QuantDesk® Machine Learning Forecast

for the Week of August 7th

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Summary

Market Outlook in the Face of the Dow and the SPY Divergence

Erez Katz, CEO, talks Artificial intelligence and Dow market trends

The distinction between traditional statistical analysis and AI-based machine learning can be summed up as follows: Statistical analysis asserts statistically significant answers to well defined questions, while machine learning analysis can provide answers to questions we never even thought of asking.

Example of Traditional Statistical Analysis

Imagine an investment professional wants to validate his/her own hypothesis that when the Dow moves higher by more than 2% in one week it signifies a bullish momentum and thus there is a strong likelihood that the Dow will continue to climb for at least one more week. A quick search in the past can identify when such a scenario occurred, at which point good event analysis software can stratify the Dow’s price action after such conditions and subsequently assess an outcome and its probability.

Example for Machine Learning Analysis

In contrast to the example above, a machine learning classifier can alert an investment professional to an abnormal condition in which the Dow and the SPY diverge by a spread of more than 1%. It may also indicate a significant reversal of a recent trend. To be specific, based on the recent rally in the US stock market, we may be reaching a point in which a correction is soon coming (within the next 30 days, for example).

US Market Outlook, Given Last Week’s SPY and Dow’s Divergence

Last week the SPY was mostly flat, while the Dow rallied by more than 2.3% to reach five sequential days of all-time highs.

DIA (Dow Jones Spider ETF)
Dow ip +5.99 July 6 - Aug 4
Image 1: DIA one-month price history – Source Google Finance
SPY (S&P 500 Spider ETF)
SPY ip +4.64 July 6 - Aug 4
Image 2: SPY one-month price history – Source Google Finance

Using Lucena’s Event Analyzer, we can quickly determine when in the past such divergence occurred and what happened to the SPY one year following such event.

SPY DIA Divergence over 0.5
Image 3: Event Scan definition between 1/1/2000 and today for conditions in which the SPY moved lower by 0.5% against its 21-day moving average, while the Dow moved higher by at least 0.5% against its 21-day moving average.

The Results

Our analysis yields an interesting scenario. First, in the past 17 years, there are only 39 instances in which such a divergence occurred. Second, these instances occurred during years of transition:

  • 2001-2003 (Dot Com Crisis)
  • 2008-2009 (Financial Crisis)
  • 2011 (Correction year)
  • 2017 (Outcome unknown…)

Judging from the historical analysis of the SPY’s price move one year after the above condition occurred, we are looking at a correction with an average drawdown of 8.5%, with a trough about 7 months post-divergence.

Event Scan SPY price trough over last 2/3 of year
Image 4: Event Scan results summary showing an average price drop trough after 147 trading days (about 7 months) of 8.31%.
Image 5: A graphical representation of the raw #s depicted in Image 4. The Event Date is depicted in the vertical white-dotted line, while the price action following the event day is depicted to the right of the vertical line. Mean price move is in yellow while the standard deviation is defined by the blue shaded areas (lighter blue signifies ½ standard deviation while darker blue signifies 1 standard deviation. In statistics, standard deviation off the mean line is used to assert most common occurrences while removing the outliers.

Conclusion

In contrast to other market doom, bloom and boom forecasters, I wanted to bring forth one point of view that should not be taken in isolation. Our proposition has always been predicated on combining human intellect and insight with machine learning intelligence. However, given the complacency in the market, it may be wise to keep a watchful eye as corrections are unavoidable and many times they catch even the most experienced investors by surprise.

Strategies Update

As in past weeks, I want to briefly update you on how the model portfolios and the theme-based strategies we covered recently are performing.

Tiebreaker – Lucena’s Long/Short Equity Strategy - YTD return of 10.92% vs. benchmark of -4.13%
Strategy for Vanguard Market Neutral Fund Institutional Shares has resulted in +10.92 increase%
Image 1: Tiebreaker YTD– benchmark is VMNIX (Vanguard Market Neutral Fund Institutional Shares).
Past performance is no guarantee of future returns

Tiebreaker has been forward traded since 2014 and to date it has enjoyed remarkably low volatility and boasts an impressive return of 47.54%, low volatility as expressed by its max-drawdown of only 6.16%, and a Sharpe of 1.94! (You can see a more detailed view of Tiebreaker’s performance below in this newsletter.)

BlackDog – Lucena’s Risk Parity – YTD return of 15.65 % vs. benchmark of 8.99%

We have recently developed a sophisticated multi-sleeve optimization engine set to provide the most suitable asset allocation for a given risk profile, while respecting multi-level allocation restriction rules.

Essentially, we strive to obtain an optimal decision while taking into consideration the trade-offs between two or more conflicting objectives. For example, if you consider a wide universe of constituents, we can find a subset selection and their respective allocations to satisfy the following:

  • Maximizing Sharpe
  • Widely diversified portfolio with certain allocation restrictions across certain asset classes, market sectors and growth/value classifications
  • Restricting volatility
  • Minimizing turnover

We can also determine the proper rebalance frequency and validate the recommended methodology with a comprehensive backtest.

BlackDog YTD increase +15.65
Image 2: BlackDog YTD– benchmark is AQR’s Risk Parity Fund Class B.
Past performance is no guarantee of future returns.

Utilities –Large-Cap Based Actively Managed – YTD return of 37.34% vs. 12.47% of the benchmark!!!

I wrote about utilities last year in an attempt to demonstrate how Lucena’s technology can be deployed to identify fixed income alternatives. Since November 2016 we have been tracking our utilities portfolio, and it has been performing exceptionally well in both total return and low volatility—well ahead of the S&P and its benchmark, the XLU.

Utilities Sector return +46.607 overall
Image 3: Utilities based strategy– captured since November of 2016. Benchmark is XLU – Utilities select sector SPDR.
Past performance is no guarantee of future returns

Industrials –Large-Cap Based and Actively Managed – YTD Return of 10.59% vs. benchmark of 7.72%

I wrote about an industrial-centric portfolio in January this year. This portfolio was designed to anticipate the administration’s strong desire to invest in infrastructure. The portfolio identifies a well-diversified industrial stock set to track and outperform the XLI (its benchmark).

Industrial Sector return +10.59 overall
Image 4: Industrials-based strategy– captured since January 27, 2017 (covered during that week’s newsletter). Benchmark is XLI – Industrials select sector SPDR ETF. Past performance is no guarantee of future returns.
Past performance is no guarantee of future returns

Forecasting the Top 10 Positions in the S&P

Lucena’s Forecaster uses a predetermined set of 10 factors that are selected from a large set of over 500. Self-adjusting to the most recent data, we apply a genetic algorithm (GA) process that runs over the weekend to identify the most predictive set of factors based on which our price forecasts are assessed. These factors (together called a “model”) are used to forecast the price and its corresponding confidence score of every stock in the S&P. Our machine-learning algorithm travels back in time over a look-back period (or a training period) and searches for historical states in which the underlying equities were similar to their current state. By assessing how prices moved forward in the past, we anticipate their projected price change and forecast their volatility.

The charts below represent the new model and the top 10 positions assessed by Lucena’s Price Forecaster.

Forecasting the Top 10 S&P
Image 6: Default model for the coming week.

The top 10 forecast chart below delineates the ten positions in the S&P with the highest projected market-relative return combined with their highest confidence score.

Forecast Top 10 S&P: ANSS, BAC, CAT, CCI, COH, EXR, GD, LEN, PRU, WLTW
Image 7: Forecasting the top 10 position in the S&P 500 for the coming week. The yellow stars (0 stars meaning poorest and 5 stars meaning strongest) represent the confidence score based on the forecasted volatility, while the blue stars represent backtest scoring as to how successful the machine was in forecasting the underlying asset over the lookback period -- in our case, the last 3 months.

To view a brief introduction video of all the major functions of QuantDesk, please click on the following link:
Forecaster

Analysis:

The table below presents the trailing 12-month performance and a YTD comparison between the two model strategies we cover in this newsletter (BlackDog and Tiebreaker), as well as the two ETFs representing the major US indexes (the DOW and the S&P).

12 Month Performance BlackDog and Tiebreaker
Image 8: Last week’s changes, trailing 12 months, and year-to-date gains/losses.
Past performance is no guarantee of future returns.

Model Tiebreaker: Lucena’s Active Long/Short US Equities Strategy:

Active Long/Short US Equities Strategy
Tiebreaker: Paper trading model portfolio performance compared to Vanguard Market Neutral Fund since 9/1/2014. Past performance is no guarantee of future returns.

Model BlackDog 2X, Lucena’s Tactical Asset Allocation Strategy:

model portfolio performance compared to the SPY and Vanguard Balanced Index Fund
BlackDog: Paper trading model portfolio performance compared to the SPY and Vanguard Balanced Index Fund since 4/1/2014.
Past performance is no guarantee of future returns.

Appendix

For those of you unfamiliar with BlackDog and Tiebreaker, here is a brief overview: BlackDog and Tiebreaker are two out of an assortment of model strategies that we offer our clients. Our team of quants is constantly on the hunt for innovative investment ideas. Lucena’s model portfolios are a byproduct of some of our best research, packaged into consumable model-portfolios. The performance stats and charts presented here are a reflection of paper traded portfolios on our platform, QuantDesk®. Actual performance of our clients’ portfolios may vary as it is subject to slippage and the manager’s discretionary implementation. We will be happy to facilitate an introduction with one of our clients for those of you interested in reviewing live brokerage accounts that track our model portfolios.

Tiebreaker:

Tiebreaker is an actively managed long/short equity strategy. It invests in equities from the S&P 500 and Russell 1000 and is rebalanced bi-weekly using Lucena’s Forecaster, Optimizer and Hedger. Tiebreaker splits its cash evenly between its core and hedge holdings, and its hedge positions consist of long and short equities. Tiebreaker has been able to avoid major market drawdowns while still taking full advantage of subsequent run-ups. Tiebreaker is able to adjust its long/short exposure based on idiosyncratic volatility and risk. Lucena’s Hedge Finder is primarily responsible for driving this long/short exposure tilt.

Tiebreaker Model Portfolio Performance Calculation Methodology

Tiebreaker’s model portfolio’s performance is a paper trading simulation and it assumes opening account balance of $1,000,000 cash. Tiebreaker started to paper trade on April 28, 2014 as a cash neutral and Bata neutral strategy. However, it was substantially modified to its current dynamic mode on 9/1/2014. Trade execution and return figures assume positions are opened at the 11:00AM EST price quoted by the primary exchange on which the security is traded and unless a stop is triggered, the positions are closed at the 4:00PM EST price quoted by the primary exchange on which the security is traded. In the case of a stop loss, a trailing 5% stop loss is imposed and is measured from the intra-week high (in the case of longs) and low (in the case of shorts). If the stop loss was triggered, an exit from the position 5% below, in the case of longs, and 5% above, in the case of shorts. Tiebreaker assesses the price at which the position is exited with the following modification: prior to March 1st, 2016, at times but not at all times, if, in consultation with a client executing the strategy, it is found that the client received a less favorable price in closing out a position when a stop loss is triggered, the less favorable price is used in determining the exit price. On September 28, 2016 we have applied new allocation algorithms to Tiebreaker and modified its rebalancing sequence to be every two weeks (10 trading days). Since March 1st, 2016, all trades are conducted automatically with no modifications based on the guidelines outlined herein. No manual modifications have been made to the gain stop prices. In instances where a position gaps through the trigger price, the initial open gapped trading price is utilized. Transaction costs are calculated as the larger of 6.95 per trade or $0.0035 * number of shares trades.

BlackDog:

BlackDog is a paper trading simulation of a tactical asset allocation strategy that utilizes highly liquid ETFs of large cap and fixed income instruments. The portfolio is adjusted approximately once per month based on Lucena’s Optimizer in conjunction with Lucena’s macroeconomic ensemble voting model. Due to BlackDog’s low volatility (half the market in backtesting) we leveraged it 2X. By exposing twice its original cash assets, we take full advantage of its potential returns while maintaining market-relative low volatility and risk. As evidenced by the chart below, BlackDog 2X is substantially ahead of its benchmark (S&P 500).

In the past year, we covered QuantDesk’s Forecaster, Back-tester, Optimizer, Hedger and our Event Study. In future briefings, we will keep you up-to-date on how our live portfolios are executing. We will also showcase new technologies and capabilities that we intend to deploy and make available through our premium strategies and QuantDesk® our flagship cloud-based software.
My hope is that those of you who will be following us closely will gain a good understanding of Machine Learning techniques in statistical forecasting and will gain expertise in our suite of offerings and services.

Specifically:

  • Forecaster – Pattern recognition price prediction
  • Optimizer – Portfolio allocation based on risk profile
  • Hedger – Hedge positions to reduce volatility and maximize risk adjusted return
  • Event Analyzer – Identify predictable behavior following a meaningful event
  • Back Tester – Assess an investment strategy through a historical test drive before risking capital

Your comments and questions are important to us and help to drive the content of this weekly briefing. I encourage you to continue to send us your feedback, your portfolios for analysis, or any questions you wish for us to showcase in future briefings.
Send your emails to: info@lucenaresearch.com and we will do our best to address each email received.

Please remember: This sample portfolio and the content delivered in this newsletter are for educational purposes only and NOT as the basis for one’s investment strategy. Beyond discounting market impact and not counting transaction costs, there are additional factors that can impact success. Hence, additional professional due diligence and investors’ insights should be considered prior to risking capital.

For those of you who are interested in the spreadsheet with all historical forecasts and results, please email me directly and I will gladly send you the data.

If you have any questions or comments on the above, feel free to contact me: erez@lucenaresearch.com

Have a great week!

Erez M. Katz - Signature

Lucena Research brings elite technology to hedge funds, investment professionals and wealth advisors. Our Artificial Intelligence decision support technology enables investment professionals to find market opportunities and to reduce risk in their portfolio.

We employ Machine Learning technology to help our customers exploit market opportunities with precision and scientifically validate their investment strategies before risking capital.

Disclaimer Pertaining to Content Delivered & Investment Advice

This information has been prepared by Lucena Research Inc. and is intended for informational purposes only. This information should not be construed as investment, legal and/or tax advice. Additionally, this content is not intended as an offer to sell or a solicitation of any investment product or service.

Please note: Lucena is a technology company and not a certified investment advisor. Do not take the opinions expressed explicitly or implicitly in this communication as investment advice. The opinions expressed are of the author and are based on statistical forecasting based on historical data analysis. Past performance does not guarantee future success. In addition, the assumptions and the historical data based on which an opinion is made could be faulty. All results and analyses expressed are hypothetical and are NOT guaranteed. All Trading involves substantial risk. Leverage Trading has large potential reward but also large potential risk. Never trade with money you cannot afford to lose. If you are neither a registered nor a certified investment professional this information is not intended for you. Please consult a registered or a certified investment advisor before risking any capital.