Industry Benchmark Performance
This must be a relief for the fund managers, posting good returns just before the end of the year. Still, they are far below the returns of the broad index markets and well below our own returns.
Blogs and Recent Publications – A New Book on Amazon!
“Kaufman Constructs Trading System” continues to do well. Thank you! 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.
Kaufman’s Fast Strike Systems on MetaStock
If you are interested in short-term trading, look at Kaufman’s Fast Strike strategies. Contact MetaStock at 800-882-3040 or go online to www.metastock.com/kaufmana.
November Performance in Brief
A remarkable month to add to a remarkable, and unexpected year. Our 10-Stock Trend portfolio inched ahead of the NASDAQ index. Performance seems to be rotating out of the high-tech and stay-at-home stocks. We continue to find stocks that are performing well from a large group that have not always been profitable.
Major Equity ETFs
We saw some volatility around Election Day, even before we knew the results. As expected, the market has moved higher, probably just due to the relief that it is over. The small caps, IWM, is the exception to the pattern, gaining far more in November than the other indices. Tradition says that it is a sign that investors are more willing to take on risk.
CLOSE-UP: Trade the Tail
I have been enjoying reading Morgan Housel’s, The Psychology of Money. In Chapter 6, “Tails, You Win” he discusses how only a few stocks can produce all the profits and cause the equity index to move higher. We have seen that recently in a narrow sector of technology and those companies that are thriving in a stay-at-home economy. I even heard today on the financial news that five stocks have kept the market afloat. I am sure you can name them.
You are not alone if you find it strange that the stock market can be doing so well while the economy (“main street”) is suffering. It is terrible to see the lines of cars waiting at food banks. However, that does not mean that we should not follow our system and capitalize on the stock market. You can always donate the profits.
So Few Making So Much
No, I am not talking about the 1% making so much money, I am looking at the few stocks that are driving the market. It is all about the fat tail. Most of you already understand the concept. It refers to those extremely long trends, like the decline in interest rates that started in 1980, or the move up in Tesla, Amazon, Apple, and even Bitcoin, before it went down…and up… (and down in some cases).
Housel uses the Russell 3000 as an example. “Forty percent of the companies in the index were effectively failures. But the 7% of components that performed extremely well were more than enough to offset the duds.” “In 2018, Amazon drove 6% of the S&P 500’s returns.” “Apple was responsible for almost 7% of the index’s returns in 2018.”
What is also interesting is that one product, after many other failures, can drive a company to outstanding success. After nearly going out of business, the iPhone has made Apple one of the most valuable companies ever. Never give up.
These are what we call “tail events.” They can be the extreme profits or the extreme losses. Amazon versus Enron, and even Bank of America.
Distribution of Runs
Those with a leaning towards gambling should already understand the random nature of numbers. If you flipped a coin 100 times, 50 would alternate between a head and a tail (25 of each). That is a run of 1. There would be 25 runs of 2, 12 runs of 3, 6 runs of 4, 3 runs of 5, and one run of 6 or 7.
Whenever we double the number of coin flips we add 1 to the maximum number in a run. Then, if we had 200 flips, we could get a run of 7, 400 flips a run of 8, 800 a run of 9, and 1000 maybe a run of 10.
Now let’s look at SPY from 2000, which is very liquid and should track the random distribution closely (except for the 5% upwards bias). Table 1 gives the number of runs and Figure 1 is a chart of the same thing. But SPY shows a run of 11 and a run of 14. That is the fat tail. You cannot see it on the chart, but it is there.
Table 1. SPY distribution of runs.
Figure 1. SPY Distribution of runs.
Where does the fat tail come from? If you look at runs 1 and 2 on the bar chart, Figure 1, the number of runs up are lower than the runs down. The missing upward runs in the short-term flipping back and forth have been moved to the tail. So we have fewer days that flip and longer runs.
Applying a Trend Calculation
Runs can be even longer if they are viewed in context of a trend, such as a moving average. If we look at 3-day upward moves, we can have +10, -5, +10 and average +5. We can treat small declines as though they did not exist. Which is why a trend system can stay with an upwards move longer and capture the fat tail. By its very method of calculation, it creates even longer fat tails.
Now let us consider the idea that a few stocks provide most of the gains, and that we need to capture the fat tail. We can simply choose those stocks for our portfolio that are doing the best, especially on a trend-following system, which exaggerates the length of the run.
The stocks that are performing best on a trend system are the ones that have the longest runs. That is what a trend system looks for. It is also what it needs because it gives up part of the profit getting in and getting out.
When you look back at your trend-following performance, you will see that there were a lot of small losses offset by very large gains in only a few stocks. But that is a successful trend-following profile.
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 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 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.
After a sluggish period for the Weekly Trend program, it now seems to be back on track, gaining more than 9% in November, keeping pace with the Daily Trend program. There is not much to say about the trend performance except that it is unexpected, and we hope it continues. My experience in the years trading systems is that the timing of profits and losses is not predictable.
Income Focus and Sector Rotation
The Daily Income Focus program posted gains between 1% and 2%, with the Daily program higher by 4% for the year, but the Weekly program lower by that amount. This argues for faster reaction to changing markets, even though we see this as a small blip in a larger uptrend. The target for this program is about 7% annually, with low risk.
Every strategy has its day, and the Sector Rotation program gained over 16% in November. Another month or two higher and the upwards trend will reappear. This program has suffered from constant “rotation” from tech to small caps and from stay-at-home stocks to housing and other basics. The problem is that “sectors” are not defined that way. These are highly focused segments of the market. The system does the best it can finding groups that come close to reflecting investor sentiment.
Another outperformer this month is the Dow Hedge program, up 17%. This program picks the best 10 stocks in the DOW 30 and exits when the risk is extreme. The DIA ETF was up 12.5% in November but only higher by 6.8% for 2020. Picking the best stocks has been a better approach.
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.
Another month of small losses but holding on to gains of 28% and 11% for the 10- and 30-stock portfolios. This has been a good year for short-term programs looking to be long on either a pullback or a pause in the trend. This program looks for pauses.
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 does not depend on market direction for profits, although these portfolios are long-only because they are most often used in retirement accounts.
Although posting a smaller profit in November than most other strategies, this program is now up 59% and 74% in the 10 stock and 20 stock portfolios. Buying stocks that are oversold relative to their index seems to be the strategy of the year. While this program has had respectable long-term performance, this year is clearly an exception.
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.”
Gains ranging from 2.6% to 4.7% puts this strategy up by 13% to 23% for 2020, far better than the industry benchmarks. We see the same pattern as in stocks, with the smaller portfolios gaining the most but with higher risk.
Group DF2: Daily Divergence Portfolio for Futures
Even with the most modest performance of all our strategies, this program gained fractionally in November and is at a break-even for the year. Looking at the chart shows that it remains consistent with its pattern. This program looks for a specific pattern of weakness within a trending market. It tends to have fewer positions and an interesting volatile pattern.
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 the last week of October by John Wiley. It is completely updated and contains more systems and analyses.
MetaStock issued an upgrade to the Kaufman Fast Strike add-on in late January. This add-on has three short-term trading systems, holding positions for one to three days in two of the programs, and about one week in the third program. They trade noisy markets, including most major index ETFs and futures, plus one program trades the VIX. You can see a description of the programs and a record of past performance on MetaStock. Anyone interested should contact MetaStock at 800-882-3040 or go online to www.metastock.com/kaufmana
Yoiks! 2021! Technical Analysis of Stocks & Commodities will publish an article on Short-Term Patterns.
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 has 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 gave a presentation at Jake Bernstein’s “Cycle” seminar. Anyone interested in a copy of the presentation should send a request to firstname.lastname@example.org.
The June issue of Technical Analysis of Stocks & Commodities published the article “Crashes and Recoveries.” It will help you figure out how the Covid-19 pandemic will play out. It will also have the TradeStation code for the “2nd Cross” strategy, requested by readers.
There are some comments in the April issue and on the current stock market drawdown and a correction to Mr. Kaufman’s article in the March issue of Technical Analysis of Stocks & Commodities
“The 1st and 2nd Cross” was published in Technical Analysis of Stocks & Commodities in the March issue. It is based on an idea of Linda Raschke and captures small but reliable pieces of a trending move.
A new article “Essential Math For Traders” will be published in the Bonus 2020 issue of Technical Analysis of Stocks & Commodities.
ProActive Advisor Magazine (on-line) published “Controlling risk that doesn’t go away,” posted on January 15.
Both of these articles are important for understanding your investment risk.
MetaStock Seminar held in Sunnyvale
Mr. Kaufman was a keynote speaker at the MetaStock conference in Sunnyvale, November 3. You can hear this presentation by going to the MetaStock website.
Technical Analysis of Stocks & Commodities published “Running for Cover,” an article by Mr Kaufman that looks at whether buying bonds after a sudden drop in the S&P can still be profitable.
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.
Mr. Kaufman spoke in Tokyo and Osaka to the Japanese association of Technical and was a keynote speaker at the 2018 IFTA conference in Kuala Lumpur, both last October. You should be able to get a copy of the presentations by MATA, the Malaysian Association of Technical Analysts.
“In Search of the Best Trend” was published in Technical Analysis of Stocks & Commodities in July 2019. An article on “Defense is Your Best Defense” will appear in ProActive Advisor Magazine also appeared in July 2019.
Mr. Kaufman was a keynote speaker at a number of IFTA conferences, the most recent in 2018 in Kuala Lumpur, and Milan in 2017. You can find his presentations on their website.
© November 2020, Etna Publishing. All Rights Reserved.