November 2016 Performance Report

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Industry Benchmark Performance

Hedge Fund preliminary reporting for November show good returns for the Equity Long Bias, but still lagging the S&P by 4% for the year. Although the small caps have done extraordinarily well, it’s difficult for a large fund to put much of its investment there due to liquidity. Hedge funds tend to invest in specific stock and bond issues, rather than the index itself.

CTA returns were mostly flat in November, following an already difficult year. Trend following has been the weakest area, which can be seen in Barclays systematic returns, the SG Trend Index, and the BTOP50. A large part of the Futures Funds rely on trend following to stabilize their performance. We’re pleased that our Daily Trend Futures program is running 10% better than the industry.

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November Performance in Brief

We may be playing catch-up with the S&P and small caps, but our November equity returns were far above the S&P and NASDAQ. All but one of our 18 equity portfolios were positive, with only the Weekly Sector Rotation marginally lower for the month, although the last three days were not included because we post only on Fridays and the last posting was November 25th.

The Daily Trend Futures Program added nice gains, putting the year-to-date at a respectable 6% to 10% return. The Weekly Trend Futures Program isn’t doing as well, and shows small losses for November, but again, the last three days of the month haven’t been posted. The Divergence Futures Program was profitable but still has a long way to go before it gets out of the current drawdown.

As we will show in the November Overview, below, we expect prices to continue higher in December and are cautiously optimistic for the first quarter of 2017.

Major Equity ETFs. An unexpected rally, especially in IWM, the ETF version of the Russell 2000, gained 11% this month for a year-to-date return of 18%. The S&P and DOW also made new highs, but it’s pattern remains mostly sideways since June.

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Blogs and Recent Publications

Look for 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 shortly on Proactive Advisor Magazine. You will also find many articles posted under Articles on our website, www.kaufmansignals.com. You can address any questions to perry@kaufmansignals.com.

November Overview: Will the Rally Continue?

There is no doubt that our investments are benefiting from anticipation of things to come. Our last month’s commentary listing a number of positives that could come from a Trump win, including lowering corporate tax rates, modifying the health care system, infrastructure spending, and easing of banking and other business regulations. We can only interpret this, along with everyone else, as positive for business

But what next? In a recent article published on Seeking Alpha, Mr Kaufman forecasts a positive December, given both history (see Chart below), a general improvement in the economy, and the romance period of the new President with Congress.

spx-from-1950

Let’s apply something more specific. First, interest rates are expected to rise. In fact, a look at 30-year bond futures (left below), shows that they are already heading down (higher yields), and are now midrange of a broad sideways trading range. If the Fed confirms a rate hike in December, this will become the current rate and anticipation could easily drive prices below the support level at 140.

At the same time we have a lot of news about OPEC finally getting its cooperating countries to cut back on oil production. There is still the issue of enforcement, which has never been very good, but Saudi Arabia is planning new, stricter oversight. So far, the market believes them because crude rallied nearly 10% in less than 3 days, putting it a about $50/barrel. That’s still a low price compared to 2015, and for those that have forgotten about $150 oil. But along with higher rates, higher oil prices will add some drag to the economy, and to the psychology of those looking to purchase homes, and those with less disposable income.

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Finally, add the uncertainty of the U.S. dollar. Analyst are unified (well, almost) that the dollar will strengthen when the Fed raises rates and the business in the U.S. is stronger than most anywhere else. Money flowing into the U.S. will seek the stock market and bonds, but will strengthen the dollar and hurt U.S. exports. The stock market will benefit for a while, but the GDP will not. The point is that there are headwinds that need to be considered. It is also likely that much of this is already in the market.

euro-and-bp

While we remain positive on the market, we could see a sluggish December, although a decline is unlikely. More likely is a “pause to reconsider” on about February 1st. That’s shortly after the inauguration and the time when the excitement has worn off and the people are waiting for something to happen. But the process is very slow, and the results are never quite as good as expectations.

In order to lower corporate rates, some other income must replace it. In order to eliminate the current Affordable Care Act, the new administration will need something to replace it. In order to remove burdensome regulation that seems to have come with the Dodd-Frank Act, there will need to be a replacement. It’s hard to see how these laws can just be eliminated, leaving a gigantic budget deficit, 30 million people with no insurance, and no regulation over “too big to fail” institutions, the ones that brought us 2008.

All this may come to pass, but not right away, and not soon enough to keep stock prices moving higher steadily. We’re advocating the well-known maxim, “buy the rumor, sell the fact,” where the rumor was the election on November 8 and the news is the reality of the new administration, which we see as about February 1.

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 decide your risk tolerance and have 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 is not reflecting the strength of the S&P rally, which would indicate that the rally may not have “legs.” To keep it in perspective with our other comments, we see higher prices in December, but it could be on weakening strength. It seems unlikely that the TSI will reach more than 35 before seeing a pullback.

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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.

Strongest

The Trend Sector ETF program buys the 6 strongest sectors of the SPDRs.

At the end of November, we had Technology (XLK), Consumer Discretionary (XLY) and added more energy (XES), Materials (XLB), and Retail (XRT).  As it turns out, energy has rallied on OPEC consolidation, and Retail seems to be benefiting for a strong start to the shopping season. We now hold:

Oil & Gas Exploration (XES), Materials (XLB), Energy (XLE), Financials (XLF), Industrials (XLI), and Retail (XRT)

Undervalued

The Timing Program buys 4 ETFs that are undervalued with respect to SPY, in expectation of rotation. At the end of November we had no position, but have since enter Preferred Stocks (PFF) and Oil & Gas Exploration (XES).  We still have room for two more sectors. We now hold:

Preferred Stocks (PFF), and Oil & Gas Exploration (XES).

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 and Income Focus

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 10% return in the 10-stock portfolio and a 6.4% return in the 30-stock portfolio does a lot to make the equity charts look better. ETFs also did well, but not by the same amount, with the 20 ETF portfolio outperforming the smaller one 4.4% to 1%. However, the Sector Rotation program gained 5.4% putting it on-track with long-term returns.

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Both the 10-stock and 30-stock Weekly portfolios are posting the best year-to-date returns, up 11.6% and 8.1%, with good gains this month. The smaller portfolio has now posted new equity highs and seems to be maintaining a nice upward trend. Both ETF portfolios had fractional gains, which are disappointing. The fast rotation of sectors into energy and banking are difficult to catch when signals only occur once each week.

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Sector Rotation and Income Focus

Both Daily and Weekly Income Focus were inactive this month, with trends going the wrong way as rates rise. Although these programs gain a great deal of their returns from dividends, they can lose all of it if the program is long as rates rise. Both programs posted a gain of 1 basis point. The Daily Program shows a year-to-date profit of 4.8% and the Weekly Program a gain of 5.8%, after giving back for the past few months. We suggest that you consider this program a hedge for you outright long equity portfolios.

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Weekly Sector Rotation was another non-event this month, posting a fractional loss. It remains slightly ahead for the year, but has suffered from very fast rotation among sectors, and very volatile moves in those sectors. On the last week of the month it moved from interest rates to Financials (XLF), Industrials (XLI), and Metals & Mining (XME). With some exposure now, we can look forward to better returns.

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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 good gains in November for both stock portfolio, up 5.7% and up 3.6% for the smaller and larger. The smaller portfolio continues to outperform the larger one. Because it takes the top picks, it is expected to gain more but with larger risk. In this case, the marginal additions to the larger portfolio are not living up to expectations. The ETF portfolio was disappointing, only gaining 21 basis points on very few trading signals. Still it marches upwards.

equity-divergence

 

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 Stock Program had more modest gains compared to the Trend Programs, greatly due to partial hedges during the month that reduced both gains and losses. Both stock portfolios are now showing NAVs near all-time highs so we’re optimistic that the uptrend will continue. The ETF portfolio gained 4% in November, putting it up more than 5% for 2016.

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Futures Programs

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.”

There were good returns in all daily Futures Trend portfolios, but the weekly posted small losses, having ended its month on the previous Friday before the big rally in energy. We’ll look forward to seeing that next month. Meanwhile the daily programs are now up 6% to 10% for the year.

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A closer look at the November and year-to-date sector returns for the Trend Program shows that interest rates continue to perform, although now it is the shorts rather than the long positions that have dominated returns since 1980. The strengthening dollar and non-ferrous metals, especially copper, added to the totals. We expect to see energy surface as a profitable sector next month.

futures-sector-returns

 

Group DF2: Daily Divergence Portfolio for Futures

There were only fractional gains in Futures Divergence in November, mostly due to the lack of trading signals. This program remains in a drawdown but maintains its long-term pattern of regular equity swings.

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(c) Copyright November 2016, KaufmanSignals.com. All rights reserved.

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