly program had a drawdown a few months ago, they seem to be tracking the same now.
Another 8% gain in May, bring the year-to-date to 36%, a remarkable run. We are going to attribute this mostly to copper in XME, but energy (XLE) and financials (XLF) have helped. We have waited patiently for this performance.
Another month of small gains keeps the DowHedge programs close to the gains in the equity index markets. The patterns in both daily and weekly programs look strong. Analysts are reverting to basic stocks and away from technology.
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.
Slow but steady this year. The Divergence program had mixed returns in May but is still higher by 4.2% and 8.2% for the year. As with the other programs, this benefited from aggressive trading.
Group DE3: Timing Program for Stocks
The Timing program is a relative-value arbitrage, taking advantage of undervalued stocks relative to its index. It first finds the index that correlates best with a stock, then waits for an oversold indicator within an upwards trend. It exits when the stock price normalizes relative to the index, or the trend turns down. These portfolios are long-only because the upwards bias in stocks and that they are most often used in retirement accounts.
Another month of gains for Equity Timing, putting this program ahead by 34% and 19% for the smaller and larger portfolios. Even without the runaway bull market of 2020, this program has been finding good entry points for its trades.
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.”
Is there a shortage in commodities? The news is playing up copper as well as grains and meats. It could be that we are seeing trends across most sectors, which would account for the steep gains for this program. All portfolios were ahead by 3% to 4% in May and are now up 27%, 20%, and 17%, in 2021 for the portfolios smaller to larger.
Group DF2: Daily Divergence Portfolio for Futures
Yes, every month we look at the chart of Divergence performance and wonder why it has this pattern. It is partly due to only holding a few positions at a time, because a divergence pattern does not occur often. That means less diversification and wider equity swings. But it seems to work for this program.
Divergence portfolios were higher by 2% to 4% for May and 8% to 11% for 2021. NAVs for all programs are near their highs.
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.
Two more articles are scheduled for Technical Analysis of Stocks & Commodities. We don’t have a date yet, but keep checking!
Mr. Kaufman gave a 30-minute presentation, “Lagged Trends,” for The Money Show on Tuesday, May 11. You can see it using the following link:
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.
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 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.
© May 2021, Etna Publishing, LLC. All Rights Reserved.