Signal Type	Trade Date	Index	Return since issued
		Nasdaq 100
		Russell 2000
		S&P 500

Market Update

Stocks posted modest gains the first two days of the week, as investors looked ahead to the Fed's decision on interest rates. As many had expected, the central bank announced Wednesday that it was lowering the funds rate by half-a-point to 3%. Coupled with the surprise three-quarter-point cut announced last week, this marks the most aggressive move by the Fed to slash rates in over 25 years. In the accompanying statement, the central bank expressed concerns about the ongoing credit crunch affecting the financial sector and the continuous weakness in the housing market. It also left the door open for more rate cuts should the economy continue to deteriorate. Stocks initially rallied after the Fed's announcement, but the gains had disappeared by session's end. The GDP report was also released Wednesday: it showed that the economy only grew by 0.6% in the fourth quarter, a number that was much weaker than expected. After opening lower Thursday, stocks reversed course to post solid gains. On Friday, the Labor Department released the employment report for January: the economy lost 17,000 jobs last month instead of creating 70,000 as had been expected. This marks the first contraction in the labor market in more than four years. The manufacturing sector did not experience such weakness last month, as the ISM announced that its index of manufacturing activity had reached 50.7 from 48.4 in December. Ignoring such conflicting economic news, investors decided to bid stocks higher after cheering the announcement by Microsoft that it intends to buy Yahoo! for $31 a share. The Internet company's stock price surged almost 50% on the day and over 400 million Yahoo! shares were exchanged, about ten times the normal volume.

The Nasdaq 100 closed the week with a solid gain of 3.69%. The S&P 500 and Russell
2000 did even better, finishing 4.87% and 6.08% higher, respectively. Despite this week's good showing, All three indexes remain located below both their 50-day and 200-day Exponential Moving Averages (EMAs).

For its part, our World Index Ranking underperformed its U.S. counterparts this week with a 0.48% loss. The portfolio consists of the 5 top-ranked world indexes as of January 4, which marked the beginning of the current 4-week holding period. The World Index Ranking portfolio is being rebalanced today, as the current 4-week holding period is now over. Please note that since we now have an active Sell signal, the World Index Ranking approach calls for selling your holdings if you follow the "Long Only" or "Long and Short" strategy. Only if you follow the "Buy and Rebalance" strategy should you remain invested in the top 5 indexes, as the strategy calls for staying invested at all times. Please go to our "Strategies" page for all the details.

Our current Sell signal remains in effect.

Trend Timing School

Cap-weighted indexes to the fore

Most popular indexes, like the S&P 500, Nasdaq 100 and Russell 2000, are so-called capitalization-weighted or simply cap-weighted, which means that the companies constituting the index are represented as a function of their respective size, the largest weighing the most. To illustrate how top-heavy these indexes really are, the top 10 companies in the S&P 500 represent over 22% of the index. All of this is great during periods like the late 1990s when large cap stocks were hot, but not so good when investors have preferred the prospects of smaller companies, as they have now done for years. This is why people invented equal-weighted indexes, and ETFs that track them, which give every stock in the index the same importance, and greatly favors smaller stocks.

Since we first introduced equal-weighted index ETFs (see the August 19, 2005 Trend Timing School article), they have become all the rage, and nearly a dozen different funds are available today. The main reason for their popularity is that they have outperformed their cap-weighted counterparts for years. Looking at Chart 1 below, from 2003 to early 2007 the Equal-Weight S&P 500 index almost doubled the return of the regular S&P 500 index. What this really means is that the smaller companies in the index performed substantially better than their larger counterparts, and anyone investing in the equal-weighted ETF (RSP - the Rydex S&P Equal Weight fund) has done proportionally better than SPY investors.

Chart 1: Equal-weight indexes lead from 2003 to early 2007



The early part of 2007 saw an important change, one that only happens once every economic cycle, with the larger capitalization indexes regaining the upper hand. Much as we saw with the small cap Russell 2000 which led the way for years only to fade badly in 2007, the cap-weighted versus equal-weighted comparison tells the tale. As illustrated in Chart 2 below, for the last year, the cap-heavy index is ahead, although both versions of the S&P 500 are in the red for that period. We are using the S&P 500 index as the example because other equal-weighted indexes such as the Nasdaq 100 Equal Weighted index have not been around long enough, but for the most recent period, the same observation applies with the cap-weighted outperforming the equal-weighted index.

Chart 2: Cap-weighted indexes lead since early 2007



This is all part of the intertwined economic and market cycles going from boom to bust, to recovery again. In the process, different segments of the economy take turns to shine at successive stages of the cycle. Towards the end of the cycle, where we currently are, the risk and volatility of smaller stocks is shunned for the relative safety of large established companies. Investors sense that if the U.S. is slipping into a recession, the larger companies which generate an important part of their business and profits overseas, and further benefit from a weakening dollar, will weather the decline better than smaller competitors which are more vulnerable to the local economy. With deteriorating market conditions comes the proverbial flight to safety.

This can be viewed even better by comparing market capitalization focused investments such as the following 4 ETFs, and their one-year returns as depicted in Chart 3:

• Large cap: QQQQ - PowerShares QQQ fund
• Mid cap: MDY - MidCap SPDRs fund
• Small cap: IWM - iShares Russell 2000 Index fund
• Micro cap: IWC - iShares Russell Microcap Index fund

Chart 3: One year fund returns, by market capitalization



The bottom line is that, just as there has been a shift away from value to growth type stocks, there has been a shift from small to large capitalization issues, as is also clearly reflected in the World Index Ranking. Since we are currently not recommending investing long in any of the U.S. market segments (we have an active Sell signal and, for those following the World Index Ranking "Buy and Rebalance" strategy, there is no U.S. index in the Top 5), this information is not directly actionable. Shifts between market capitalization segments do not play any role in our Model but the primary reason we are very much interested in them is that they mark the steps through the cycle and provide added confirmation that we have indeed entered the contraction phase.

FAQ of the Week

Question: Why is buying PSQ better than shorting the QQQQ, and buying QID even better?

Since their introduction in 2006, we have recommended buying inverse ETFs as a better alternative to shorting. For the Nasdaq 100 index, this means the Short QQQ ProShares fund PSQ (-1x), and the double inverse exposure UltraShort QQQ ProShares fund QID (-2x). The traditional shorting of the QQQQ was fine, outside of retirement accounts, except for one big detail: margin interest. For the entire time you are short, and your broker loans you the shares you sold short, he also charges you interest which at the moment is in the 9% range. The 0.95% expense ratio of the inverse ETFs is a much better deal, and it helps sidestep all the hassle and risks of shorting.

OK, so now we know it is financially advantageous to buy PSQ instead of shorting QQQQ, but why would buying QID be better? The main reason, lower costs, is revealed in the comparison Table 1 below. We do not recommend investing on margin or taking a leveraged position, but instead of buying a given sum of PSQ we suggest buying one-half that sum of QID, for the same resulting leverage. Because the leveraged funds are used so much more as hedges by institutional investors, the higher trading volumes narrow the spread (the difference between the bid and ask prices). There is currently a difference of about 5 cents between PSQ and QID spreads. While 5 cents does not seem like much, for someone trading larger positions this cost differential can add-up over time. And you still have the other half of the cash which you can park in an interest bearing money market fund.

Table 1: Comparing leveraged and unleveraged inverse ETFs

Ticker	PSQ	QID
Name	Short QQQ ProShares	UltraShort QQQ ProShares
Objective	-1x Nasdaq 100	-2x Nasdaq 100
Net Assets	$67.89M	$1.26B
Average daily volume	142,114	32,832,700
NAV	$62.00	$50.21
Spread	$0.06	$0.01
Expense ratio	0.95%	0.95%

One last word of caution regarding these leveraged investment vehicles: negative compounding. While these index funds generally achieve their daily performance objectives (double or double the inverse return of the index) very accurately, during trendless market phases when an index mostly bounces around, the leveraged funds will steadily lose ground and under perform their indexes. For more details on this read "Do leveraged ETFs suffer from negative compounding?".

Warm wishes and until next week.

The TimingCube Staff