September 2016 Performance Report

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Industry Benchmark Performance

The last few days of the month turned a loss into a breakeven for most of the broad index ETFs, holding on to nice profits for the year. Hedge funds are mixed and it’s reported that Perry Capital is closing down.

For investors who don’t trade, the market looks higher, but for traders and systematic programs, it’s been very erratic getting there. CTA performance is mixed to flat. The MSR Trend Index (bottom right in the table), a combination of other indices including the GSCI, shows how difficult it’s been, when you add multiple costs on top of flat performance.

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Blogs

Last month Mr Kaufman published an article on Seeking Alpha, showing the most likely trading scenarios following this election. A modified version of that article has been included in this report.

You can find all of Mr Kaufman’s Forbes articles at https://www.forbes.com/sites/perrykaufman. Other articles can be found on www.equities.com, Modern Trader, and Technical Analysis of Stocks & Commodities. You can address any questions to perry@kaufmansignals.com.

 

September Overview: The Fine Line Between Politics and the Market

Will the Fed raise rates? Is Janet Yellen waiting because the economy is not strong enough or because of the upcoming election? Or both? We certainly don’t think the economy is strong enough, even if unemployment goes to zero. The numbers don’t seem to reflect the struggles of most workers, and haven’t since the financial crisis of 2008.

With that in mind we have the average gain of the three major equity index ETFs up 8.76% for the year, with the SPY flat for September. It could be that money is flowing back into the market, that putting off an interest rate hike is good for corporate profits, or that Europe is worse off than we are. When we see the SPY at the bottom, QQQ in the middle, and the small caps (IWM) on top, traditional analysis says that investors are willing to take risks. If not, they run to the Dow.

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How to Trade the Election

History shows that the few days and weeks following the election can post large gains and losses. This election seems to be a prime candidate for volatility. The good news is that there is a high probability that you can profit based on the reaction the day after the election.

Based on a simple analysis, if the stock market trades higher the day after the election, there is a 90% chance it will be another 3.1% higher on the 3rd Friday (a little more than three weeks). If it trades lower right after the election, there is a 69% chance it will be another 1.84% lower on the 3rd Friday. Since 1924 it has been as much as 12.75% higher and 8.92% lower. Those are good odds and we expect that this election will result in a bigger rather than a smaller move.

By the Numbers

Looking back at all the Presidential elections from 1924, we’ll use the Dow Industrials to track the market reaction. In Table 1, the year of the voting is in the first column, followed by the price on the Monday before the election, then the Wednesday after the election. The next four columns have the Dow price for each of the next four Fridays. Note that 1984 was the first time that Election Day was not a holiday. So much for the good old times.

Of the 23 elections, 10 resulted in an immediate uptick on Wednesday, while 13 posted lower prices.

To make it easier to see the market reaction, Table 2 shows the same results in percentage returns. The years highlighted in red are those in which the Wednesday after Election Day (the next day) was lower. The four columns in blue at the far right show the progression of the Dow on each of the following four Fridays.

Looking only at the 10 Elections in which the Wednesday price was higher, if you had bought on the close of Wednesday, then each of the following Fridays would have shown higher profits, with the fourth Friday up an average of 3.5%. For the 13 down Wednesday, the third Friday showed the largest gain, an average of 1.8%. It should not be surprising that the downward pattern is shorter due to the upwards bias in the stock market. These patterns can be seen in Chart 1.

Will This Year Be Different?

That depends if you consider a 3- week move of 10% to 15% “different.” Both sides have stirred up a maelstrom of economic anxiety. If we watch the way in which the stock market reacts to the poll numbers as we near Election day, we will see how the traders view the election outcome. And, if there is a significant movement in the week or two ahead of the election, it will pave the way for a big move after. The plan is that whichever way the S&P moves on the day after the election will determine the following three weeks.

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Table 1. Dow Jones Industrials Average prices before and after each Presidential election, from 1924.

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Table 2. Election patterns in the Dow expressed as returns, from 1924.

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Chart 1. Progression of returns for entering longs on a stronger Wednesday (left) or selling short on a weaker Wednesday (right).

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.

SPY was flat in September with the Trend Strength Index tracking it higher, then starting to show more weakness than the ETF. Given the consistent noise, it’s easy to expect some pullback here rather than a continued move higher. The TSI remains near it’s overbought level.

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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 September, we had exited financials (given the news of Wells Fargo and Deutschebank. We also hold two position in Energy resulting from a more likely agreement within OPEC to cut production. The reality is yet to be seen. We now hold:

Preferred (PFF), Technology (XLK), Energy (XLE), Industrials (XLI), Oil & Gas Exploration (XOP), and Consumer Discretionary (XLY).

Undervalued

The Timing Program buys 4 ETFs that are undervalued with respect to SPY, in expectation of rotation. We abandoned the energy ETFs as well as Preferred Stocks after a rally and are now holding:

Staples (XLP), Health Care (XLV), Consumer Discretionary (XLY), and Metals & Mining (XME).

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.

The daily equity trend programs were all profitable this month, but still lag the major index ETFs. Year-to-date returns vary from fractionally lower to up 3.3%. We expect that a lot will change based on the election and that systematic performance is more likely to succeed than discretionary trading. Time will tell.

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Small gains in the stock portfolio and small losses in ETFs keeps the performance patterns unchanged for September. The 10-stock portfolio remains the bright spot.

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Sector Rotation and Income Focus

Sector Rotation blipped up a fraction this month, exiting the energy complex in favor of Emerging Markets (EEM), Technology (XLK), and Metals & Mining (XME). Given its volatility, it could easily make new highs if the election is either worrisome of reassuring.

The new Income Focus program remains 4.18% higher for the year after this month’s loss of over 2%. The program began shortly before the 2008 financial crisis, when these ETFs became available. While all of our programs have risk, we expect this one to show steady gains similar to the past 7 years. It has the advantage of dividend income to offset losses.

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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.

Gains in all portfolios cut year-to-date losses in the smallest 10 stock program and brought the Sector Rotation to a gain of 3.88% for 2016. The ETF program continues its steady slog upwards.

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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 put in the best performance of our programs this month, up about 2.3%, with the Sector Rotation adding just under 1%. We’re optimistically eying the stock performance chart for new highs.

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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.”

Gains of over 2% in the $250K and $500K portfolios keep the performance of all three daily trend program up 8% to 11% for the year, surprisingly similar to the major stock ETFs. Weekly Futures were mixed with only the largest $1 million portfolio profitable, but all portfolios ahead for the year. While the weekly program was ahead of the daily for the first part of 2016, the daily program is now looking better.

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Group DF2: Daily Divergence Portfolio for Futures

Losses in September continue the drawdown pattern for Divergence Futures. We continue to wait patiently for a recovery.

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

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