October Midmonth Comments & September Performance

October Midmonth Comments

The long awaited downturn in stocks has arrived. Our Trend Strength Index dropped below zero last Friday, October 10 and tonight Oct 14, reads a negative -15.9 on a scale of +100 to -100. The chart below shows the severe change in the trend since its high on July 3, but the most important formation is the lower high in the TSI in September, when the SPY rallied to new highs but the TSI showed a strong divergence. There was a break of the previous TSI lows of 22.2 on October 1st that has been followed by a sharp sell-off.

While it is impossible to predict what will happen next, we caution that reducing exposure is always a safe action. Our Timing program has liquidation virtually all its positions, the Divergence program holds only a few, and the Trend program has been reducing the size of its holdings.

History shows that there a V-bottom is very unusual, except when a panic sell-off turns out to be based on false information. In this case we would expect some small amount of consolidation, followed by a rally based on bargain hunting. There is nothing wrong with this market fundamentally, but it has been stretched beyond reason and has been overdue for a normal correction.

TSI midmonth

September Performance Report

SEP Performance

Forecasting expectations seems to be getting more complex. Our Trend Strength Index keeps weakening, this month turning down again in a very weak divergence pattern (see more below), but the U.S. economy is stronger. Wasn’t that the same pattern we saw in 1987? Not quite. The final reports of that crash blamed everything on program trading, which was then bombarded with new rules. But program trading was the reaction, not the cause. We think the Fed’s policy of micromanagement won’t prevent another crash, but it will prevent a crash based on the same combination of events. That’s not much of a consolation, except that the market itself seems to produce the recovery. There was fear of inflation then, but the Fed assures us that’s not the case now. There is also uncertainty when a new war is looming. When the market doesn’t agree with the Fed interest rates go up (futures down), as they did in mid-2013 (see the 5-year Note chart below). The market always tries to anticipate the future. With a strong economy and no noticeable inflation, rates seem to have stabilized, waiting for another comment from the Fed to drive yields higher.

The contrast between the weakening trend and the stronger economy is a concern. The technicals want to show that expected increases in interest rates will hurt the economy. From that we would expect the result of this tug of war to be greater volatility, which has started to show in the VIX. The consolation is that, even if we see a sharp sell-off, the market always recovers by itself. Therefore, hedging you risk is good strategy, but history shows that standing on the sidelines is a mistake.

The three situations shown in the charts below reflect the market reaction to the 1987 crash, the first Gulf War, and the invasion of Afghanistan and subsequent years. We can combine those events in some way to reflect what is happening today, with one foot in the door of a new Mideast conflict. In all three cases, sustained bull markets followed not long after the events. Are there just too many buyers or do we exaggerate the impact of these events on the market, only to be constantly proved wrong? Is war ultimately good for our economy? Certainly, President Putin thinks it’s good for Russia.

Our conclusion is that risk is likely, and a drawdown in the market is inevitable, but in the past staying in the market has proved the best strategy. Risk control is essential, but there is no reason to bail out. For those that can, diversification into futures, including commodities, would be one way to control risk. Trends resulting from a strengthening dollar, declining oil prices, and falling gold, have given this year’s futures portfolios a needed boost.

SPX war history

Fed Funds History

a5-year notes

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.

 1Trend strength index

The TSI turned down again a week ago, making the comparison between the SPY and TSI look like a weak divergence pattern. We know that Wednesday, October 1 (the day after this chart was created), was a sharply lower day for the S&P, taking the TSI down to about 4, a significant new low. That value says that all stock trends net out at zero at this time, that is, there is no bias either up or down, but a standard interpretation would favor a sell-off before a recovery. We should expect smaller Trend program positions as that strategy scales down its exposure. The Timing program hedged part of its exposure on the last day of the month based on the first of three trends turning down. Risk protection is most often entered reluctantly, and often is not profitable, but the few cases where the market continues lower require that we continue to hedge when necessary.

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

Trading a long-only program in equities means that losses cannot be avoided when the market turns down. We systematically reduce our risk exposure and limit the losses with well-defined rules. It is an unpleasant but normal process that allows us to manage our investments in the most responsible way. The chart below shows the year-to-date pattern of the major equity benchmarks. The SPY and QQQ are performing similarly, but the small caps, IWM, are very week. Traditionally, this means a shift to the safety of the more reliable stocks. While the pattern of SPY looks as if it’s forming a rounded top, it’s not yet developed enough to be conclusive. The Trend Strength Index would say that some more downside is likely.

2Major Index ETFs

All of our stock and ETF programs posted losses in September, paralleling the broad index markets. The Trend program fared best and the larger portfolios posted better returns than the smaller ones. All that is normal, even though we prefer the market to go up. Nearly all programs are holding on to nice gains for the year, with the daily Trend program ranking first and the weekly Trend second.

In futures, the Trend program is showing remarkable returns after a long, stagnant period.  All three portfolios, although trading varying sets of futures markets, are showing about the same monthly and year-to-date returns. The CTA industry is also doing well this year because it is dominated by trend following. See more detail later in this report.

The futures Divergence program is struggling, however, with the smallest portfolio giving up all its profits for the year. If you consider the combined returns of the two futures programs, they still outperformed the industry benchmarks. Viva diversification!

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) removed the rest of Energy (XLE), given the sharp decline in crude oil prices, and replaced it with the more conservative Preferred Stocks (PFF). Current positions are:

Preferred stocks (PFF), Materials (XLB), Financials (XLF), Technology (XLK), Heath Care (XLV),and Consumer Discretionary (XLY)

The Timing Rotation program (buy low) drastically reduced its exposure and holds only 3 of 8 possible positions, with only energy (XLE) held from the previous month. Its current positions are:

Reit (VNQ), Energy (XLE), Consumer Discretionary (XLY)

This month we only see Consumer Discretionary (XLY) in both groups. That means XLY has a strong long-term trend but is now oversold relative to SPY. We see those as particularly opportune trades.

A Standing Note on Short Sales

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.


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 posted losses in all portfolios but held up well. The smallest, less diversified portfolio lost 3.14% and the large 1.94%. Year-to-date results remain very good. Positions are a mix of NYSE and NASDAQ, so the returns should be compared to an average of SPY and QQQ. This month’s returns do not reflect as a significant change in the long-term performance. The underlying interpretation of the Trend program can be seen in the Trend Strength Index which, as of October 1, had a value of about 4. The net of all positions tracked shows a neutral trend. The portfolio, however, seeks to find the strongest of those stocks, but in a market that wants to go lower, all stocks are dragged along.

3Trend equity NAVs

The Weekly Trend Program for stocks did slightly better than the daily, while the ETFs did about the same. As the chart below shows, the smaller stock portfolio has had higher returns and higher risk.

4Weekly Trend Equities

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 a poor month but remains higher for the year. As with the other equity programs, it is limited to long positions; therefore, a turn to the downside will always hurt. While it may look unimportant on the charts below, a loss is always unpleasant but part of the process. The smaller 10 stock portfolio posted a larger 6.85% loss for September, while the more diversified 30 stock portfolio lost 2.07%. We’ve added another 25 stocks to the portfolio, which should help in the selection process.

The Divergence ETF Rotation program posted only a minor loss of 0.69%.

5Divergence equity

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. 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 we had a rare case of Cliff’s Natural Resources (CLF) hitting our stop on its way down to much lower prices. We also set a well-timed partial hedge on all positions on the last day of the month. While we all prefer the stock market to rally and take a small loss on the hedge, risk protection is an important part of the strategy. September losses in stocks look normal on the chart below.

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.

We indicated the holdings of the ETF Timing program 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. September losses in the ETF program have given back its year-to-date gains and positions have been reduced considerably to protect against risk.

6Timing program

 Futures Programs

The Trend Futures program was a ray of sunshine this month, and even with losses in the Divergence program, the net of the two outperformed the benchmark CTA indexes. The chart below shows that profits are more widespread in the Trend program with interest rates, FX, and ags holding the gains for the year. That reflects the anticipation of higher rates as the Fed ends Quantitative Easing, the gains in the U.S. dollar mostly reflecting the lag in the European economy, and a sharp downturn in grain price countered by much higher meat prices. The Divergence program has had a difficult two months, with losses eating up year-to-date profits in the smallest portfolio. An overview of all markets in the sectors is shown in the chart on the right. Gains still remain in bonds and ags.

7Futures 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.

For more information about our revised “portfolio allocation methodology” read the article in the drop-down menu under ‘Articles.’

The Trend program continued to add to gains this month, posting 11.4% to 14.5%, with the year-to-date now between 23% and 28%. 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.

7aBenchmark table

The charts below show the daily and weekly Trend program performance. The order of best returns is classic for the weekly, with the smallest portfolio gaining the most with the highest risk, and the largest portfolio showing the lowest returns and the lowest risk. On the other hand, those markets unique to the $500K daily portfolio are far outperforming the other portfolios. It’s something that can’t be predicted, but is certainly a pleasant event. We believe that the continued outperformance of our Trend program, compared to the benchmarks, is due to selecting specific markets and avoiding an overly diversified portfolio, which must include markets that have been underperforming for some time, even though they may have a 25 year net gain.

8Trend futures

Group DF2: Daily Divergence Portfolio for Futures

While the Divergence program took a modest loss last month, that loss when added to the previous month turned the smallest portfolio negative for the year. The $500K and $1M portfolio still retain 3% and 9% gains for the year. The Divergence program must assess the direction of the trend in order to decide which way prices are likely to go once the divergence pattern is resolved. With an erratic market, that becomes more difficult.

We would like to emphasize the importance of diversification, even when one asset takes a loss. If you view both futures programs, the Trend and Divergence, as two unique strategies, the combination of the two will produce a much better information ratio (returns divided by risk) than either one. And, there are more times when both return profits than when they both have losses.

Another point to consider is that both futures programs target a volatility of about 12%. That means a drawdown of 12% is well within the range of acceptable performance and will happen from time to time. That may seem large, but the stock market had done far worse. The Russell is now in a “retracement” pattern, exceeding 10%. This may turn out to be the opportunity many investors have been waiting for to enter the market.

9Divergence futures

Guidance notes in italics are repeated each month for our new readers.

© Copyright 20141005, P.J. Kaufman. All right reserved.


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