Kaufman Signals

October 2019 Performance Report

Industry Benchmark Performance

Equity returns through October are running 3% to 11%, with the best being the long equity portfolios. That makes sense when the market is near or at all time highs. Still, the major equity index ETFs have returned 17% to 28%, so the managers are only returning half of the overall market gains. In all fairness, a return exceeding 10% each year is very satisfying for the investor.

Futures are not faring as well, with losses posted in all the benchmarks. There are two months to go in the year and the CTAs still show net gains, so all is not lost.

Kaufman’s Fast Strike Systems on MetaStock

For more information on these short-term trading systems, contact MetaStock at 800-882-3040 or go online to www.metastock.com/kaufmana.

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

October returns for equities were generally good but futures continue to drawdown, paralleling the industry. Year-to-date results would look good for most years but are not much more than half of the major index returns. On the other hand, it is the price we pay for having risk controls in a market where prices keep changing direction. Still returns of 10% to 15% are respectable and far better than the competition.

Major Equity ETFs. Another reversal in the direction of prices as three of the major equity index markets defy gravity. This month there is hope that the U.S. and China will reach a “partial” trade agreement, whatever that means. Traders seem ever hopeful. There is no denying that all but the small caps have made new all-time highs. Investors should be happy about that.

CLOSE-UP: It’s the Premise

I was at a MetaStock conference in Sunnyvale this past weekend and one of the speakers was Jake Bernstein. Jake is the expert on seasonality and seasonal trades, which everyone should consider as part of their trading strategy diversification. The point that he emphasized was that a good system needs to be based on a sound premise. I’ve always believed that to be true, but it never hurts to be reminded.

The three main speakers were Jake Bernstein, Rob Hoffman (the winner of many live trading events), and me. All of us are algorithmic, that is, our trading is 100% rule based, but each of us have very different approaches. That proves there are many ways to trade successfully. But only if the underlying method has a sound premise. What are those sound premises?

Long-Term Trend Following

Most of my own trading portfolio is based on trend following. I believe that 70% of all professional fund managers are long-term trend follows. The reason it works is that most markets are driven by interest rates, and interest rates are set by the Fed, or another Central Bank or Monetary Authority. They don’t raise and lower rates without careful planning and with clear objectives, either dampening inflation or stimulating the economy.

The Fed acts in small steps. When the economy looks overheated or inflation is too high, the raise rates ¼ point, then watch how the market reacts. Of course, they don’t acknowledge that they watch to stock market, but they do. In fact, a healthy part of their analysis includes the direction of stocks and futures. After the first incremental raise, they follow with another, and if necessary, another. These raises, and their hinting of further raises, will cause in uptrend in yields. When the economy is struggling, they lower rates incrementally, causing a downtrend in yields. It’s all very predictable. That is why most of the money made in futures funds is in interest rates, and why many funds allocate more than 50% of their assets to interest rate futures, even though it exposes them to a lack of diversification.

Then interest rates are the primary driver and it is a sound premise for trend following. Changes in interest rates affect FX rates the most because money flows to the countries with the highest yield net of inflation and net of political instability. So you don’t see Argentina as the beneficiary of high interest rates, with inflation at over 50% this year.

What about the equity markets? Stocks are more complex and stock prices are a combination of good management, debt, planning, and quarterly returns. While lower interest rates help companies financing their debt, a good economy will float all (at least many) boats. The stock market will rise when interest rates fall, but the patterns will be erratic.

Seasonality

There is no premise more valid than seasonality. While the Northern Hemisphere dominates the agricultural sector, South America has improved production considerably. In the north, crops are planted in the Spring and harvested in the Fall. There is no way we can change that. Then prices tend to be higher before and during growing season and lowest during harvest. If agricultural prices start out low in the Winter, you have an excellent chance of profiting from a rally during the summer, and then a decline into harvest.

Jake also points out the tendency for stock prices to rally just ahead of Thanksgiving and just ahead of Christmas. You can profit from this by buying 2 or 3 days ahead of the holiday and exiting on the day before the holiday. It is a simple strategy that has a high probability of success and a sound premise based on consumer behavior.

There are also seasonal stocks, such as airlines, resort hotels, and home builders. By applying seasonal analysis, which can be found in Jake’s books or mine, you can buy one month and sell a few months later. Not only are these sound premises, but the approach offers good diversification from trend following and other strategies.

Short-Term Trading

What is the sound premise for short-term trading? It’s not as clear, so we need to look a bit deeper. There are no fundamentals that would explain why you can make money on a 1, 2, or 3-day trade. While news and economic reports drive prices, they are very inconsistent. In fact, short-term price moves look like noise. And that’s the sound premise. The S&P is a perfect example. It will produce profits if you trade a 100-day moving average, even though there will be significant drawdowns. It will not work with a moving average of less than 10 or 15 days. Prices are just too noisy.

For short-term trading we need markets with more than average volatility in order to offset the cost of commissions and slippage, and we need markets with fast breakouts (for trading in the direction of the price move) or markets with a lot of noise and volatility (for mean reversion systems). Choosing the right market for short-term trading is as important as choosing the right market for trend following. Not all markets work for either approach.

The classic example are the equity index futures, shown in Figure 1. S&P, NASDAQ, and EuroStoxx all show profits when using a long-term trend, generally greater than 60 days, and losses as the trend gets faster. You can trade these markets either as trending or mean reverting if you choose the right time frame.

Figure 1. S&P futures trend optimization.

In Figure 2 we see the pattern in less liquid markets. It turns out that high participation results in high noise. Even though the S&P will be profitable using a long-term trend, it will not be nearly as profitable as interest rate or FX markets, which have much stronger trends and less noise.

As an example, Figure 2 looks at the results of trend following for the DAX and Hang Seng Index, both important markets but with far less volume. While there are losses in the fastest calculation periods, the profitable trend results include a much broader range of calculation periods. These markets will be better candidates for the trend then for mean reversion.

Figure 2. Less liquid markets tend to do better using a trend strategy.

Finding Patterns, or Just Noise

There are traders that swear there are consistent patterns that can be exploited in short-term trading. I agree with that because the 3-day trade, based on the Taylor method has worked for more than 50 years. But the easiest way to trade short term is to use noise. You can trade the breakout but be sure to take profits whenever they come to you because noise will cause prices to change direction quickly. You can be a mean reversion trader and take advantage of the noise buy selling a short-term rally or buying a fast dip, expecting price noise to cause a reversal and generate a profit. Either one is a sound premise but requires clear rules based on volatility and risk control.

Rule Number 1: A Sound Premise

There are many, many strategies that work successfully. Some have smaller, steady profits, others have larger drawdowns. I can’t say that any one is better than another as long as they have the one common thread: a sound premise.

Computers have become remarkably powerful and there is a temptation to let the machine find an apparently successful trading method. It just doesn’t work that way. We can always overfit price data and appear to have a system that has high returns and low risk. But it will never translate into real profits. Start with a sound premise and develop your system around that concept. You’ll be sure that the market will be on your side.

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.

Another month where the S&P shows lackluster moves, but eventually advances. Professionals know that the most consistent trends occur when the investing public has no confidence that prices will go higher. It seems that must be playing a part in this move. News is discouraging. There are trade issues, dysfunctional politics, Boeing trying to get the Max off the ground, the Fed easing for fear of a recession, and yet we are again on new highs. Our only advice is to have a system and stay with it!

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.

The smaller Equity Trend programs both performed well in October, the Daily program matching the SPY gain of 2.78% and the Weekly program higher by 3.83%. All four Equity Trend portfolio are doing well, even while they lag the equity index markets. The daily program seems to be in a clear uptrend again, while the weekly program is fighting back from a larger drawdown.

Income Focus and Sector Rotation

Mixed returns in October with the daily program losing 40 bp and the weekly gaining 37 bp. Neither changes the picture of steady returns shown in the charts below.

Sector Rotation

A small loss of 43 bp leaves the chart of the Weekly Sector Rotation program unchanged. New high equity would make this program look much better, although it still offers good diversification from what the professionals call “sector rotation.”

DOW Arbitrage

A loss of 1% leaves this program hanging near its high equity. There hasn’t been enough volatility, let along extreme volatility, to trigger the arbitrage that acts as a hedge against risk. In the meanwhile, it trades the best of the DOW.

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.

The 10-stock Divergence portfolio gained over 4% in October while the larger 30-stock portfolio lost ove 1%. Overall, the more selective, smaller portfolio far outperforming the larger one, now up more than 24% for 2019, slightly ahead of SPY. While the larger portfolios tend to be more stable, the smaller ones can produce higher returns.

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.

Another small gain in October but results are nearly flat for 2019. The combination of buying undervalued stocks and hedging when the trend turns down has prevented this program from going anywhere this year. Just when it starts to improve returns it faces a drawdown that results in putting on a hedge and offsetting partial gains. We like the program because its concept is different, but more profits would be welcome.

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.”

Another loss of 4% to 5% following the run-up in the previous few months drops the returns of the daily program to 18%, but the larger portfolios to between 5% and 8%. These are inline with the industry even though they are disappointing. The weekly program also lost the same amount, but this offsets all gains for 2019. Overall, futures are struggling to find a trend.

Group DF2: Daily Divergence Portfolio for Futures

Another month of modest losses continues the upwards but volatile pattern of this program. Even with two months of losses, year-to-date returns range from above 10% to above 17%. Far better than trend-following returns in the futures industry.

Blogs and Recent Publications

Trading Systems and Methods, Sixth Edition

The sixth edition of Trading Systems and Methods was released the last week of October by John Wiley. It is completely updated and contains more systems and analyses.

MetaStock Strategies

MetaStock has launched the Kaufman Fast Strike add-on. It has three short-term trading systems, holding positions for one to three days in two of the programs, and about one week in the third program. They trade noisy markets, including most major index ETFs and futures, plus one program trades the VIX. You can see a description of the programs and a record of past performance on MetaStock. Anyone interested should contact MetaStock at 800-882-3040 or go online to www.metastock.com/kaufmana

Upcoming in December 2019

Technical Analysis will publish an interview with Mr Kaufman in the December issue.

MetaStock Seminar held in Sunnyvale

Mr. Kaufman was a keynote speaker at the MetaStock conference in Sunnyvale, November 3. You can hear this presentation by going to the MetaStock website.

November 2019

Technical Analysis of Stocks & Commodities published “Running for Cover,” an article by Mr Kaufman that looks at whether buying bonds after a sudden drop in the S&P can still be profitable.

September 2019

“A Simple Way to Trade Seasonality” was published in the September issue Technical Analysis of Stocks & Commodities. Seasonal trades and filters can be a big asset to market timing and put you on the right side of a price move.

Book Interview

Mr. Kaufman appears as a chapter in Mario Singh’s new book, Secret Conversations with Trading Tycoons, published by FXI International.

May 2019

A second part of the interview with Caroline Stepan at TalkingTrading.com was just posted.

March-April 2019

Mr. Kaufman was interviewed by Caroline Stephen at TalkingTrading.com. It covered a wide range of topics. It has not yet been posted but should be available soon.

We thought the article in ProActive Advisor Magazine would be in March, but it should appear any day in April. It is “Let’s Be Realistic About Drawdowns.” Most traders don’t pay enough attention to the drawdown history of their trading, or of any system trading. Large drawdowns are infrequent but can be ugly. This article shows how to assess them and some ideas on reducing drawdowns.

January 2019

Technical Analysis of Stocks & Commodities will publish “Volatility: What They Don’t Teach You In Grad School,” in the January edition.

December 2018

An article appeared in ProActive Advisor Magazine looking at all calendar patterns, including the Santa Rally, the Presidential Cycle for 2019, the January and May effect, and seasonal patterns in ETFs.

In January Technical Analysis of Stocks & Commodities will publish an article showing the real relationship between price and volatility, which will surprise you. It should change the way you size your positions.

Older Items of Interest

For older articles please scan the websites for Technical Analysis of Stocks & Commodities, Modern Trader, Seeking Alpha, ProActive Advisor Magazine, and Forbes. You will also find recorded presentations given by Mr. Kaufman at BetterSystemTrader.com,  TalkingTrading.com, FXCM.com, systemtrade.pl, the website for Alex Gerchik, and Michael Covel’s website, TrendFollowing.com.

Mr. Kaufman spoke in Tokyo and Osaka to the Japanese association of Technical and was a keynote speaker at the 2018 IFTA conference in Kuala Lumpur, both last October. You should be able to get a copy of the presentations by MATA, the Malaysian Association of Technical Analysts.

 “In Search of the Best Trend” was published in Technical Analysis of Stocks & Commodities in July 2019. An article on “Defense is Your Best Defense” will appear in ProActive Advisor Magazine also appeared in July 2019.

Mr. Kaufman was a keynote speaker at a number of IFTA conferences, the most recent in 2018 in Kuala Lumpur, and Milan in 2017. You can find his presentations on their website.

You will also find many articles posted under Articles on our website, www.kaufmansignals.com. You can address any questions to perry@kaufmansignals.com.

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