October 2016 Performance Report

oct-performance-summary

Industry Benchmark Performance

The equity and futures markets are floundering, along with the performance of fund managers. Although the composite results shown in the Benchmarks table below don’t look disastrous, they may not contain all the information.

According to a number of articles and Venture Capital Post (Nov 1) “World Hedge Fund Managers [are] In Trouble.” The past three years has averaged a return of 2% and $51 billion has fled hedge funds in 2016. Perry Capital closed their doors in August, saying that their style of investing no longer worked.

benchmark-performance

What does work? Not much unless there is some directional movement in prices, or higher volatility for arbitrage. And most managers prefer the trend to be upward. The daily Trend Futures program, which still shows profits for 2016, has had a bumpy ride, seen in the chart below. After a brief surge in interest rates and FX in July, all sectors have been struggling, with equity index markets the biggest drag. Our program is well ahead of the industry.

sector-returns

October Performance Review

During October, many of our programs have taken defensive positions, but only after posting losses. Just like people, they can’t foresee the future, only react to the actual events.  Given the impending elections, it won’t be the first time that the last two months of the year bailed out the industry. Most equity programs and the futures trend programs are holding small gains or small losses. The worst performance is in the smaller equity portfolios, that have less diversification, while the best returns for the year are in the Equity Timing program and the Trend Futures program.

Given the very mixed performance of the Hedge Fund and Futures Industry, our returns are “normal” and our futures returns are far better. That puts us in a good position when the next significant move occurs, which could begin November 9th.

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.

October Overview: A Trading View of the Election

There is extreme polarization leading into this election, but what should we really expect? There are both fundamental and technical impacts likely on prices in all sectors.

The Big Picture

The Technicals: Our article last month said that the day after the election will be the direction of prices for the rest of November. On October 31st, USA Today published “History says buy stocks now,” concluding that the market will rise an average of 7.4% from the beginning of November (before the election) through next April. Our posting on Forbes in June, “The Pattern in Politics,” showed that the first year of a new presidency, 2017, is generally good, but has been above 10% during the past four cycles. Given the upwards bias of the stock market, the USA article is probably correct, but the month following the election can still be very volatile and very different from the long-term move.

chart-1-the-presidential-cycle-from-1948

chart-2-range-of-returns

 

Friendly to Business: We see both candidates as friendly to business. Some of that involves trade deals, some lowering corporate taxes, some trying to focus on too much regulation. It seems that Clinton has moved left on some of these issues, adjusting to Sanders’ position to attract his supporters, but still generally supports international trade deals. In the final analysis, Americans buy cheap rather than American made products, and isolationism is expensive. Trump’s claim to “renegotiate” trade deals is unprecedented and unlikely. A contract is a contract, even in Trump’s world. We see GDP continuing at a modest pace of 2-3% into the foreseeable future. We think the Fed will raise rates another ¼ point but have no idea when.

Issues and Markets

Health care. Trump wants to abandon the current system, and Clinton wants to fix it. We see either one as a benefit for the providers and pharmaceuticals, giving them a further opening to increase pricing during the confusion. During the last surge of “regulation” and “restructuring,” they raised prices in advance of taking on new customers, and we expect the same. This is not a comment on whether it’s right or wrong, just what seems to happen. We expect profits to increase for the health care industry as it did from 2009 as the new Affordable Health Care Act was implemented.

health-care-hlv

 

Energy. OPEC reports have finally taken the tone of lowering output, but history has shown that there is a big gap between an agreement and action. OPEC countries all want higher income for oil, and that only happens when you sell more, not less. Even if they agree to lower output, the tradition is to cheat and sell more when no one is looking (but there are people who look). We expect oil prices to remain under $60 for the next year, perhaps touching below $40 for a short time, but the energy companies continue to show slow growth. This has little to do with politics and more with the economy and greed.

energy

 

Interest Rates. Interest rates are the underlying factor for both the stock market and the U.S. dollar. Through this past August, bonds show that higher rates were expected, but that expectation seems to have disappeared. With the U.S. bonds and the Eurobund stabilizing here, we don’t see a shift until the election results can be sorted out, or if anyone can make sense of them. We don’t see the EU raising rates, but the Fed remains a possibility.

interest-rates

 

The EU, Canada, and Britain. The threat of the Fed raising rates seems to be keeping the U.S. dollar strong, even though those threats haven’t materialized. We see the greatest likelihood of the dollar weakening after the election. A rate hike of ¼% is already in the market, and any rhetoric of changing trade deals can’t be good for the dollar: less trade, weaker dollar. Somehow we just don’t see “less trade” happening unless it due to a worsening economy. But the concern is there. Trump wants to renegotiate and Clinton has moved to the left to try to get the support of Sanders’ followers. We see it as all “sizzle,” but it can still affect prices for a while.

As for Britain, we forecasted a drop to 1.20 after Brexit as the first leg, then another drop if Scotland made noise about being unhappy leaving the EU. We do have some Scottish discontent, but also a new trade deal between Canada and the EU which gives all the signs of Canada replacing Britain. A nail in the coffin, making the EU less negotiable with the British. So much for proximity. We’re not sure about the timing, but expect another leg down for the sterling.

currencies

 

Government Overhaul and Taxes. Call us cynical, but the idea of Congress voting for term limits is beyond our comprehension. People don’t vote themselves out of office, or give away incredible benefits. A Clinton presidency may try to raise taxes on the wealthy, but that will only happen if there is a Congress favorable to the idea. For a Trump presidency, we can’t see anything happening that would be contrary to his personal gain, so we don’t expect much in change here.

Major Equity ETFs. After a positive pattern in September, NASDAQ and the small caps have clearly come off, but SPY has been the most stable. It could just be election jitters because the economy is jugging along, even at a slow rate. Given the uncertainty of everything this year, these markets are still ahead more than 5%.

major-etfs

 

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.

We thought it likely to get a pullback last month, with the TSI near its highs. The index has now gone neutral ahead of the election, indicating that our stock portfolios are more sensitive to the political climate than the SPY, which still holds a tendency to continue higher. The small pullback in SPY seems to reflect the wait-and-see attitude of the market. We expect no change from here to next Tuesday unless the polls reflect some significant change.

trend-strength-index

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 October, we had exited Preferred Stocks (PFF), Industrials (XLI), and replaced them only with Financials (XLF), leaving us underleveraged. Deutschebank seems to have become old news with uncertainty replacing it. We now hold:

Technology (XLK), Energy (XLE), Oil & Gas Exploration (XOP), Consumer Discretionary (XLY), and Financials (XLF).

Undervalued

The Timing Program buys 4 ETFs that are undervalued with respect to SPY, in expectation of rotation. At the end of October we exited the last of our positions, Industrials (XLI), and are now out of the market. Whether that’s good or bad, it’s a clear statement that the risk is unacceptable.

NO POSITIONS

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.

Losses in all portfolios reversed September’s gains and show net losses for the year in the smaller stock and ETF portfolios, including the Trend Sector Rotation. A good move in the last two months, a situation that happens often enough, can still make this into a good year. In the meanwhile, the programs continue to cut losses and follow the rules.

equity-trend

 

The Weekly Equity program continues to stay above water and well ahead of the daily stock program. We can only attribute that to holding positions rather than jumping on board the more volatile companies. The long-term picture for the stock program looks good and is positioned to take advantage of whatever comes in November. The ETF program doesn’t have the wide choice of stocks and has now given back its gains for the year. We expect it to find the best sectors once the market starts to move.

weekly-equity-trend

 

Sector Rotation and Income Focus

We added a weekly version of the Income Focus program this month because they track very closely. The daily is doing slightly better for now, but the weekly will hold the positions if there is uncertainty in the market. In October, both lost a little as that uncertainty caused rates to move a little higher. The overall pattern is very stable and the program offers a good alternative or companion to the smaller stock portfolios.

income-focus

 

Sector Rotation program lost nearly 4% in October but holds on to a gain for the year, with the chart still looking promising. The program has taken defensive positions, with equal holdings in the Aggregate Bond ETF (AGG) and the mid-term interest rate ETF (IEF). It’s another statement about the uncertainty of the markets.

weekly-sector-rotation 

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.

They look steady and only the smaller, 10-stock portfolio is in a noticeable retracement, but we continue to wait for a good move. The 8 ETF program is still ahead nearly 4% for the year, and the larger 30-stock portfolio is fractionally ahead. Waiting for a rally can be tiring.

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 is holding on to the best performance of the year, profits in all portfolios, although not something that you would write home about.  Modest losses this month in all portfolios keeps the stock programs from making new highs. We hope the election will cure that. Meanwhile the ETF program continues its sideways pattern.

equity-timing

 

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.”

A reversal in all Trend portfolios took away a chunk of profits in the daily program and left the weekly program slightly down for the year. If we look back at the earlier chart of sector returns (near the beginning of this report), we see that the two big winning sectors are interest rates and FX, and those have been slowly chipping away at gains. The futures markets are the most likely to react strongly to election results, so we’ll have to wait to see if any trends develop that can be captured.

trend-futures

 

Group DF2: Daily Divergence Portfolio for Futures

Losses in October were very small, but the entire year has been one of a pullback from portfolio highs, on increasing volatility. Again, the election outcome can change everything.

futures-divergence

 

©Copyright October 2016, Kaufman Signals. All Rights Reserved.

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