We just wanted to take the time for a brief portfolio
update. We took long positions on the Brexit sell-off (around SPX 2000). We
moved money into biotech, commercial & regional banks, capital markets and
transports. The sectors had done well and we spent the last week taking
profits. The markets seem to be consolidating and stalling and could be prone
to weakness over the next several weeks.
We are entering a traditionally weak part of the year and
the upcoming election season could exacerbate volatility in the near future.
The chart below via Business
Insider shows the seasonality of returns on a monthly basis.
With the VIX sitting at such benign levels, it makes sense
that the market will at least stall and consolidate if it doesn’t correct at
some point. With the upside potential of the markets currently stymied by
complacency and considering our gains in the portfolio from the Brexit bounce,
we believe the best course of action is to raise cash and wait for a more
enticing entry.
On the SPX daily, the bull run appears tired as most oscillators
and the MACD have all turned lower and volume is thinning. There is also a bearish divergence between the
percent of stocks in the S&P 500 trading above their 50D moving average and
the overall index (%SPXA50R on the chart below). A pullback to 2120-2130 would
be a welcome event and allow us to reposition ourselves.
The daily Nasdaq has the same chart risks as the SPX. Make
note of the bearish MACD cross that occurred last week.
Outside of raising cash and writing options against our core
positions we are contemplating adding smaller positions of silver and the U.S.
dollar to the portfolio. As far as silver is concerned, the precious metal is
oversold on both the RSI (5) and fast stochastics oscillators although we will
wait to see if the RSI (14) trend can retake the 50 level that it has held from
the start of the year. We would also like to see MACD turn higher off this
support level. Should some renewed signs of strength emerge, we will take our
position. The weekly silver chart shows the uptrend of 2016 remains intact with
the oscillators holding above their midpoints and the MACD remains in a rising
pattern. Silver is sitting on its 200W moving average.
The US dollar has weakened recently as can be seen in all
the oscillators. The MACD histogram and all the oscillators have started to
turn higher last week as the dollar approached what appears to be near-term
support. On the weekly US dollar chart we can see a flagging pattern off its
parabolic run from last year. The more sensitive oscillators are oversold at
this point but the MACD remains in a bullish pattern. We will most likely take
smaller positions in both silver and the US dollar but will certainly wait
until the outcome from Jackson Hole this week before moving in a more
aggressive fashion.
Pairs Trading Model
We have recently launched a new fund strategy that utilizes
a heavily levered portfolio in creating a long/short dynamic with the
intensions of capturing spreads due to distortions in relative pricing
performance.
Our objective is to
create a long/short portfolio that minimizes portfolio volatility and attempts
to capture pricing spreads between the long and short positions. We will use
models that attempt to capture the behavioral dynamics between two like securities
allowing us to profit by buying the instrument with the greatest probability of
outperforming on a relative basis against our secondary offsetting
instrument.
We are using a relative performance z-score between two like
securities to assist in determining potential rotation opportunities. Similar
to technical analysis, we will be using several objective signals to recognize
potential profit opportunities. We will also utilize relative strength of the
combined performance of the two instruments.
Once the trading criteria is met, we then confirm the
correlation between the two instruments. A high positive correlation is
preferred to confirm our directional bias, i.e. long/short. Two instruments
with a strong negative correlation and a long/short structure is in essence a
one-sided position.
In order to account for volatility, we choose the
appropriate allocation towards each trade. We accomplish this by using a recent
beta test (six months). We run our covariance and variance to determine the beta
between the two instruments presented. The beta applies to the primary
instrument and the secondary instrument will be given a value of one. We will
run the R-squared between the two to confirm correlation. Once the beta is
calculated we apply 1-(Pb/Pb+1) where Pb is the primary beta to determine what
percent of the trade is long and short.
Once we enter a position we calculate our potential downside
risk using one, two and three standard deviation pricing variation of the two
instruments over the past six months. As a stop loss, a one or two standard
deviation movement against us will trigger the unwinding of the position. For
profit taking purposes, it appears a one standard deviation increase between
the relative z-score and its signal line (15 day moving average) is a good
initial exit. We will most likely take one-third the position off at this
level, another one third if it were to hit that level again and leave the
balance in place until the z-score exhibits a bearish cross to its signal. We use
a histogram to help assist us in this process.
The figure below represents our dashboard. This pulls all
the relevant information from the models into one easy to read box that can be
viewed real-time.
New Pairs Trades
Given our defensive stance in our core portfolio as
mentioned above it doesn’t surprise us that the current pair’s signals we are receiving
are defensive in nature.
Long Consumer
Staples (XLP) / Short S&P 500 (SPY)
As can be seen from the relative performance Z-score below
the pricing differential between the consumer staples sector and the S&P
500 have reached extremes. We like to see the pricing differential near -2
standard deviations from the mean as we put on the long/short position.
On the daily XLP, the index is sitting on its 50D moving
average that has been a key support level for quite some time while RSI (14)
and MACD are pointing higher. Given our hesitation about further market gains
within the S&P 500 as mentioned earlier we find the risk reward dynamics
for this trade to be quite favorable.
The next chart shows the relative price performance of the
XLP (long) and the SPY (short). We have marked the instances when our relative
price performance z-score reached extreme points (green arrows). We have also
marked the corresponding periods when RSI (14) touched the 30 level and the
corresponding bullish MACD cross. We have started to build on this position and
expect a rotation to a more defensive stance over the coming weeks.
Long Insurance
(KIE) / Short Financials (XLF)
The relative performance Z-score below the pricing
differential between the insurance sector and the financials have reached
extremes. We like to see the pricing differential near -2 standard deviations
from the mean as we put on the long/short position.
On the daily KIE, the insurance ETF has been consolidating
but nearing a potential breakout from resistance. The daily financials ETF
chart shows a similar pattern but hasn’t approached its breakout level yet.
On the relative performance chart we have marked the three
extreme z-score readings using green arrows. We have also highlighted the times
when RSI (14) approached 30 and the bullish MACD crosses. We are also encouraged
by the support the 200D moving average has provided. We consider these levels a
key support area. We believe this pair’s trade offers a favorable risk/reward
dynamic and we will continue to build a position over the next days and weeks.
Long Health Care
Services (XHS) / Short S&P 500 (SPY)
The relative performance Z-score below the pricing
differential between the health care services sector and the S&P 500 have
reached extremes. We like to see the pricing differential near -2 standard
deviations from the mean as we put on the long/short position.
The health care services ETF has gotten mauled over the past
few weeks. Given its oversold condition and the possible near-term support we
decided to add this pair’s trade to the portfolio. We would have greater
confidence in the trade once we see MACD and RSI start to turn higher and will
most likely add to the position should those events occur.
On the relative performance chart we have marked the extreme
z-score readings using green arrows. We have also highlighted the times when
RSI (14) approached 30 and the bullish MACD crosses. While this model has a
less reliable history of buying opportunities, we will nonetheless take this
position, albeit with a smaller average position size.
Long S&P 500
(VOO) / Short Technology (XLK)
The relative performance Z-score below the pricing
differential between the S&P 500 and the technology sector have reached
extremes. We like to see the pricing differential near -2 standard deviations
from the mean as we put on the long/short position.
The daily XLK chart shows a relatively healthy tech trend
recently but we have seen the RSI start to head lower from an extreme
overbought position and the MACD has suffered a bearish cross last week. It the
recent past, these events have been negative scenarios for the ETF.
On the relative price performance chart we have gotten
several extreme readings over the past year. These signals have marked periods
of weakness within the tech sector but the real win was in April of this year
as Apple (AAPL) took its toll on the tech sector.
Bottom Line: In both
our core equity portfolio and our newly launched pair’s portfolio we are taking
a defensive stance over the next several weeks. Given the historically soft
seasonal and election year equity patterns we are waiting for at least a brief
pullback before we increase our exposure to more cyclical sectors and higher
beta instruments.
Happy Trading
Joseph S. Kalinowski, CFA
Email: joe@squaredconcept.net
Twitter: @jskalinowski
Facebook: https://www.facebook.com/JoeKalinowskiCFA/
Blog: http://squaredconcept.blogspot.com/
Web Site: http://www.squaredconcept.net/
No part of this report may be reproduced in any manner
without the expressed written permission of Squared Concept Asset Management,
LLC. Any information presented in this
report is for informational purposes only.
All opinions expressed in this report are subject to change without
notice. Squared Concept Asset
Management, LLC is a Registered Investment Advisory and consulting company.
These entities may have had in the past or may have in the present or future
long or short positions, or own options on the companies discussed. In some cases, these positions may have been
established prior to the writing of the particular report.
The above information should not be construed as a
solicitation to buy or sell the securities discussed herein. The publisher of this report cannot verify
the accuracy of this information. The
owners of Squared Concept Asset Management, LLC and its affiliated companies
may also be conducting trades based on the firm’s research ideas. They also may hold positions contrary to the
ideas presented in the research as market conditions may warrant.
This analysis should not be considered investment advice and
may not be suitable for the readers’ portfolio. This analysis has been written
without consideration to the readers’ risk and return profile nor has the
readers’ liquidity needs, time horizon, tax circumstances or unique preferences
been taken into account. Any purchase or sale activity in any securities or
other instrument should be based upon the readers’ own analysis and
conclusions. Past performance is not indicative of future results.
No comments:
Post a Comment