Industry Benchmark Performance
We expected October to be volatile, but it took a bigger toll on the overall market, and our programs, than we had expected. Early reporting of funds tends to be the better results, so we expect larger losses than are shown in the industry summary below. All except the equity multi-strategy programs are posting net losses for 2018, and even those results might change when all funds report.
Blogs and Recent Publications
Find this at the end of this report. We post new interviews and reference new articles each month.
October Performance in Brief
No program was immune from losses in October, some more, some less. It happens as a matter of course. Given a year that started out with a remarkable January gain, then eroded performance, then rallied, and has taken away most, if not all of the gains, we are only grateful that there were gains to be taken away. November and December tend to be good performers, so there is still time for a decent return in 2018.
Until the price direction becomes clearer, our program portfolios have taken “defensive action,” moving away from stocks that have had big equity swings. That may slow the recovery of profits but tends to be much safer.
Major Equity ETFs. Most of the benchmarks have given back their 2018 gains, but there is still a 30% gain from the 2016 election until January of 2018. NASDAQ had gained the most and now has given back the most, but still remains with the largest net gain. The small caps (IWM) tend to be hurt the most in times of uncertainty, as investors more to safer choices. That action also accounts for losses in NASDAQ which have been driven by the FAANGS. Big gains earlier this year indicates volatility, which can also mean risk.
CLOSE-UP: Goodbye October
We’ll review the chart of the frequency of higher returns for SPY that was shown last month. October has a lower history of returns, about 55% positive prior to the bull market, which is in-line with the normal upwards bias of the U.S. equity markets (Figure 1). On the other hand, Figure 2 shows that October takes a jump in volatility. The months before 2008 should be seen as the normal pattern. During a bull market volatility is not going to show extremes.
Figure 1. SPY frequency of higher returns by month.
Figure 2. SPY volatility of returns by month.
Then we should expect the 2018 holiday shopping season to improve returns and help investors forget October. Volatility should be down in the next two months and profits up. Naturally, nothing is guaranteed, but that’s what history shows.
For the most part, tech stocks were the driving force throughout most of 2018. As shown in Figure 3, NetFlix (NFLX) peaked up 110% followed by an erratic TWTR up about 90%. Facebook (FB) has been weaker all year due to Congressional hearings and an expected large investment in locating “fake news” that is directed through Facebook. The Chinese stocks, Bidu (BIDU) and Alibaba (BABA) have tracked each other but suffer the pressures of the overall Chinese equity market which is down substantially.
Figure 4 shows the net drawdown from the peak in July 2018. Apple (AAPL), Amazon (AMZN), and Google (GOOGL) are holding up but others have given back as much as 27%, well into what stock analysts call a “bear market.”
Figure 3. Tech stocks in 2018.
Figure 4. Drawdown in tech stocks from the peak in July
You’ve probably already heard all the reasons for the volatility and the reversals. Maybe the reasons don’t matter because explaining something afterwards may make you sound smart but doesn’t make any money. In this case, we’ll look at the reasons to decide if they will be relevant in the next two months.
1. Continued Fed rate hikes. The Fed has announced that it will continue to increase rates based on a good economy. They need to get the rates up high enough so that, if there is another “recession,” they are able to lower rates to stimulate the economy. That’s all fair. But even when they say they don’t look at the market as an indicator of how their actions are being received, I don’t believer that’s true. In addition, the President is pressuring them to stop raising rates. Granted, he has no authority to do anything, but the Fed may think about their image a bit more. I believe either (1) the market will now rally and the Fed will raise rates once more, or (2) the market will decline and the Fed will delay raising rates. Either way, the investor should be insulated from much more downside.
2. Trade war. We seem to have an agreement with Canada and Mexico, small changes from the NAFTA agreement, and a political victory for the administration. The rally at the end of last week was based on Trump’s expected talks with Xi, something that was called off last time. This announcement smells like a campaign promotion. No one that we spoke to in Asia thinks a deal will happen soon. The market is moving on expectations, so it can reverse as quickly. Tariffs have not yet shown up in prices for most consumers, so voters are not yet clear how it will affect them. But it will show sooner in corporate profits as Wal-Mart raises prices on consumer goods and sales decline. It may not happen during the holiday season as much as after December, but it will happen if the negotiations with China fail. China is motivated to resolve the problems, given the sharp drop in their stock market. On the other hand, China does not want to be intimidated into doing something. It does hold a strong card in that it buys a great deal of U.S. debt. If it sold that debt, it would not be good for the U.S. Fewer buyers would mean higher interest rates, not a process that can be controlled by the Fed. To us, it looks like a stalemate. As long as that continues, we see corporate earnings for those companies affected by imports as declining.
3. The Election. This Tuesday U.S. voters go to the polls unless they have already voted. There is a lot of early voting in the U.S. If the Republicans hold both houses we will have continued aggressive trade negotiations, immigration, deregulation, and protectionism. Social issues are important, but they don’t affect the price of stocks. We’ve discussed trade, and a great deal of deregulation has already happened, in our opinion, some good, some bad. We are concerned that the safeguards that were supposed to protect us against another 2008 are being eaten away. On the other hand, severe compliance for small banks that serve the Midwest agricultural community is too much. The best election results are when the houses are split, that is, one is controlled by the Republicans and one by the Democrats. Then only the issues that are good for both get passed. History shows that is the best for the country. We’ll find out this week.
We think that the offsetting effect will net a modest gain during the final two months of 2018. Holiday shopping and good cheer should temper a pessimistic outlook for a short time. After that, we are faced with reality and we will reassess the situation. One of the rules of successful forecasting is to continually reevaluate the situation, not be stuck in a decision that you made based on old information.
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 275 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 Trend Strength Index reflects the internal strength (momentum) of all the stocks that we track, about 275. These stocks tend to have a stronger trend than the typical stock. It is also a mix of stocks from the S&P and Nasdaq, with a few smaller caps, but none trading fewer than an average of 1 million shares per day.
We admit that forecasting a precipitous drop in equities is difficult, so we don’t claim to have any foresight. We did state that the Trend Strength Index did not reflect the trend of the market, but good news or bad news could change it. In this case it looks as though the market is running out of steam and is nervous about a decline. Higher rates by the Fed doesn’t help.
As for the Trend Strength Index, previous lows of about -40 are nearby, so we expect no more than minor declines and then a better picture for the next two months. If we’re wrong, it could look a lot like the same pattern we saw in 1987.
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.
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 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, 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.
A nasty month for stocks. The daily program did better than the weekly program because it could change positions sooner during the downturn. There are always pluses and minus to faster and slower trader. In this case, switching sooner was better, but often slower avoids whipsaws. Reversal happen as part of any trading program, but the trend comes through at the end, so staying with the program has always turned out to be the right strategy.
Income Focus and Sector Rotation
A small loss in the income focus program due to the Fed continuing its tightening policy is expected. It turns out to be good diversification in this volatile market. Both daily and weekly programs are slightly down for the year, again as expected when income cannot offset the expectations of higher rates.
The Sector Rotation program is going through a bad period and took another loss in October. But then again, so did all the markets. In the big picture it remains near its highs but the market will need to settle down before it can continue its uptrend.
The DOW Arbitrage program gave up all its profits for 2018, but the reversal is still less than the beginning of 2018. Its pattern of performance shows quick rebounds and any monthly gain will put it back in the profit column.
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.
A familiar pattern for October can be seen in the recent sell-off, but the 10 stock program is still posting a net gain for 2018. Even with the October loss, the larger 30-stock program shows a steady pattern with much less volatility.
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 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.
Fractional losses make this program the best performer in October, and the smaller portfolio holds on to small gains for the year. Neither program shows the large loss seen in the other programs. This program will hedge using in index ETF when the trends turn down, while continuing to find stocks that are likely to rebound from an oversold condition.
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.”
Even with losses, the Trend Program for futures is holding on to profits for 2018. Normally, when stock declines are severe, futures will profit by being net short. This phenomenon is called “crisis alpha.” Futures gains, which are leverage, can offset stock market losses, as they did in 2008. Of course, that requires that the equity markets continue to drop, which is not a pleasant thought for most of us.
Group DF2: Daily Divergence Portfolio for Futures
We were hoping for a better month for the Divergence program, but most portfolios took a 5% loss. This program enters in the direction of the trend when there is a pause. In this case, the pause turned out to be a reversal of direction, not what the program wanted to see. We’ll look for November and December to be better.
Blogs and Recent Publications
MetaStock will be offering a program with four of Mr. Kaufman’s short-term trading strategies for ETFs, stocks, and futures. They should be available by mid to late November.
Mr. Kaufman appears as a chapter in Mario Singh’s new book, Secret Conversations with Trading Tycoons, published by FXI International.
Mr. Kaufman spoke in Tokyo and Osaka to the Japanese association of Technical Analysts on various techniques for trading Japanese markets. You can contact the organization for a copy of the presentation. Mr. Kaufman was presented with a Japanese translation of his newest book, A Guide to Developing a Successful Trading Strategy.
He also spoke about “Making Volatility Work for You” at the 2018 IFTA conference in Kuala Lumpur. It was an excellent conference with many good speakers. You may be able to get a copy of the presentation by contacting MATA, the Malaysian Technical Analysis organization.
“In Search of the Best Trend” will appear in Technical Analysis of Stocks & Commodities this month.
A new article on “Defense is Your Best Defense” will appear in ProActive Investor Magazine this week.
Mr Kaufman spoke to the Austin chapter of the CMT Association (previously the MTA)
He was interviewed by Jacek Lempart for his blog systemtrade.pl, serving the European Polish investors. The interview will be posted soon.
A new interview with Mr Kaufman has been posted on the FXCM website (Forex Capital Markets) as of a few days ago.
Mr. Kaufman spoke at the Trader’s Expo in New York on Monday, February 26th. His presentation was on ways to reduce risk that traders forget to use.
Mr. Kaufman has a presentation in Jack Schwager’s FundSeeder webinar, which should now be available online.
There is an interview on YouTube conducted by Alex Gerchik for his Russian audience. We think you will find it enjoyable and helpful. The link is:
Technical Analysis of Stocks & Commodities published Part 1 of a two-part article on profit-taking and resets, in their January issue. The first part looks at trend following and the second at short-term trading. Part 2 is scheduled for the February issue. Before that, they published “Optimization – Doing It Right,” in the September issue.
Mr. Kaufman was a Keynote Speaker at the IFTA annual conference, hosted by the Swiss technical analyst’s association (SIAT) held in Milan, Italy, in October 12-16, 2017. A video of the presentation has been posted on the IFTA website.
“Portfolio Risk in Uncertain Times” was just posted on Seeking Alpha. It shows a better way to structure your portfolio. Prior to this, you will find “Living Off Profits,” which shows how much you can safely withdraw from your account without seeing spiral down out of control. Before that Seeking Alpha published “What Are the Odds?” a look at how to assess the risk of loss for any investment.
Modern Trader published “Dogging the Dow in the current edition, and a new article “Trading Opening Gaps” in stocks, scheduled for January 2018.
The IFTA Journal published an interview with Mr Kaufman in the most recent quarterly issue.
The broker FXCM will post a live interview with Mr Kaufman, taped on October 30.
ProActive Investor Magazine published Keeping Risk Under Control on June 22. Check their website. It will be publishing other articles later this year.
Andrew Swanscott at BetterSystemTrader.com (a good source for trading systems) has put up an edited version of an older presentation of Mr. Kaufman’s. It’s all about price noise and the Efficiency Ratio.
Look for past 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 Proactive Advisor Magazine. You will also find many articles posted under Articles on our website, www.kaufmansignals.com. You can address any questions to firstname.lastname@example.org.
© November 2018, KaufmanSignals. All Rights Reserved.