Signal Type	Trade Date	Return since issued
		World	U.S.
			Nasdaq 100 (QQQQ) Russell 2000 (IWM) S&P 500 (SPY)

Market Update

The main averages managed to post solid gains this week, with tech stocks leading the way. After an initial drop, markets rebounded Monday following the release of a better-than-anticipated ISM index of manufacturing activity for January. Stocks continued to climb Tuesday, helped by better-than-expected earnings reports from drug companies Merck and Schering-Plough and a 6.3% increase in existing home sales for December, a number that was significantly above projections. After an up-and-down session that left them mostly unchanged Wednesday, the main indexes resumed their advance the next day, buoyed by a rally in financial stocks on hopes that changes in the accounting rules that govern the sector would help large U.S. banks divest their bad assets. The Nasdaq Composite gained 2.1% during the session. The government released its January employment report Friday morning. As the economy continued to deteriorate, it showed that almost 600,000 nonfarm jobs were lost last month, sending the unemployment rate up to 7.6%. The dismal news could have triggered a stock sell-off, but investors instead decided to focus on the likely approval of the government's massive stimulus package and bank rescue plan. All major averages rallied as a result, with the S&P 500 posting a 2.7% daily gain.

For the week, the S&P 500 (SPY) and the Russell 2000 (IWM) respectively gained 5.01% and 5.58%. Both ETFs remain located below their 50-day and 200-day exponential moving averages (EMAs). They were outperformed by the Nasdaq 100 (QQQQ), which posted a 7.95% weekly gain as tech leaders were particularly strong. As a result, the ETF has now crossed back above its 50-day EMA but remains located well below its 200-day EMA.

For its part, our World portfolio posted a 5.31% gain this week. The portfolio consists of the 5 top-ranked world ETFs as of January 30, which marked the beginning of the current 4-week holding period. Please note that since we now have an active Cash signal, the World 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 ETFs, as the strategy calls for staying invested at all times. Please go to the "Our Service" page for all the details.

Our current Cash signal remains in effect.

Trend Timing School

How much leverage should I use on my investments?

Imagine you have the ultimate market timing system which tells you precisely when to be long and when to be short; why wouldn't you bet all of your money, and as much of someone else's money as they let you borrow? The main reason is that no one has found the ultimate market timing system yet - we humbly recognize that ours is not perfect and probably never will be. Still, many investors are attracted by the lure of higher potential profits associated with leverage. Leverage can be defined in the investing lingo as a factor by which market gains (and losses) are multiplied. In this article we will review the array of leverage instruments and techniques at our disposal, and compare their respective merits and weaknesses.

Before we get to the main topic we must deliver a public service message which is: not to use leverage beyond reason. As always we encourage strategies that place financial security first through balanced approaches. We are often tempted by the impressive long term return that can be achieved with a fully leveraged Long and Short strategy, but no one wants to look at the downside. How much drawdown can you take? With margin you theoretically stand to lose more than you invest. For the majority of investors we do not recommend leveraging more than 20% of their investment. A Long and Short with Margin strategy in contrast, if applied to your entire capital, represents 100% margin, 5 times more than we advocate. Moreover, many investments such as the top ranked World ETFs are typically volatile and risky enough without applying further leverage.

For those not familiar with margin investing we would suggest reading "Margin trading explained". For those in more of a hurry we quote:

"To understand how margin trading works, let's look at a specific example: if you have a margin account with $10,000 of your own money, you could borrow up to the same amount from your broker to purchase stock for a total portfolio of $20,000. That's what's called being on full margin because from your perspective you have borrowed a full 100% of your own capital. From your broker's point of view you meet the maximum 50% initial margin rule because you are on margin for 50% of your overall account value. If the stock you purchased has increased by 30% in value by the time you sell, your portfolio is now worth $26,000 and $16,000 of that is yours ($26,000 minus the $10,000 you borrowed from your broker). This represents a net gain of $6,000, or a 60% return on your $10,000 investment. Without the margin trade you would only have gained $3,000.

As with short selling there are costs, restrictions and risks. The costs are mostly in the form of broker fees and interest on the borrowed money. You will first need to open a margin account or convert an existing account depending on the broker. In addition to the maximum 50% initial margin rule discussed above, the SEC also defines a maintenance margin of at least 25%. Your broker may be more restrictive than that and require a maintenance margin of 30% or even 35%. The maintenance margin is the minimum account balance you must maintain before your broker issues a margin call. Whenever the equity in your account (value of the stock minus what you owe the broker) falls below the minimum maintenance amount (value of the stock multiplied by the maintenance margin) your broker will force you to either liquidate your stock position or add more cash to the account.

Using the previous example, if instead of increasing by 30% the stock you purchased loses 25%, the equity in your account would be $5,000 ($20,000 minus 25% = $15,000, minus the $10,000 you borrowed = $5,000). This $5,000 is about 33% of your $15,000 portfolio value, which would satisfy a maintenance margin requirement of 30%, barely."

To add to the complications and limitations of margin trading, it is prohibited in qualified retirement accounts such as IRAs. Luckily, there have been alternatives available and the table below compares them.

Leverage instruments and techniques

	Maximum  leverage	Risk	Cost	Ease of use	Other issues
Margin	2x	High	High	Low	Not allowed in IRAs
Leveraged mutual funds	2.5x	Medium	Medium	High	Slippage (end of day trading) Negative compounding
Leveraged ETFs	up to 3x	Lowest	Low	Highest	Negative compounding
Options	10x+	Highest	Low	Lowest	Not allowed in IRAs by certain brokers

Sophisticated investors have always exploited options to create leverage. Because of their complexity and leveraging power options can be deadly for the non-initiated, which is why they earn the highest level of risk of all the alternatives. Yet, in the hands of an expert, they can yield actual risk levels substantially lower than other approaches. A series of four Weekly Updates from June 27 to August 8, 2008 (6/27/08, 7/11/08, 7/25/08, 8/8/08), described an option strategy which can achieve performance comparable with that of equity based strategies with a much smaller portion of capital at risk (say about 10%). This means options let you apply much more leverage than margin does, and by applying them wisely your overall market exposure can be decreased substantially.

For a long time, the only way to simplify all of this and side-step many of the issues, and circumvent the no margin trading in retirement accounts rule, was to instead use the leveraged mutual funds that seek to achieve the same results as margin trading. Fund families such as ProFunds and Rydex have been around for years and have made Long and Short strategies practical for hundreds of thousands of investors.

Even easier to use these days are leveraged and inverse ETFs. They go further in addressing investor concerns than any of the alternatives. They are by far the simplest to use and trade like stock at any time during the day. Their lower costs and risks make them the hands-down winners for most investors. Plus these days there are plenty to choose from, in all flavor of leverage like with the DirexionShares family that is now offering several Bull/Bear 3x ETFs (see the FAQ below for more details). The only remaining drawback is the negative compounding effect which under certain market conditions will negatively impact performance (See our article from two weeks ago: "What to expect from Inverse and Leveraged ETFs?").

As a final note, we want to remind everybody that leveraged ETFs are powerful, and as such that they need to be used with caution. By committing only a fraction of his/her capital, one could expect to match the performance of a strategy that would otherwise have exposed the whole portfolio.

FAQ of the Week

Question: What are the latest leveraged ETFs?

Here is a short list of some of the latest index leveraged and inverse ETFs that we are aware of. This is certainly not exhaustive as the Financial sector is flooding the market with new ones almost on a daily basis:

ETF Long / Short	Reference Index	Leverage	Fund Family
QLD/QID	Nasdaq 100	2x	ProShares
DDM/DXD	Dow Jones Industrial	2x	ProShares
SSO/SDS	S&P 500	2x	ProShares
UWM/TWM	Russell 2000	2x	ProShares
BGU/BGZ	Russell 1000	3x	Direxion
TNA/TZA	Russell 2000	3x	Direxion
MWJ/MWN	Russell Midcap Index	3x	Direxion

Warm wishes and until next week.

The TimingCube Staff