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

Market Update

Following the announcement by Bank of New York and Mellon Bank of a $16.5 billion merger, stocks rallied Monday, sending the Russell 2000 to a new all-time closing high. Tuesday saw the release of the ISM index of service activity for November, which rose to 58.9 from the 57.1 October reading. The number was better than expected and helped alleviate fears of a slowing economy induced by last week's disappointing ISM manufacturing report. After a positive start Thursday, the major averages retreated to close lower on the day, as investors locked in profits ahead of Friday's employment data. The jobs report ended up being a strong one, as the Labor Department announced that non-farm payrolls increased by 132,000 in November, better than the 105,000 gain economists had predicted. Hourly earnings only rose 0.2%, showing that wage growth should not add to inflationary pressures. The main indexes moved higher on the news to close the week on a positive note.

The Nasdaq 100, S&P 500 and Russell 2000 respectively gained 0.62%, 0.94% and 1.46% on the week. All three indexes remain located above both their respective 50-day and 200-day exponential moving averages (EMAs).

For its part, our World Index Ranking portfolio gained 2.02% this week. The portfolio consists of the 5 top-ranked world indexes as of 11/10/2006, which marked the beginning of the current 4-week holding period. Please note that the World Index Ranking portfolio is being rebalanced today, as the current 4-week holding period is now over.

There is no change as far as our Model is concerned and our Buy signal remains active.

Trend Timing School

Market indexes, broad versus narrow

Just like technical analysis on which it is based, trend following can be adapted to just about anything, over any timeframe and anywhere. There are even people using it to day-trade pork belly futures. Trend Timing is a very specific variety of trend following, and understanding what it is helps us keep a clear vision of how our investment system works. We focus on the stock market, not commodities, interest rates or real estate. The time horizon of the trends we chase is months, not hours, days or weeks. Our Model is after the broad market trend as represented by market indexes, not an individual stock, segment or sector. In today's highly interconnected world, broad market trends are worldwide phenomena and disconnects do not last long. The catch is that all stock market indexes are not created equal.

It is important to distinguish the broad market trend which our signal is based on from the cornucopia of stock market indexes in existence and the investment vehicles that track them. Our Model has always been driven by the Nasdaq Composite index because it is very broad, its characteristics lend themselves to detecting trends better than others, and it has been very representative of the direction of the stock market at large. Yet, nothing is perfect. While the Nasdaq Composite holds all the stocks traded on the Nasdaq exchange, about 3,400 domestic and international companies, the industry distribution is somewhat skewed. The top three industry sectors in the index are Computer Software & Hardware (over half of the index), Health Care and Financials. A point of comparison is the Wilshire 5000 which is seen by many as another good "total market" index, but it has an industry composition that is different from that of the Nasdaq Composite. Its largest industry sectors are Materials & Services, Consumer Non-Durables, and Financials.

To show the diversity of stock market indexes, from the literally hundreds of U.S. indexes we have listed a representative sample in Table 1 below. We classified them as "Broad Market", by the size of companies they include, or by the style (growth or value) they focus on. And we did not even get into industry sectors which constitute an entirely separate universe which would deserve a dedicated article.

Table 1: Selected U.S. Market Indexes by segment and style

Index Ticker	Index Name	Long ETF Ticker	Short ETF Ticker
Broad Market Indexes
^IXIC	Nasdaq Composite	ONEQ	---
^NYA	NYSE Composite	NYC	---
^RUA	Russell 3000	IWV	---
^SPSUX	S&P Composite 1500	ISI	---
^DWC	Dow Jones Wilshire 5000	VTI	---
Large Cap Indexes
^DJI	Dow Jones Industrials	DIA DDM (2x)	DOG DXD (-2x)
^NDX	Nasdaq 100	QQQQ QLD (2x)	PSQ QID (-2x)
^NUS	NYSE 100	NY	---
^RUI	Russell 1000	IWB	---
^OEX	S&P 100	OEF	---
^GSPC	S&P 500	SPY SSO (2x)	SH SDS (-2x)
Mid Cap Indexes
^MID	S&P 400	MDY MVV (2x)	MYY MZZ (-2x)
Small Cap Indexes
^RUT	Russell 2000	IWM	---
^SML	S&P 600	IJR	---
Growth Style Indexes
^SKX	S&P 500 Growth	IVW	---
Value Style Indexes
^SZX	S&P 500 Value	IVE	---

Yet another way in which indexes differ is the way they are calculated. Most indexes are so-called market cap weighted, which means that the larger companies exert more influence over the index than the smaller ones. Because of this design flaw there have recently been efforts to create "equal weight" indexes, such as the Nasdaq 100 equal weighted index (^NDXE), which give every company, large or small, the same exact weight. These equal-weight indexes, and the investment vehicles which track them, are expected to perform better over time on the basis that small companies outperform the large ones in the long run. That is the theory anyway, and only time will tell.

In the first approximation, the investment that is best correlated with our signal is the Nasdaq Composite itself, yet we have long recognized the diversity of indexes and the opportunity they represent. Despite their radically different compositions most indexes are quite well correlated, meaning they generally move in the same direction, but their relative strength varies over time. Going through repeating economic and market cycles, different segments of the market take turns in leading. While, on average, one would do well by simply investing in the Nasdaq Composite which drives the trend, most investors have a desire to beat the averages and the market at large. For this very reason we have been reporting on the Nasdaq 100 , Russell 2000 and S&P 500 indexes as three distinct destinations for our investment dollars. As the world of ETFs grows in variety and richness we steadily expand the "What to trade?" section of the "Resources" page.

The challenge is to identify which of these indexes and investment options are likely to perform best next. The "Performance with individual security or index" section of the Results page is a handy tool to analyze how a particular index or equity has performed with our signals over various periods of time. While longer term results provide a good handle on the level of correlation, selecting shorter time frames gives us a feel for momentum and actual performance in the current environment.

To simplify the selection process even further we introduced the World Index Ranking service. Even if one focuses exclusively on the U.S. stock market, the rankings reveal the momentum of seven widely accepted domestic indexes (Nasdaq Composite, Dow Jones Wilshire 5000, Dow Jones Industrials , Nasdaq 100 , S&P 500 , S&P 400 , and Russell 2000 .)

The bottom line is that the more you stray from the broad index which is used to establish the trend, the higher the chances that the correlation will decrease (see "The correlation coefficient"), but the availability of so many indexes and their tracking ETFs provides the more aggressive Trend Timer an opportunity to achieve higher returns than the market as a whole.

FAQ of the Week

Question: What are short and leveraged ETFs?

Traditional index ETFs have as objective to match the daily performance of the index that they track, but a new generation of ETFs provides the ability to approximate the effects of shorting that index and/or trading it on margin. Since you can buy and sell these short and leveraged ETFs like any other stocks, they help simplify trading, lower costs, and also help circumvent the "no shorting" and "no margin" trading restrictions placed on most retirement accounts. The table below provides a simple explanation of what the four categories of ETFs actually do:

Table 2: Daily performance objectives of various types of ETFs

Regular ETF	1x
Leveraged ETF	2x
Short ETF	-1x
Short and Leveraged ETF	-2x

Since we first announced the availability of these innovative ETFs in June (What are ProShares ETFs?) and July (What is an UltraShort ETF?), everything has been quiet on the news front, but the trading activity has picked up at a brisk pace. While the liquidity of ETFs is not as critical an issue as it is with individual stocks (see "Is it risky to use illiquid ETFs?"), we need to be vigilant and avoid any security with large spreads between bid and ask prices. Therefore, it is nice to see that the volume of most of these new short and leveraged ETFs has already risen to levels where it should not be much of a concern anymore, with spreads down to the 4 to 6 cents range.

Interestingly, the short and leveraged types are seeing volumes that are routinely four to five times those of the long and leveraged ones. This is no doubt due to the rapid acceptance of these investment vehicles for hedging purposes and to replace more tricky and cumbersome options. The stand out in terms of market acceptance is the UltraShort QQQQ ProShares which strives to deliver double the inverse of the Nasdaq 100 index. Chart 1 below plots the meteoric rise of QID to an average daily volume of about 2.8 million shares barely 5 months after inception. Its spread is now routinely down to 1 cent, as low as the most traded ETFs like QQQQ.

Chart 1: QID daily volume since inception

Warm wishes and until next week.

The TimingCube Staff