October 2015 Performance Report

Oct2015 Performance table

October Overview: What happened to “Bad news is good news?”

U.S. investors are a fickle bunch. For five years the Fed has lowered rates or held then at essentially zero. Whenever they said “The economy isn’t strong enough to raise rates” the market rallied. Lower rates are good for business. But in the mid-September Fed meeting they continued to say “It’s too soon to raise rates” and the market sold off 5.6% in 7 days. Why the change? Why would investors think that raising rates was a better scenario?

They don’t know, they just react to news. After seven days of declining S&P prices, the index turned around and, as of the end of October had gained 10.6%, slightly off its highs a few days earlier. In the chart below, NASDAQ (QQQ) is at highs, the S&P (SPY) next, and only the small caps (IWM) are not showing strength. Typically, the small caps are the ones that lead the market when speculation is rampant, so we’re guessing that investors are still “playing it safe.” The underlying reason for the rally is the same as it has been in the past five years – the U.S. economy is doing well, even if not exciting. Because there is no justification for a bear market, investors are buying any reasonable sell-off, and a 10% drawdown is traditionally a key buying level.

Major ETFs

Interest rates are still the main focus. The chart below shows the 10-year and 30-year bond ETFs. Each time they try to rally in anticipation of higher yields they are beaten down. Still, a chartist would say that the lows of mid-2012 have held and there is a small uptrend. Not surprising. We don’t see the Fed lowering rates, just waiting for a better time to raise them, if ever. From our view, there is always something negative happening in the world that can give the Fed a reason to hold rates at zero. We now think that the Fed will raise rates when inflation is above their target of 2%, that is, unless they raise their target.

TNX and TYX

How close are we to higher inflation? We take crude oil and gasoline prices as an example. On the left chart below the price of unleaded gas has declined to about $1.30/gal. That translates into an average price at the pump of about $2.10 (we normally add 70 to 80 cents for processing and delivery). Futures (on the right) show anticipated prices going lower, which should translate into even lower gasoline prices, given that the winter is a slower driving period. That doesn’t argue for higher inflation, so we have no idea if the Fed will raise rates anytime soon. They can certainly continue to avoid it if they choose.

Crude futures and cash

 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.

October System Performance

A remarkably varied performance paralleling the very surprising turn-around in equities. The smaller portfolios in the equity programs all gained significantly over the more diversified portfolios, with the 10 Stock Trend Program up10.49%, the 10 stock Divergence Program up 16.08%, and the Weekly 10 Stock Trend Program up 8.53%. The Timing Program, which was fully hedged during most of October, and is now 2/3 hedged, gained only 1.57% while offering considerable diversification.

Futures posted equally volatility returns, with the Divergence program gaining 7.61% after being much higher before a late-month reversal, while the Trend program did the opposite, losing 7.55% because of the repeated changes of direction. While this shows that these two programs are uncorrelated, we look forward to months when they are both profitable.

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.

From doom and gloom back to optimism. Last month we expected a slow recovery based on the weakness of all equity trends. This month the situation looks quite different but still not strong. A Trend Strength value of near zero indicates no clear direction. It is certainly possible that the recent pullback cleaned out the “weak hands,” those investors with no staying power. But a new upward move has not yet materialized, even with this strong recovery. Discretionary traders need to be cautious; system traders need to follow their system.

Trend Strength Indix

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.

Strongest

The Trend Sector ETF program buys the 6 strongest sectors of the SPDRs. October started with no positions in this program but in the past week, the rally has generated buy signals in Preferred Stocks (PFF) and Consumer Discretionary (XLY). Holding two of six possible positions shows that the overall market is still weak.

Preferred Stocks (PFF) and Consumer Discretionary (XLY).

Undervalued

The Timing Rotation program began September with no positions and showed low activity all month. While the program buys undervalued stocks, it avoids those that are not performing well. As the end of September we held only the financials (XLF) but were fully hedged (that is, 50%) using longs in SDS or shorts in SPY. During October, the sharp drop in all equity index markets put the program fully hedged (50% of the risk). Small profits in October showed that our ETFs fared better than the overall market. October started with financials (XLF) hedged 50% using SPY:

Long Financials (XLF) hedged 50%

At the end of October it had added Preferred Stocks IPFF), Utilities (XLU), Metals & Mining (XME), and Retail (XRT). Because of the rally, the hedge using SPY was reduce from 50% to 16.6% (a total hedge of 1/6th). The portfolio currently holds:

Financials (XLF), Preferred Stocks IPFF), Utilities (XLU), Metals & Mining (XME), and Retail (XRT). It is hedge 1/6 of the risk using SPY or SDS.

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.

The 10 stock Trend Program gained 10.5% in October, moving returns back towards highs. The 30 stock portfolio, more diversified, had a gain of 2.82%. Our indicators show that the market has moved from bearish to neutral during the last part of October. The ETF program held no positions for most of October, showing that these markets react to the same factors no matter how you group the stocks.

 

Trend program equities

 

The Weekly Stock programs did slightly better than the daily programs, with the small portfolio gaining 8.53% and the larger on gaining 3.88%. Considering the defensive action needed during the sell-off, we see these as excellent returns. The ETF weekly program was similar to the daily, holding no positions all month. While it did not participate in the rally, it also cut losses during the decline. The year-to-day returns for the small portfolio is 5.1% compared to 2.6% for the SPY.

 

weekly trend

 

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 was the biggest surprise in October, posting a 16% return in the small portfolio of 10 stocks, bringing the year-to-date to a gain of 6.5%. The 30 stock and the ETF programs also did well, with gains of 8.1% and 4.25% respectively.

Divergence for stocks

 

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.

When you’re fully hedged protecting long positions in a downtrend, a small profit shows that the stock selection outperformed the index. The Timing program returned between 1% and 2% net of the hedge, a good performance in a difficult market. Meanwhile, it continues to provide good diversification.

 

Timing for stocks

 

CHANGES TO THE DATA USED IN THE FUTURES PROGRAMS

Now that the Futures trading floors have all but been eliminated, there is no “open outcry” session. That means there is no morning open because all market open about 30 minutes or 1 hour after the previous day’s close. At that time very little news has happened and prices open quietly on low volume. Many large traders may adjust their positions and rebalance their portfolio. Our data is updated between 7:30 pm and 9:00 pm, New York time. That’s after the “new day” starts, making it impossible to give orders to be executed “On the Open.” However, our experience is that waiting until about 8:20 am in New York allows you to get what was once the opening price. While we will post all returns using the closing prices for futures (except for the Weekly program where we’ll use the Sunday evening open), we encourage traders to execute in the morning before the economic reports are released, which is typically at 8:30 am.

In our experience, over many years, the direction of the price reacting to the economic report is most often in the direction of the system trade. Of course, there are noted exceptions, but these are far less than reports that confirm your current position. In addition, our study of using the opening price rather than the close of the same day has shown that returns are better. Using the close is still very profitable, but the open has been consistently better. If you are able to place orders for the open, we encourage you to do that.

To help, we now put the recommended time of execution (in New York) on the Order sheets. If you’re not available at that time, then execute on the close. European markets were always executed on the close, so not everything has changed.

Also note that the time difference between New York and Europe changes in the Spring and Fall when the U.S. changes its clocks back and forth to capture Daylight Savings Time. Last week the time difference between New York and London was 4 hours. This week it is 5 hours. To get the correct time, simply type into your web search engine (for example, Google), “Time in New York.”

 Futures Programs

October showed opposite results for the Trend and Divergence programs, with Divergence gaining nearly 12% before dropping back to 7.6% in the $250K account. The other portfolio also performed well and year-to-date returns now range from 2.9% to 7.4%. The Trend program lost its gains for the year, posting losses of up to 7.5% for the month. For the same reason Divergence did well, the Trend did poorly – fast price movements and frequent reversals without any clear trend. We like to see the Divergence program doing well, because the Trend program is most often ahead.

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.”

In October, the CTA industry lost ground while equities rallied. We prefer diversification where both assets profit. Our Trend program underperformed the CTA average but our short-term Divergence program is far ahead of the Newedge Short-Term Benchmark. We need to remember that the fundamentals that drive the futures markets are much broader and deeper than those that drive equities. Returns are rarely correlated except during a period of extreme stress, when returns may be sharply opposite, a phenomenon called “crisis alpha.” So we put up with sideways performance for the extreme protection it provides during difficult times.

CTA returns

The Trend Futures Program posted losses of -7.5% to 5.1% on erratic price movement. Given the large gains last year, this program still ranks extremely high in long-term returns. Although the smaller portfolios have outperformed, we believe that more diversification is better for stable results.

 

Trend futures

 

Group DF2: Daily Divergence Portfolio for Futures

Switching to executions on the close rather than the open, has smoothed out returns in this program, although it has reduced the returns of the smallest 250K account. This program tends to be under-diversified because it needs to find specific patterns in a limit number of markets. For most accounts, the majority of trades will come from the U.S. and Europe. October was an outstanding month and year-to-date returns are now between 2.8% and 7.4%.

 

Divergence futures

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