November was another good month for equities and an exceptional month for futures. Our equity programs added good returns but not quite as good as the benchmarks. The market had a remarkable and unexpected recovery from the sharp sell-off in October and although it still has residual signs of weakness, it continues to move slowly higher. Money is said to be flowing into the market, now that we’re five years into a bull market. For the bears, that’s a classic sign of nearing the top, but the persistence of this market is unusual.
The big event of the month was on Friday, the last day. OPEC decided not to reduce quotas, allowing the market to find its price – and it did. Futures were off about 7% and we understand cash was off closer to 10%. That favored the airlines, which were up sharply and hurt other transports, such as rail. Still, the large futures portfolio gained over 5% on Friday, an unusually large gain. Most often we expect price shocks to hurt profits, but we won’t complain.
To focus on futures for just a moment, Barclays Hedge shows that the Trend systems, which represent the majority of managed funds, are up over 14% this year. This is explained by the idea that it’s not really that one trending system is better than another, but that, when the market trends, all trends systems are profitable. The sector breakdown shown later in our Trend Futures review, actually shows that all sectors are profitable this year except the equity index. That’s not so surprising. The equity index markets have a history of being the noisiest, that is, they may show a strong trend, but it is broken up with substantial pullbacks. With all other sectors making money, led by interest rates and agricultural, the total picture is a large gain.
The difference between one trend program and another is the portfolio allocation. Traditionally, futures portfolios have had fixed allocations, where funds are preassigned to a wide range of markets. That worked best in the 1990s when most markets were trending, but did not do well during 2005 to 2010. Companies such as Man and Winton have little choice because the manage billions and billions; therefore, they need the diversification for liquidity. Or do they?
Diversification reduces risk but over-diversification depresses returns. It is very unlikely that a large number of markets will be trending at the same time. Even within a sector that is doing well, some of the markets are not helping. If we were to eliminate the worst of those performers then total returns would be much better. Our Trend Futures programs are now up 34% to 52% for the year, far better than the 15% posted by Barclays Hedge. Our program trades a smaller set of markets at any one time, seeking those that are producing good returns, even though we might be underleveraged. What good is it to be more diversified if those markets that are added are losing money?
The only program to suffer in November was Equity Timing. That program buys stocks discounted to the major index that have a history of recovering. It has been a steady performer, but sometimes buying cheap is followed by buying even cheaper.
What are the pundits forecasting for the stock market? Another few percent higher before the end of the year, and some think this bull market is only midway. That would be nice, but increasing inflows are a concern. When the general public enters, the top can’t be too far away, but that still may be years, as we saw in the internet bubble of the late 1990s. The best advice is to follow a systematic approach and hold the course. It will tell you when to exit and not cut your profits short.
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 TSI made a sharp recovery from a low of -25 back above +30, but still well off the highs of last June. At the same time, the SPY has regained an upward trend and gone to new highs. The TSI for Sector ETFs was never as weak, dropping as low as +32 (anything above zero shows the trend is still intact), but has actually recovered less that the individual stocks and looks weaker on the chart. Timing is always a problem. We know that a Sentiment Index can show overbought or oversold but cannot predict when the market will turn. It’s one of the great challenges of trading.
We continue believe that the stock market will struggle to go higher and there is a significant risk of decline. Because our programs are algorithmic, they will take action when it actually occurs.
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.
Overview of September
Our equity programs are back to full exposure after the October decline. Of our 24 programs, 21 were profitable in November, a good month. The Trend program is essentially even with the SPY, up about 13% for the year, with the smaller portfolio up 19%. The Divergence program is running behind but that is mostly due to lack of signals to fill the portfolio. Specific patterns, combined with good performance may not occur at the same time. The Timing program posted the only negative returns, proving that buying undervalued stocks requires patience. Sometimes they take time to recover.
The chart below shows that both the SPY and QQQ have reached new highs but the small cap IWM is now in a classic trading range. The Qs are running ahead of SPY but also show more volatility.
Futures remain the shining star of 2014 and are a good argument for strategy diversification, which is much more important than market diversification. The daily and weekly Trend program, and the daily Divergence program all posted returns from 4.25% to 12% for November, adding to an already good year. More about this later in the report.
Strongest and Weakest 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 strongest sectors of the SPDRs. This month the program continued to hold the same portfolio that it held at the end of last month. Current positions are:
Preferred stocks (PFF), Heath Care (XLV), Staples (XLP), Utilities (XLU), and Vanguard Reits (VNQ).
The Timing Rotation program (buy low) exited Technology (XLK), it’s only holding at the beginning of the month While it was partly hedged using the SPY early in the month, it removed that hedge as the stock market returned to a positive trend. It now holds
Financials (XLF), Staples (XLP), and Health Care (XLV).
Note that Health Care is in both programs, indicating that it has been very strong but had a pullback in October that allowed it to be bought by the Timing Rotation as undervalued.
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 hedge 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.
PEFORMANCE 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.
Recovering from the previous month, the Trend program posted good returns for all portfolios, averaging about the same as the broad stock market index. In October these programs reduced exposure as the market pulled back. That action would look brilliant and necessary had prices continued lower, but the sharp recovery caught everyone, including algorithmic systems, by surprise. That causes a lag in the ability to reset full exposure. Even with that, year-to-date performance of the Trend program is very much in line with equities, and an outstanding return so far in 2014. The smallest portfolio of 10 stocks is still well ahead of the others.
The Weekly Trend Program performed better than the Daily Program. It can avoid exiting on a 1-day sharp reversal, as we saw in some of the tech stocks this week, and stays with the longer trend. While that can also have its downside, the history of performance shows that the daily and weekly programs yield about the same returns.
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 had a nice recovery this month, but tends to be underleveraged because it can’t always find enough reliable trading signals to fill the portfolio. Returns for November were up from about 1.2% to 2.5%.
The Divergence ETF program draws from even a smaller set of ETFs which also cover world markets. It posted a gain of 1% for November. Despite the lack of selection, performance over the years has been remarkably consistent.
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.
Hedges were lifted this month as the equity market recovered from its sharp decline in October. Hedging protects the program from extreme losses but also reduces returns when the market recovers. It takes some days before the program recognizes that the recovery is enough to lift the hedge.
Combining the hedge with buying undervalued stocks was not a good scenario for the Timing program in November. It was the only program that posted a net loss. While the hedges in both the SPY and QQQ dampened returns during the recovery, some of those stocks that were entered as oversold still refuse to recover. It’s difficult to fight a stubborn market. Timing portfolios lost from a fractional amount to over 3% for November.
It’s been years since the entire Managed CTA Industry has had good performance. We’re pleased to say that our Futures Trend portfolios are outperforming the industry by a factor of 3. Daily and Weekly Portfolios gained from 4.39% to 12.06%, making the year-to-date return total from 34% to 52%. It is interesting that no two years are the same. The last returns of this magnitude were in 2008 when the stock market collapsed and futures programs gained from their shorts in equities and longs in bonds. This year is very different. Returns are across the board in all sectors except equities (as shown in the left chart below).
We explained briefly in the summary at the beginning of this report that equities have never been a good performer for macrotrend programs because they are the noisiest of all markets. Perhaps it’s the nature of the participation, but even when there is a trend, as in the past five years, it is an erratic one (from the view of a trend system, of course). While equity index futures are important for diversification, and an occasional profit, they are not the backbone of long-term returns.
It should not be surprising that energy was the biggest winner in November, with its major decline capped with a 7% drop in futures on the last day of the month, the result of an OPEC decision not to reduce production. Pundits think oil prices may drop another 15%. We hope they’re right. But big gains from the year don’t come from a single sector, and the chart show large gains in FX due the stronger dollar, and equally large gains in agricultural products, often an overlooked sector.
The Divergence Program did equally well this month, posting gains from 4.25% to 5.06%. The smallest portfolio has been in a drawdown this year, a function of the smaller selection of markets, but the larger portfolios are performing well. The sector returns below on the right show that equities have the worst returns with bonds and agriculturals posting the best for both November and year-to-date.
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.”
Newedge shows that the entire CTA Industry continues to do well.
The charts below show the daily and weekly Trend program performance. The charts look similar to last month but the gains in the most recent run-up are extended even more. We won’t repeat the numbers again, but we hope this continues.
Group DF2: Daily Divergence Portfolio for Futures
We’ve taken the Divergence historical NAVs back another 4 years to 1988 to be consistent with the Trend program, in case anyone notices that the beginning of the chart looks different from last month.
The Divergence program also had a fine month and a nice recovery from losses in October. While year-to-date returns are behind the Trend program, the unique strategy of pattern recognition lends excellent diversification to any portfolio. The largest portfolios, which have more markets, are outperforming the smaller portfolios.
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