Industry Benchmark Performance
November was profitable overall for the Hedge Fund and CTA industry, with most tracking showing gains for both the month and the year, and all slightly better than the broad S&P Index.
Overview: Is This the Top or Just a Deep Breath?
Even with NASDAQ posting new highs, as shown in the chart below, there are an increasing number of reasons that are keeping new buyers on the sidelines:
- 9 Months of sideways index movement could look like the end of a bull market
- A stronger dollar that hurts exports but favors lower cost of imports
- Likelihood of higher interest rates that might dampen economic activity
- The OPEC threat to cut production (very unlikely when they all need money from oil)
- Weaker world economies with uncertainty over whether China’s numbers are correct
- A surge of terrorist activities
Only the stronger dollar is a reality, all of the others are expectations. And dampened exports are not as important to the economy as cheaper imports. That’s the same for oil. Energy companies are taking a beating, but the consumer has more money to spend. There are more consumers than energy companies. The comparison of the US 3-Year bond and the Eurobund is interesting because they track closely even when our interest rate policies are completely out-of-phase. Only now the ECB is aggressively forcing down rates while the U.S. is on the verge of raising rates. Yet you couldn’t tell from the charts. The EURUSD is much clearer, touching into the 105 range before rallying sharply to 109 (on Dec 3) following the ECB disappointing rate announcement. So we may have seen the bottom although a sustained rally in the euro is very unlikely given the two different phases of recovery.
As for other commodities, gold is at a low (it often moves opposite the U.S. dollar) and copper reflects the slowdown in the Chinese economy. Crude oil has touched under $40 and will need more than an OPEC meeting to change direction.
All in all, we see a positive slant to the U.S. economy but hesitation to invest more in the stock market. If interest rates do move up on the Fed action in December, then many investors will opt for the certainty of riskless returns in bonds rather than a stock market that can’t seem to move higher. Our conclusion is: More of the same sideways movement in the broad index but likely opportunities in individual stocks and futures sectors. The market is simply taking a deep breath waiting for something to motivate investors and a significant downturn is unlikely.
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 do it will volatility that his higher 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 an investor, you must understand their risk tolerance and their financial well-being.
November System Performance
If we could only consistently predict which strategy would be the winner the next month! Last month the Divergence program was strong in both stocks and futures. This month Trend Futures were strong while other strategies and markets ended on both sides of zero, much the same as the Index markets. The smallest portfolios all did the best, and all beat the SPY. Larger portfolios performed closer to the S&P.
Year-to-date, the Equity Divergence program is performing best, with the Weekly Equity Trend also doing well. All the ETF programs are underperforming a small amount but have held very few positions during the past month. Returns may have been small, but so was the risk.
The futures programs reversed again, with the daily and weekly Trend gaining nicely while the Divergence program gave back most of last month’s profits. We’ll show in the review of Futures that most gains were in the strong dollar while the losses were concentrated in the index markets.
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.
Investors must have been bargain hunting when the stock market sold off in September, but they seem to have exhausted their buying power. Highs in the SPY fell short of a new high while the Trend Strength Index is now right at zero. That indicates a balance between up and down trends over all stocks that we follow. While it gives us an opportunity to beat the market by stock selection, we prefer a raging bull market where anything you pick turns into a profit. That’s not going to happen right now.
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 Trend Sector ETF program buys the 6 strongest sectors of the SPDRs. November started long Preferred Stocks (PFF) and Consumer Discretionary (XLY), and has added Technology (XLK). Holding only three of six possible positions shows that the overall market is still weak. At the end of November we were long:
Preferred Stocks (PFF), Technology (XLK), and Consumer Discretionary (XLY)
The Timing Rotation program began November long
Financials (XLF), Preferred Stocks IPFF), Utilities (XLU), Metals & Mining (XME), and Retail (XRT). hedged 1/6 of the risk using SPY or SDS.
It exited Financials (XLF), Metals & Mining (XME), and Retail (XRT), and now holds:
Preferred (PFF), Reits (VNQ), Oil & Gas Service (XES), Technology (XLK), Staples (XLP), Utilities (XLU), and Consumer Discretionary (XLY), all hedged 17% (1/6) of the risk using SPY:
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
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 small gain in the 10 and 30 Stock programs keep us near our equity highs, looking for a new leg up. With the broad index going sideways, we’ll count on individual stocks outperforming. As long as the whole market doesn’t turn down, chances are good. The ETF program is just now setting long positions after an extended time of little to no activity. Unlike individual stocks, the ETFs reflect a broader sample and fewer of them have shown a positive trend during the past two months.
The Weekly Stock programs beat the daily program with a return of slightly more than 2%, holding on to last month’s gains and now near all-time highs. The ETF programs were mostly unchanged because of the few positions held during the month.
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 posted small gains in the stock portfolios and a marginal loss in ETFs. Returns are now significantly above the lows of the retracement and looking much stronger. Even with the small loss in ETFs, the trend of that program is intact.
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 1.7% gain in the 10 stock portfolio is still only a small blip on the chart but a good sign. We’re still hedged 1/6 of the risk because the broad index has not yet fully turned higher. It is possible that it will be some time before all equity index trends turn up. The large portfolio and the ETF Rotation both posted fractional losses.
NEW DIVERGENCE PORTFOLIOS
Last month we discussed changes to all the futures programs due to changing data, the elimination of the “morning opening price” in most futures markets. Nearly all markets now open about 30 minutes after the official close, even though volume can be very light until morning.
Because we process data at about 8 PM New York Time, we cannot enter orders “On the Open.” Most futures markets are now executed On the Close. Even though the returns are similar, our experience is that sooner is better for placing orders. The longer you wait, the more the price can move. We now show the recommended execution time on the Order sheets, slightly before the release of U.S. economic reports because history shows that those reports most often confirm the positions that the systems are currently holding.
The amount of market “noise” (erratic price movement) determines the success of waiting until the close. Those markets with high noise benefit from waiting while stronger trending markets, such as interest rates, may not. These data changes have resulted in some performance changes in the Divergence Program which in turn has allowed us to change expand the markets traded in the portfolio. We believe these changes will be a significant improvement to the program.
November showed opposite results for the Trend and Divergence programs, this month with the Trend program gaining more than 10% and the Divergence program losing from 5% to 12%, giving back from one-half to all of October’s gains. Although diversification in futures and stocks often leads to lower risk and better returns, this year both groups are essentially flat.
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 new report describing our revised portfolio allocation methodology. It can be found in the drop-down menu under “Articles.”
The Trend Futures gained 10% to 12.5% in the daily program and 7% to 9% in the weekly, reversing last month’s losses. The bar chart below shows that FX, metals, and some energy have been the net gainers for the year, with equity index and ags the net losers. That same pattern was mostly in evidence in November with the exception of the ags which recovered half their yearly loss. We have continued to benefit from the stronger dollar as well as the decline in copper.
Group DF2: Daily Divergence Portfolio for Futures
The performance in the chart below represents the historic returns of the new portfolio. The performance shown in the Summary Table at the beginning of this report is performance tracking, which posts the daily returns of the current positions. The tracking will reflect the new portfolio performance going forward.
In November the Divergence program lost part of the large gains posted in October. That can be seen in the chart below. On average, each portfolio has lost about one half of the most recent gains. This program shows more volatility than the Trend Futures program because it is most often holding only a few positions that satisfy the divergence pattern. We see it as an excellent means for diversification.
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