Industry Benchmark Performance
Early reporting of equity performance indicates a profitable month, running at about the same rate as our equity programs, but lagging the major equity index benchmarks. Futures are posted daily, so that performance reflects returns through September 29. Of those, the BTOP 50 is the best indication of the Industry, off about 2% for September and down 4.39% for 2017. The SG benchmarks are showing larger losses. It’s shaping up to be a good year for equities and a poor year for futures. For updated returns, go to www.barclayhedge.com. We’ll update this table after more data is available.
Blogs and Recent Publications
(We’ve moved this section to the end of the report.)
September Performance in Brief
A good month for equities and a poor month for futures. The chart below shows that the SPY and QQQ have had slow but steady moves higher, while IWM has had wide swings, making it difficult to capture those gains. Nasdaq, up a remarkable 23% this year, posted a loss for September. A little rain must fall.
Most of our equity programs gained on the S&P in September, with the small Divergence and Timing portfolios up 3.65% and 7.22% respectively. Timing is having the best year, up nearly 17%.
Futures are going the other way, even though the daily portfolios are holding on to profits for 2017. The weekly program gave back some hard-earned gains in September.
Major Equity ETFs. Even with the rhetoric between the U.S. and North Korea getting hotter, the equity markets continue to rally. The S&P looks remarkably stable and gives no sign of changing direction.
This month: Rethinking Your Portfolio
We all know that diversification into uncorrelated assets reduces risk. When you select stocks, it’s good to pick them from different sectors. For the bigger picture, we’ve always heard that putting part of your equity into stocks and the rest into bonds is safe. During a good economy, you profit from stocks and make a small amount in bonds (or lose a little). During a bad economy, you lose in stocks and profit in bonds. Seems reasonable.
But times change. Sadly, terrorism has become a familiar event. When an attack occurs, there is some movement to the safety of bonds, but not always. The sabre rattling between the U.S. and North Korea was reflected in defense stocks, primarily Lockheed-Martin (LMT), Raytheon (RTN), and Northrop-Grumman (NOC). Other aerospace stocks, such as Boeing, are too diverse to react.
Let’s take a fast look at some past events and the markets that moved as a result. By the way, we won’t look at gold because its reaction is too uncertain.
Two Decades of Crises
October of 1987 saw a stock market crash of 27% on Monday and Tuesday, the 18th and 19th. At the same time, bonds rallied. A good argument for stocks and bonds.
The internet bubble burst in January 2000, sending Nasdaq down nearly 90%. The chart below shows the S&P declining from the beginning of 2000 to 2003, while bonds gained. Another reason to have both stocks and bonds.
Then there was 9/11. Stocks plunged and the three defense stocks rallied. We’ve added Boeing (BA) to the chart below to show that it does not fit the pattern. Bonds dropped with stocks, then rallied when stocks recovered. They did not provide a hedge
(Left 9/11 defense) (Right 9/11 bonds)
Skipping to the current North Korean “crisis,” we see that our three stocks had a strong rally while the S&P stayed sideways. Again, the bond reaction was lagged and didn’t offer much protection.
N Korea and defense (left), bonds (right)
Our New Portfolio
Without going through all the detail, which you will want to do yourself, our new portfolio would first trade 2/3 bonds and 1/3 stocks, rather than the other way. That would balance the risk far better than being heavily weighted in stocks, as seen in the next chart.
Next, we rebalance so that we have 19% defense stocks (15% to 20% if you prefer), 54% bonds, and 27% stocks. The final picture won’t look much different from the previous chart of stocks and bonds, but we are anticipating the future, rather than reacting after-the-fact. Portfolio returns are slightly lower. You’ll need to consider it an intellectual challenge. Are you willing to take a slightly lower return to be better protected from a truly bad scenario involving terrorism or war? We think the answer should be “yes.”
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 determine your risk tolerance and how much 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 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 false signal, with a weak trend signal not getting any follow-through from the S&P. The low volatility allows the Trend Strength Index to show modest weakness when the S&P goes sideways or just decreases in volatility. At this time, we interpret the Trend Strength Index as neutral.
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.
The Trend Sector ETF program buys the 6 strongest sectors of the SPDRs.
At the end of August positions:
Preferred Stocks (PFF), Technology (XLK), Utilities (XLU), HealthCare (XLV), Materials (XLB), and Metals & Mining (XME)
End of September we held the same positions:
Preferred Stocks (PFF), Technology (XLK), Utilities (XLU), HealthCare (XLV), Materials (XLB), and Metals & Mining (XME)
The Timing Program buys 4 ETFs that are undervalued with respect to SPY, in expectation of rotation.
At the end of August positions were:
Financials (XLF), Industrials (XLI), and Consumer Discretionary (XLY)
We now hold:
Preferred Stocks (PFF), Staples (XLP), Healthcare (XLV), and Consumer Discretionary (XLY)
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, Income Focus, and Dow Arbitrage
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.
Small gains for all the Equity Trend Portfolios, with the 10-stock portfolio advancing 2.55%, catching up to the larger 30-stock portfolio. They now both show gains of near 12% for the year. The sector ETF program has been looking better, now making new highs.
The Weekly Equity Program ticked up 2% for the 10-stock and 3.25% for the 30-stock portfolio, a nice gain. On the chart, the 10-stock looks to be in a steady upward trend. The ETFs had fractional losses but the recovery still looks intact.
Income Focus and Sector Rotation
Small gains for the Weekly program and small losses for the Daily, but both charts look remarkably similar. It make be a boring approach, but it doesn’t often have a drawdown that would get you nervous, and they crank out from 4% to 8% each year.
A fractional loss in September but the equity remains in an upward trend, very near all-time highs. The stock market has not yet decided which sectors will benefit from the economy, first healthcare, then technology, then who knows?
A gain of 2.06% put the 2017 returns up 20.59%, a remarkable performance from Dow stocks. We don’t expect this run to continue, but we’re happy to have it continue as long as possible.
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.
A strong performance for the Equity Divergence Portfolios, up 3.65% and 1.81%, although difficult to see on the charts. The ETF portfolio gained 0.11% but keeps its upward trend.
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.
An outstanding month for the Timing Program with the 15-stock portfolio up 7.22% and the 30-stock portfolio up 3.97%. That puts the smaller portfolio up 16.93% for the year, offering both good returns and diversification. The ETF program gained fractionally and the best that can be said is that it continues to recover.
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.”
Futures continue to try our patience, but our experience over 40 years has shown that this is what it does. There can be years of sideways movement with some profits and some losses, then a gigantic gain, as we see in the charts below. When there is an economic crisis, futures are the only place to be.
In September both Daily and Weekly programs posted losses, the weekly more than the daily. The daily program is holding on to some reasonable profits and is far ahead of the CTA Index. The weekly program remains in a sell-off and is tracking close to the Industry performance. That’s not much of a consolation when we prefer profits, but it shows that there is nowhere else to go.
Group DF2: Daily Divergence Portfolio for Futures
Unlike the Trend program, the Divergence program posted small gains in all portfolios. The 2017 has surprisingly respectable returns of 11.25%, 5.65%, and 6.05%. For futures, finding divergence trades is more difficult because of the fewer markets, so the smaller portfolio will have relatively more trades. The overall equity picture remains good.
Blogs and Recent Publications
Mr. Kaufman is planning a 2 to 3-day seminar in Shanghai and Beijing in March 2018, sponsored by the Chicago Institute of Investing. The topic will be “Developing a Successful Algorithmic Trading Strategy.” It will be in English and Chinese. For more information contact Katie.Tian@chicagoii.com.
Mr. Kaufman will be a Keynote Speaker at the IFTA annual conference, hosted by the Swiss technical analyst’s association (SIAT) to be held in Milan, Italy, in October 12-16, 2017. See you there!
Seeking Alpha has published “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.
Technical Analysis of Stocks & Commodities will publish a two-part article on profit-taking and resets. The first part looks at trend following systems and the second at short-term trading.
Technical Analysis of Stocks & Commodities has recently published “Optimization – Doing It Right,” in the September issue
Modern Trader published “Dogging the Dow in the current edition, and a new article “Trading Opening Gaps” in stocks, scheduled for January, 2018.
ProActive Investor Magazine published Keeping Risk Under Control on June 22. Check their website. It will be publishing other articles later this year.
Technical Analysis of Stocks & Commodities has published The Return of High Momentum in the July issue, a new intraday system that combines both high momentum and mean reversion into a single strategy.
The Swiss Technical Analysis Society (SMAT) has published Creating Your Own Sectors in their current quarterly publication. If your focus is higher returns, It shows that simple market selection is far better than a packaged ETF.
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.
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