October 2014 Performance


xPerformance Table 2014-11-06_6-04-30


We kept expecting a reversal in the stock market and have used our Trend Strength Index to show how the momentum of stocks is much weaker than the broad SPY returns. The sharp decline mid-month was followed by an unexpected V-bottom and new highs. It was an unusual scenario, to say the least. Some notable hedge funds closed their doors at the end of the month, the result of turning from long to short, a strategy that we don’t think works for stocks.

All of our equity programs rely in some way on the direction of the market, but can only profit when prices go up because we expect investors to be using their IRAs or other retirement accounts. But we also have shown to our satisfaction that the short side of the stock market does not produce much in the way of either long-term or short-term profits. Prices drop quickly and recover slowly (well, except for this month), making it difficult for investors to capture profits on the short side.

The trend programs, which have had the biggest gains over the past 5 years, achieve those gains by holding the long positions during modest reversals. They take a risk in order to avoid  getting in and out of a trade. In October the sharp drop triggered short-term and medium-term trends, turning down, and many positions were  closed out or hedged. Our Trend Strength index turned down, touching  25%, a clear indicator that the sentiment had turned.

The Trend Strength Indicator shown in the left chart below has only just gone back to neutral, neither an upwards or downwards trend, with a clear divergence pattern still showing. Any chartist would be cautious because that pattern indicates  a weak market – higher prices but at a slower rate. Our algorithmic trading program recognizes this lack of internal strength in the market and resets positions slowly. While that may be prudent, it can be disappointing.

But consider what would have happened if stock prices kept declining and the trading programs had not reduced their exposure? You would be justified in saying that there was no risk control, and risk control is what makes algorithmic trading valuable.

 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. 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.

1 Trend Strength Index

The TSI continues to show weakness in the stocks that we follow,  a combination of S&P and NASDAQ shares. While the index has bounced off the lows of about -25, the stock market is rising at a slowing rate, the very definition of a classic divergence pattern. It is now essentially at zero. It is interesting to see that the same index calculation applied to the SPDR sectors ETFs is stronger, never getting near zero, although the same divergence pattern exists.

We still believe that the stock market will struggle to go higher but there is a significant risk of decline.  Our programs have been underinvested for the past two weeks, reflecting the algorithmic equivalence of caution.

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

Even though our systems reduced their exposure to the long side of the market, a sharp downturn always brings losses. The chart below shows that both the SPY and QQQ have reached new highs but the small cap IWM still shows weakness. Once positions are exited to avoid further risk, resetting those positions is a slower process.

2 Major ETFs

The Trend Program, by far the slowest to react, posted the largest losses, not so much in absolute numbers but in comparison to the overall market, as reflected in the SPY. The Divergence and Timing programs had small losses. The Trend Program is still well ahead of the SPY for the year, while the Divergence and Timing Programs are mostly profitable but lagging the SPY.

In futures, both the weekly and daily Trend Programs continue to outperform. The steadily stronger U.S. dollar and rapidly declining energy prices have helped, but the surprise is the profit from interest rates, again on the decline. This is a case where an analyst would have expected higher rates only to be surprised by events not following the prescribed fundamentals. The Divergence program is suffering in the smallest account from lack of diversification; otherwise, the program is holding on to some gains for the year.

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 Rotation program (buy strong) has been renamed Trend Sector ETFs, which we think is clearer and simpler. It still buys the strongest sectors of the SPDRs. This week the program kept only Preferred Stocks and Health Care (XLV), removing  Materials (XLB), Financials (XLF), and Technology (XLK Current positions are:

Preferred stocks (PFF), Heath Care (XLV),Staples (XLP), Utilities (XLU),  and Vanguard Reits (VNQ).

The Timing Rotation program (buy low) reduced positions again from 3 to 1, exiting Reit (VNQ), Energy (XLE), and Consumer Discretionary (XLY). It now holds only

Technology (XLK), partly hedged using SPY short or SDS long.

There are no ETFs held by both programs.

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.


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.

The Trend Program took the biggest loss this month. During good times, it’s the lag in the trend that allows the program to hold on to winning trades, but when that trend turns, the lag also hurts profits. In September the stock market gave all signs of turning down, causing most programs to exit many long positions and, for some large hedge funds, to go net short. As we know, the S&P made an unprecedented reversal to the upside, catching most algorithmic traders by surprise. Those that were net short suffered badly. Our Programs show short positions, but our long-standing analysis is that macrotrends seldom extract a profit from the short side of the stock market. Those moves are too fast and too short, with only a few exceptions (such as 2008). Even the gains of 2008 would not have offset the previous losses from short sales.

Having said all that, the smallest Trend portfolio of 10 stocks took the biggest loss of slightly more than 4%, while the more diversified 30 stock portfolio was only down fractionally. Year-to-date returns are still excellent. The ETF programs also posted losses and are now flat for the year.

3 Trend stocks and ETFs

The Weekly Trend Program showed that using weekly data is an added smoothing factor. It did not exit many of the longs that occurred midweek, and the smaller 10 stock portfolio netted a gain of over 4%, beating the SPY. The large Weekly portfolios were marginally lower and the Weekly ETFs off between 2% and 2.5%.

4 Weekly Equity NAVs

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 similar losses, with the smaller 10 stock portfolio down 2.5% and the larger 30 stock portfolio off less than 1%. The Divergence program also uses multiple short-term trends to decide the direction of the next trade. The sharp change of direction can also fool a pattern-based program. As we see from time-to-time, there is no trading method that is foolproof. Algorithmic trading has the advantage of controlling risk better than most other methods.

The Divergence ETF Rotation program posted only a minor loss of 0.84% and its long-term performance looks intact (see the right chart below).

5 Divergence for equities

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.

This month the program entered two of three hedge positions while also reducing its overall exposure. That hedge worked well for the first few days while prices dropped, then offset the gains when prices rallied. The overall effect was a small loss but with much lower risk. We can’t fault the program for taking defensive action on a volatile drop in stock prices, and there is still a negative tone to the market so that two of the three hedge positions were still intact at the end of October. The 15 stock portfolio lost 1.65% and the 30 stock portfolio lost 2.80% in October.

The ETF rotation portfolio has a strategy contrary to the Trend Rotation. This one buys undervalued ETFs while the Trend program buys the outperformers. While the Trend program can achieve high returns with high risk by selecting from a broad range of stocks, the Timing program targets moderate returns with low risk. Not all stocks qualify because they do not necessarily track any index.

The holdings of the ETF Timing program and the change from last month are shown earlier in this report under “Strongest and Weakest ETFs.” All of our ETF programs tend to be less volatile, with lower returns than the stock programs, by the very nature that ETFs are an index. October posted a small loss, adding to the total loss of 3.5% for the year. Because of the recent swings in the market, positions have   been generally reduced.  

6 Timing NAVs

Futures Programs

The Trend Futures program added to its outstanding year, posting another 4% gain in the $250K and $500K portfolios, and 3% for the largest $1M portfolio. The Divergence program, on the other hand, continues to struggle. The smallest portfolio, the least diversified, had the largest 4.4% loss, while the two larger portfolios are still positive for the year.

The distribution of profits for the two programs show that interest rates are a significant factor, a surprise in an economy that is uncertain about the future direction of rates. These programs are both profiting from the renewed downturn in yields. The Trend program is also showing large gains for the year in FX and Ags. We know the U.S. dollar has strengthened significantly in the past month, and that direction is easy to pick up for this program. But agricultural products (“Softs”) have the biggest gain for the year. It should be noted that not many of the CTAs or hedge funds trade agricultural products because they are now considered “too small” to include in their portfolios.

The Divergence program has only profited in bonds this year, but that gain has been able to offset losses in other sectors. In October there were small losses in all sectors.

7 Futures sector returns

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 program continued to add to gains this month, but less than last month’s spectacular returns, posting 3% to 4.26% with the year-to-date now between 28% and 32%. This is far better than the industry benchmarks, shown below, although all categories are profitable, a nice change from the past few years and a good argument for diversification.

7b CTA Benchmarks

The charts below show the daily and weekly Trend program performance.  The $500K portfolio for the Daily Trend program continues to do well, although the order of returns this month reflected the diversification of the programs, with the smallest portfolio gaining the most and the largest the least. The Weekly Futures program has made up for the sideways period of the past two years and is now posting strong new highs. This month all portfolios exceeded the returns of the daily programs, gaining from 4.75% to 7.06% and a remarkable 25% to 44% for the past one year.

8 Trend Futures NAVs

Group DF2: Daily Divergence Portfolio for Futures

And then we have the Divergence program, going through a drawdown while the Trend program is reaching new highs. We like to think the different underlying premises of the two strategies provide good diversification, but most investors prefer diversification where both program are always profitable.

The charts below show the recent reversal, but that can be deceiving. Reversals should be considered as a percentage, so a larger drop near the top may actually be a smaller reversal than one earlier in the chart. While none of us like losses, this drawdown is nothing unusual and well within the framework of past performance.

The smallest Divergence portfolio is the one taking the largest losses, again due to lack of diversification. While it has the best chance of outperforming the more diversified portfolios, it also has the most volatility. The $500K and $1M portfolios are still profitable for the year.

9 Divergence Futures NAVs

Copyright 2014-Kaufman Signals October Performance Report-All Rights Reserved

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