September 2015 Performance Report

Sep Performance Table

September Overview

In 1776, when Thomas Paine said “These are the times that try men’s souls” he was talking about the American Revolution, but he might have been talking about the stock market. Prices collapse one day and jump up the next, only to collapse again. Normally, when volatility spikes, it comes down in an orderly manner (as seen in the VIX chart below). Less often, it can spike again, indicating another extreme move. But for investors, he real problem is not the volatility, but the direction of prices. Technicians note that the S&P has traded in a 230 point range for the past 15 months. Is this is a broad distribution leading to a sustained downtrend, or another temporary trap for investors?

 

VIX 2015

Why is this so frustrating? It would be nice if we could be sure that the market will rebound after dropping 50% as it did in 2008. Then we could hold our positions. It certainly doesn’t look as though the U.S. economy is imploding or we’re at risk of any type of meltdown, but investors that just abandon ship can cause temporary damage, as they did in 1987.

Our solution is to have a plan and follow it. You don’t need to be an algorithmic trader, as we are, but without a clear plan you are floundering around, hoping for the best but exposed to unnecessary risk. Yes, when your plan says to exit but you don’t want to take a loss, it’s difficult to act. But the plan must have an exit condition. If it turns out to be a short-term downturn then you miss some of the recovery; however, if it’s a long-term downturn, you miss the biggest part of the loss. You can’t have it both ways. You can’t be protected from every downturn and take advantage of every up move. You need to give up something for risk protection.

Yes, these are trying times. They are not the markets we have enjoyed for the past few years, but this is reality and you need a plan in place to deal with it before it happens, not afterward.

Biotech

As an example of a plan, look at the chart of the ETF BIB (Biotech) below. It has an 80-day moving average in gold, representing a typical macrotrend time period. If we use the moving average line to decide our position, we would have held the trade for the past year, entering on June 5, 2014 at 42.14 and exiting on August 12, 2015 at 90.05. It’s not the high of 104.69, but then it’s not holding the long at today’s price of 59.60. No system is perfect, but there are many systems that are better than not knowing what to do. And they don’t need to be complicated.

BIB chart

Repeating Our Previous Advice (from August)

For those readers not following our programs, there are defensive considerations, independent of the specific trading systems, that may be helpful:

  1. Don’t buy a stock that is in a downtrend.
  2. Continue to hold stocks that are strong, even if the index is in a downtrend.
  3. Hedge your portfolio using ETFs. Scale into the hedges as the downtrend expands. If the market turns back up and you lose a little on the hedge, that’s OK. You’ll make more on your portfolio.
  4. If you trade futures, remember that futures go short, and that serves as a hedge in a steep sell-off. It’s called “crisis alpha,” and it’s the reason why institutions use futures.

September System Performance

We have continued to reduce the leverage in our equity portfolio as nearly all trends have turned down. All of our equity portfolios lost less than the major index ETFs, especially the small caps. Losing less is not as much fun as making more, but it is one of the important features of systematic trading. The Futures Trend program actually showed a gain, the Futures Divergence about flat, and the Weekly Equity and Futures both have minor gains. We consider that good for an overall economic picture that is clearly weakening, and investor sentiment dropping even faster.

In a declining market the larger, more diversified portfolio outperform the smaller ones. That changes when prices are heading higher because the smaller portfolios tend to be higher beta, running ahead of the general market.

A picture of the major equity index ETFs shows the current situation. The spike down last month was followed by a steady recovery that has now turned into a new low in the SPYs and IWM, but with the QQQs not far behind. Unfortunately, our stock “internals,” shown in the Trend Strength Index in the next section, shows further weakness.

Can we give you a prediction of what will happen in October? No. It’s all up to investor psychology. If most investors hold then the market will be more stable, perhaps even recover. There is no apparent economic crisis, but there could be a slow erosion if investors prefer interest rates rather than equities. Unlike our previous optimism, we don’t see a fast recovery. We seem to be settling into a bear market.

Major ETFs

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.

Our Trend Strength Index clearly reflect the tone of the market. Even with a small recovery in the SPY, the blue Trend Strength line continued to weaken. At a value of -60 the TSI is very low, indicating that nearly all the stocks that we track are in a long-term downtrend. It’s unlikely that a turn-around will occur quickly.

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.

Strongest

The Trend Sector ETF program buys the 6 strongest sectors of the SPDRs. because all sector ETFs are in a downtrend and our program is long-only, there were no position at the beginning of September and no position entered or exited in September. Given the decline in the overall market, we see that as good.

No positions held

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. We would expect small profits when if XLF outperforms the overall index. As it turned out, the program held its own with only a fractional loss in September.

This month started with no position and ended long XLF hedged 50% using SPY:

Long Financials (XLF) hedged 50%

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.

 PEFORMANCE 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.

Both Trend Equity Portfolios declined slightly and far less than any of the major equity index ETFs. In the Overview and in the section on the Trend Strength Index we’ve discussed the nature of the market, so we won’t repeat it here.

Trend equities

The Weekly Stock programs a small positive uptick in performance, but that might be due to the posting does not include 3 days of the last week in September. Overall, the weekly equities program track similarly to the daily program, so we’re not expecting much change from the added data

Weekly 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 posted similar, small losses in each of the three portfolios, beating the major equity index ETFs. All portfolios remain in a drawdown.

Divergence equities

 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 Program held the market to small losses, mainly due to a full 50% hedge (the maximum) in all positions. As with most of the other portfolios, there are fewer stocks that satisfy the trading conditions, so the portfolios are generally underleveraged.

Timing equities

 Futures Programs

The Divergence futures program posted large gains in August, even after a small pullback in returns during the last days of the month. It is now well ahead of the benchmark CTA index. The Trend programs had mixed returns, better for the smallest portfolio and slightly down for the larger ones. Year-to-date, the larger portfolios still reflect the battering due to the Swiss Central Bank intervention earlier in the year.

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 August, the CTA industry gained enough to put year-to-date performance into the positive column for the Newedge Index, but still slightly negative for the broader BTOP 50. The Short-Term Index (in which our Divergence Program fits) is still significantly negative for the year. Overall, futures are doing much better than equities this year.

Newedge

The Trend Futures Program posted gains of 1.5% to 4% this month, continuing its recovery and outperforming the benchmarks. Patterns in the three portfolios are different due to different markets traded and the added diversification in the largest portfolios. The $1M portfolio is the only one still holding a loss for the year, reflecting the surprise action of the Swiss Central Bank. The Weekly Futures program is running well ahead of the Daily Program, up more than 10% in the smallest portfolio, a welcome return for those investors also in equities.

Trend Futures

Group DF2: Daily Divergence Portfolio for Futures

The Divergence Program also held onto its big gains in the past few months, posting returns between +1% and -1%. Two of the three portfolios are showing good returns for the year. Futures are turning out to be good diversification this year.

Divergence futures

©Copyright September 2015 – Kaufman Signals – All Rights Reserved

 

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