The Machine Monthly Newsletter – December 2010
FROM THE DESK OF LARRY CONNORS
Welcome to our 2nd issue of The Machine Newsletter.
If you have read my posts before, you know that I often mention how markets go up, markets go down, and markets go sideways. Today let’s look at how to proactively take advantage of the times markets are rising.
In The Machine we have four separate categories, which allow you to have long positions when the markets rise. Two are short term categories and two are longer term trend following categories.
The two short term categories are mean reversion in Stocks, and mean reversion in ETFs. Each of these categories have individual strategies to take advantage of the time when markets become oversold compared to their historical daily levels. Each take advantage of the quantified fact that markets above their 200 moving average have historically risen after they have pulled back to more extreme levels.
Today we’ll look at the equity short term long mean reversion strategies.
Within The Machine, we have 10 separate strategies that have over 11,000 variations from which you can choose from (more strategies will be added in the near future including the historically high performing Long Pullbacks V2 Strategy). Even though there are many thousands of variations for you to choose from, (which by the way allows you to put your mind to ease about how robust these strategies are), you can sort each strategy by a number of separate metrics including its Compounded Annual Growth Rate (CAGR), Sharpe Ratio, Historical % Correct and a number of other metrics.
Every strategy (as of January 2011) has the exact same philosophy, which we have been publishing for more than 1 1/2 decades.
- The stocks are in longer term up-trends above their 200 day ma.
- They have recently pulled back significantly.
- They have pulled back even further today triggering a buy signal.
- They are sold into strength above their 5-day moving average or above a 2-period RSI reading above 70 (unless you elect to choose a strategy with a stop).
These four rules combined have consistently shown historically above average edges since 1989. The Machine displays data starting from 2001, but we have internal studies going back over two decades showing the same behaviour. During this period of time there have been wars, multiple presidents, an internet boom/bust/boom, a major credit expansion followed by a major credit crisis, along with dozens of other major political and economic events. Yet these strategies have consistently performed year after year, better than any other trading philosophy that has been published.
I know you are likely using the equity mean reversion strategies as they are the backbone of The Machine. I’ll add a few additional guidelines for you consider for your portfolio.
- The Long Pullbacks strategy has the highest CAGR. The new Long Pullbacks V2, coming soon, has even higher average yearly returns. Long Pullbacks are one of my favourite strategies and many traders use it. If you decide it belongs in your portfolio, don’t only look at CAGR; look at the Sharpe Ratio also to identify good past performing variations.
- When you build a portfolio, you may want to look at the level of pullbacks and blend them. This means using one strategy to take advantage of shallow pullbacks, a second to identify mid-level pullbacks and a third to identify deep pullbacks. There are a number of ways to do this but the simplest way is to look at the level of the limit order entry. 2-4% for shallow pullbacks, 6% for mid-level pullbacks and 10% limits for deeper pullbacks. This blend allows you to apply a balanced approach to your short term mean reversion equity strategies.
- Because there are so many thousands of variations available to you, select ones that other people will likely not be trading. The reason is that The Machine licensee base is growing almost daily and it’s very easy for someone to simply build a portfolio using highest CAGR or highest Sharpe. This is not necessary the best way, and it will potentially lead to crowding in the set-ups around those variations.
Go deeper into the selection meaning not using #1 or #2 historically best performing. We’ve built portfolios using the 100th best variations for Sharpe with combined strategies and the test results were solid. Few if anyone else will be selecting variations that deep, and that means there will be little competition for fills at those levels. You don’t need to go all the way to #100. The point is that The Machine is deep and as more people license it may be best to find variation sand strategies that few others are likely using.
I hope these guidelines are helpful to you. Using the Strategy Selector to guide you is also another way to do this and many people told me it has tremendously helped them build a historically high performing portfolio that is correct for them.
In my next post, I’ll share with you how to add short term mean reversion strategies with ETFs to your portfolio.
Enjoy the holidays!
Larry Connors is CEO and co-founder of The Connors Group and TradingMarkets.com
USING THE MACHINE AS AN INVESTMENT ADVISOR
By: Darrell Kay of Kay Investments Inc.
This is my first article for The Machine Monthly Newsletter and I’d like to thank the Connors Group for the opportunity to discuss using The Machine from an investment advisor’s perspective.
In this article I would like to focus on what I consider the top priority for a Registered Investment Advisor (RIA): protecting capital. This reminds me of the phrase “First, Do No Harm”, which is taught to medical students and is part of the Hippocratic Oath.
Many, if not most, RIAs think their top priority is to beat the returns of the market averages or indexes, such as the Dow or S&P 500. The approach is usually to allocate money in a certain diversified way and then wait. This approach is known as ‘buy and hold’. So, if the markets drop 40% and the clients’ accounts drop 33% these advisors can declare victory.
The ‘buy and hold’ method works as long as the market keeps rising consistently. The problem is that this method has produced poor results since 2000 and especially bad results since the end of 2007. In fact $100,000 invested in the market averages in October 2007 would be worth somewhere around $80,000 in December 2010.
One way to think of risk management is in terms of what we call “drawdowns”. This refers to how far your account has dropped from a peak to a low point before once again making a new account high.
All investment methods have drawdowns. The key is how deep they go and how long they last before your account recovers. The S&P 500 (a common “average” of the stock market) is still in a drawdown from 3 years ago. The depth of this draw-down (how bad things became) was over 50% at its worst; and we would still require a gain of approximately 25% from this point (December 2010) just to return to the old peak.
I’m just not comfortable with this level of risk for clients and have invested a great deal of research time and expense into exploring alternatives.
My firm has created what we call our All Market Portfolio (AMP), using The Machine, a technology tool provided by the Connors Research Group. We call it AMP because the portfolio is designed to be able hold value or make money in different market scenarios: up, down and sideways.
The Machine provides many types of strategies, all with different risk reward characteristics. Some work over periods of months, while some work over periods of days. Some make money when the markets go up, while some make money when the markets go down. As an RIA we build AMP by blending various Machine strategies in a proprietary manner.
What AMP has done for our RIA business is to take market worries out of the equation. We no longer lose sleep about whether the market takes a nose dive or tomorrow whether it continues to trend upward. While we cannot eliminate drawdowns, we feel that The Machine is a truly outstanding tool for controlling and greatly reducing them.
Please visit our company website, www.kayinvestments.com for further information.
WHAT’S RIGHT & WHAT’S WRONG WITH THIS PORTFOLIO
By: Phil Suarez
The annual meeting for the Chairman’s Club members was held in Boca Raton, FL earlier this month. It was a great weekend for users of The Machine to see the latest research and to explore new ways to improve their trading performance. One of the exercises conducted at the conference was a section entitled “What’s Right & What’s Wrong With My Portfolio.” The group found this to be an eye opening exercise. The following is a replay of the interactive session.
If a money manager came to you and stated that she or he has had double digit positive returns every year since 2001, would you be interested? His/her Sharpe Ratio is above 2.0 and the max drawdown is under -8%. This money manager does not utilize leverage and only trades a handful of times a month
Would you be interested? The results from the backtest from 2001 to present are:
- Annual Return (CAGR) = 28.52%
- Sharpe Ratio = 2.79
- Win % = 74%
- Average Trades/Year = 80
- Maximum Drawdown = -7.5%
Just by looking at the returns, money would run to this manager. But after we look under the hood, we can find some flaws with the portfolio. Let’s look at the components that make up this particular portfolio.
- 33% in a single long, short term mean reversion strategy.
This strategy has a minimum volume of 1 million shares and can have a maximum of 10 positions
- 33% in a short strategy
This strategy has a maximum of 5 positions
- 33% in gold
So after seeing how these results are created are you still interested?
First, what’s right about this portfolio?
Obviously the high annual growth rate is attractive. As is a Sharpe Ratio that is over 2.0. The fact that the largest historical draw down was only -7.5% is also very appealing. And this portfolio averages only 80 trades per year. There’s a lot to like about this portfolio.
So what is wrong with this portfolio?
When building a portfolio, your first concern should be managing your risk. One of the best ways to manage risk is through diversification. Most asset managers preach diversification of asset classes. The Machine allows you to go even further and diversify your strategy methods. This can be a much more effective form of diversification.
In 2008 the world learned the hard lesson that when the market crashes hard all asset classes become very highly correlated. This means that during a financial crises you are not protected by being in bonds or gold or by diversifying your asset class holdings because money gets simultaneously pulled out of everything.
In those types of markets you want to be in cash or in strategies that sell the market short. This is why strategies that have a high cash allocation and short strategies should be a part of your portfolio.
While gold can have a place in your portfolio, a 33% allocation could be excessive. What if gold is in a bubble and that bubble crashes? It could be very painful to watch a third of your portfolio fall like an internet stock in 2001. A reduced allocation to gold in this portfolio may make more sense.
The next part that stands out is the short strategy only has 5 positions. As mentioned before, it is advantageous to use short strategies for those times when the markets go down. However, in this case a third of the portfolio is allocated to 5 short positions. This means that 6.6% of your portfolio is allocated to each short stock position. Including a second short strategy or adding more positions will diversify amongst more individual names and lessen some of the potential risk.
The portfolio is also constructed of one long strategy and one short strategy. The Machine makes it easy to use multiple strategies in each group (long, short, long timeframe, short timeframe, stocks, and ETFs). This reduces the concentration in specific strategies or methods which can also mitigate risk.
What happens in a slowly rising bull market? You can notice that there are no trend following strategies. Trend following strategies buy big cap stocks or ETFs that are in long term up trends. These are long timeframe strategies that can play an important role in balancing performance. These are especially useful in times when the markets are lacking the volatility that the short term strategies capitalize on.
And last but not least, there are no ETF strategies. Adding ETF strategies will create even more diversification as well as help make your returns smoother and more consistent over the longer term.
To summarize, although this portfolio has very nice returns, many risk management aspects of the portfolio can be improved. Ideally your portfolio should be constructed of stock and ETF strategies, long and short strategies as well as short term strategies (mean reversion) and long term strategies (trend following). When building a portfolio, always think BALANCE.
Phil Suarez is Director of Education for The Connors Group
Due to limitations on the screen size, The Machine has not been formatted for iPhone and iPod products, but it is possible to access your daily signals. Additionally, users that have access to the Screener should note that it will not display on the iPod, iPhone or iPad due to that operating system not supporting Adobe’s Flash product.
WHAT’S NEW IN The Machine
- Users now have the ability to request new features, enhancements, or other ideas for The Machine via the just released User Requested Features item under Help – Feature Requests. All users will be able to submit and vote for the requested features.
- Sample Portfolios are available for both users of The Machine and The Machine – Lite.
- November return numbers were available for all users as of December 10th.
- The video from the November User’s Group Meeting is now available for viewing under Education – Presentations for all current users.
- To learn more about other recent additions and enhancements to The Machine, please check out our What’s New.