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

Market Update

As momentum keeps building, this week saw the market reach several milestones: the Dow Jones Industrial Average closed at a new all-time high of 13,264.62 while the S&P 500 finished above the 1,500 mark for the first time since September 2000. Stocks started the week by falling Monday which marked the last day of April, as investors decided to book some of their profits following a strong month for stocks. The weakness did not last however, as the major averages quickly returned to their winning ways to post gains every remaining day of the week. Most of the action came Wednesday, after the Commerce Department announced that factory orders rose a better-than-expected 3.1% in March. The positive news helped alleviate concerns over a weak economy raised by last week's disappointing GDP report for the first quarter. Falling oil prices also helped stocks move higher, with the Nasdaq Composite gaining 1% on the day. The April employment report was released Friday and was positively received by investors: if the 88K increase in nonfarm payrolls was a bit short of expectations, the fact that hourly earnings only increased 0.2% versus the expected 0.3% helped calm inflation fears. Stocks again rose on the news, also supported by a 2% drop in oil prices and speculative reports that Microsoft may be actively trying to acquire Yahoo!.

The Nasdaq 100, S&P 500 and Russell 2000 respectively gained 0.25%, 0.38% and 0.77% on the week. All 3 indexes rest above both their 50-day exponential moving average (EMA) and 200-day EMA.

For its part, our World Index Ranking portfolio outperformed the US averages as it posted a 2.46% gain this week. The portfolio consists of the 5 top-ranked world indexes as of April 27, which marked the beginning of the current 4-week holding period.

Our current Buy signal remains in effect.

Trend Timing School

The derivative time bomb

If some of you have lingering nightmares about the derivatives and integrals endured in calculus classes, relax, this is about something else altogether, and much worse.

After reviewing the concept of leverage and various leverage instruments and techniques (see last week Trend Timing School, "Leverage beyond margin") we felt an obligation to look at the world of derivatives and the dangers that loom ahead. As investors we have the right and the duty to question any practice which potentially threatens our wealth. As a minimum we owe it to ourselves to be aware of the issues and the risks and act accordingly to protect against them.

We are not investment bankers or economists and cannot judge financial instruments and their respective merits and disadvantages, or their possible impact on the economy. For that we rely on the experts. For one, legendary investor Warren Buffet has warned repeatedly against derivatives over the last few years. He describes these increasingly complex and convoluted financial instruments as "time bombs" and "weapons of mass destruction" which not only present a "catastrophic risk" to their buyers and sellers, but to the economic system as a whole. You only discount warnings from the world's second richest man at your own peril.

According to Investopedia, a derivative: "... is a security whose price is dependent upon or derived from one or more underlying assets. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Most derivatives are characterized by high leverage.".

Derivatives have been around for decades and were originally designed and used by investors to hedge market risks, essentially as insurance against unwanted market movements. For example, a U.S.-based money manager investing heavily in the European stock market could take a hedge against possible weakness of the euro versus the U.S. dollar via leveraged foreign exchange contracts, and virtually eliminate the currency risk. Alas, derivatives have since become investments in their own rights with investment banks selling them by the billions to their clients in order to speculate on the future of anything from interest rates, foreign exchange, equities and commodities, all without buying the underlying investment. There are contracts on anything from the weather to who will be the next American Idol or President. Las Vegas has never seen gambling on such a scale.

The most recent report of the BIS (Bank for International Settlements) on OTC (Over-The-Counter) derivatives market activity places the global derivatives market at 370 trillion dollars. This is the total amount outstanding of all such contracts in the so-called G10 countries which curiously is made up of eleven industrial countries (Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Sweden, Switzerland, the United Kingdom and the United States). To place the size of the derivatives market in perspective, the total market capitalization of companies listed on its 54 member bourses reached $51 trillion at the end of January 2007 according to the World Federation of Exchanges. This means that the global virtual market for derivatives is worth over seven times the valuation of all real companies traded on major world stock markets! Just a short 8 years ago in 1998, the derivatives market was "only" $70 trillion.

Hedge funds have seen a meteoric rise in large part because of greed and how they are structured. The fund and the money managers are compensated in part by a flat assets-based fee typically in the 1% to 3% range, but more importantly on a percentage of gains achieved. Such performance fees are commonly in the 20%+ range and become an all consuming motivator for the mostly inexperienced thirty-something money managers running them. Here is the tradeoff they face: if the funds gambles work out they make a fortune, if they don't the clients lose their investment. With no personal downside there is no practical limit to the risk some of them are willing to take. Add to the mix the fact that the entire derivative sector is essentially unregulated and devoid of the extensive oversight and control the U.S. Securities and Exchange Commission (SEC) exerts on other markets, and we end-up with an explosive mix prone to extensive "innocent optimism", "human error and misjudgment", and ultimately "outright fraud" all of which have unexpected consequences and sooner or later lead to "accidents".

Derivatives are subdivided by broad risk categories and by far the largest segment representing about 70% of the whole are interest rate derivatives, followed by foreign exchange derivatives for about 10%. Credit default swaps and commodity contracts make up much of the rest. Equity linked contracts amount to less than 2% of total derivatives. While the basic contract types are well known, imagination is about the only limit as to how they can be structured. For example, Synthetic Collateralized Debt Obligations are a form of credit derivative. Rather than the traditional pools of assets such as bonds and loans, the pools of credit derivatives that back synthetic CDOs include instruments such as credit default swaps, forward contracts and options.

So how real and imminent is this threat? There have already been isolated cases in which derivatives have caused meltdown spirals for the companies involved, such as the well publicized demise of the Long Term Capital Management (LTCM) hedge fund in 1998. Most everyone remembers the downfall of Enron which collapsed in large part because of its fraudulent dealings in energy derivatives. Yes, these were isolated cases which have swiftly been contained. Since then, derivatives backed by other derivatives have become linked in such tangled International webs that no one really understands the extent of it. Risks are assumed that can only be truly quantified and measured years down the road. It is this global interconnection of contracts which has experts worried because the entire derivatives market is built like a castle of cards. They have been warning about scenarios in which the major world economies could spiral out of control. No one can predict for sure when the "big one" will hit the derivatives markets but there are many potential triggers: a war in Iran, a major terrorist strike on the U.S., an accelerated slump in the dollar, spiking inflation and many more.

In the unknown, the wise thing to do for us Trend Timers is to pull back from any investments in derivatives we do not fully understand and control, and that includes removing a lot of the excess leverage many of us still have. To protect against the indirect effects a derivatives crisis would have on the economy and the stock market, we can only rely on our trend following system to get us out of harms way if and when things really turn sour.

FAQ of the Week

Question: Why short QQQQ with the World Index Ranking?

When contemplating the World Index Ranking Long and Short strategy, many wonder why we recommend shorting the Nasdaq 100 ETF QQQQ instead of the top 5 indexes themselves. Yes, there are ways to short some of the world markets such as Japan which could be shorted via the UltraShort Japan ProFund UKPIX (double inverse), or options on EWJ, or futures on the Nikkei index or even options on the futures. But for the U.S. investor there is simply no practical way of shorting most countries.

Regardless of availability of shorting instruments, assuming that the top 5 ranked indexes are the ones that should be shorted during Sell signals would be a grave mistake. The World Index Ranking service grades stock markets by the strength of their momentum, and our backtesting has shown that holding the best 5 with a Buy and Rebalance strategy does better than the market even during bear markets. You never want to short the hottest markets. Conversely, we can also warn anyone now convinced they should short the 5 bottom markets instead that this would be an equally ill advised plan because the markets that have been down the most are typically the ones with the smallest remaining downside risk.

The timing component of the strategy is provided by our Nasdaq Composite index based Model. During Sell signals, our downside insurance, U.S. markets and other well correlated world markets have a strong probability of declining and we take shelter. Instead of gambling on which world markets are currently best correlated, we take the low risk approach of shorting the Nasdaq 100 which is by definition always well correlated with the Nasdaq Composite. It offers many shorting instruments starting with shorting the QQQQ itself, the inverse ETFs PSQ (-1x) and QID (-2x), as well as a full range of options and futures.

Warm wishes and until next week.

The TimingCube Staff