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

Market Update

After a 2-month rise, stocks finally gave up some ground this week as all major indexes retreated over the five-day span. It does not come as a surprise that stocks were due for a break after their strong performance of late. Markets simply cannot advance indefinitely and pullbacks such as the one we experienced this week are not only normal, but ultimately healthy as they remove some of the complacency that has built up in the markets. Most of the negative action took place on Wednesday: all indexes fell sharply as illustrated by the Nasdaq Composite's 3% daily loss. The weakness was largely caused by a disappointing retail sales report for April, as the government announced a 0.4% drop in sales instead of the flat reading analysts were expecting. Investors faced more bad news the next day as jobless claims came in higher than expected and Wal-Mart released an uninspiring earnings report. Yet, stocks managed to reverse course to recoup a good chunk of Wednesday's losses. The main averages finished the week on a negative note as they lost ground again Friday, albeit on noticeably low volume. The market was affected by weakness in financials and a drop in energy stocks caused by lower oil prices. Two reports released Friday painted the picture of an economy that is still decelerating, but at a slower pace: consumer prices were flat in April and manufacturing activity in the New York area contracted less than anticipated last month. Meanwhile, the University of Michigan index of consumer confidence hit its highest level in 8 months. This could result in increased consumer spending in the coming months, which would of course provide a much-needed boost to the economy.

The Nasdaq 100 (QQQQ), S&P 500 (SPY) and Russell 2000 (IWM) respectively lost 2.51%, 4.59% and 6.37% on the week. All 3 ETFs are located in-between their 50-day and 200-day exponential moving averages (EMAs).

For its part, our World portfolio posted a 4.13% loss this week. The portfolio consists of the 5 top-ranked world ETFs as of April 24, which marked the beginning of the current 4-week holding period.

Our current Buy signal remains in effect.

Trend Timing School

Market Equilibrium

There are many interesting theories in the financial and investing worlds but few are as fervently defended, and disputed, yet as stubbornly enduring as the Efficient Market Hypothesis (EMH) and its predecessor the Random Walk Theory.

In summary, EMH is an investment doctrine that postulates that any attempts at beating the market are doomed because stock prices already reflect all relevant information. EMH states that there is no link between past prices and future prices, and no relationship between the price of one stock and that of another stock. Past movements or trends cannot be used to predict future behavior. The chance of a stock's price going up in the future is the same as it going down. About the only concession made by EMH proponents is that they recognize that over the long-term stocks exhibit an upward trend.

There cannot be any skills involved in buying or selling stocks because it is a pure game of chance. There is no such thing as an undervalued stock because that information is widely known and instantly rectified. No investor can have an edge in spotting a stock with a better gain potential or in identifying a trend because no one has access to information that is not already available to everyone else.

Not surprisingly, this purely theoretical concept was conceived in academia and is backed by mountains of research, books and thesis galore. The efficient market idea originated in the 1950s with Maurice Kendall and got developed further in the 1960s by Eugene Fama. The theory gained a lot of popularity in 1973 when Burton Malkiel published "A Random Walk Down Wall Street " which to this day is high on the list of top-selling finance book. Most of the evidence in favor of the hypothesis is circumstantial statistics showing that most investors and most mutual funds fail to beat the markets. Since Wall Street is founded on analysis and stock picking it is quite surprising to see how popular EMH has been. Maybe it has to do with the fact that the biggest beneficiary of EMH thinking is the Buy and Hold strategy. If you have no chance at beating or timing the market you might as well stop wasting your time trying!

Well, as Trend Timers you can imagine that we are not exactly fervent supporters of the EMH philosophy. And since EMH declares both fundamental and technical analysis futile and obsolete, we have a lot of prestigious company in opposing it.

Empirical evidence against EMH can be found in the fact that there are well known investors (e.g. Warren Buffett) that have beaten the market with techniques that are not supposed to work, consistently and over long periods of time. There are portfolio managers and mutual funds that year after year have better performance than others. How can this be when the efficient market is purely random? Anyone looking at charts comparing various stocks and markets (see for example our charts in the June 11, 2004 Trend Timing School) can see that there are very strong relationships between stocks, and that price movements are very far from random.

An EMH paradox is that the profit-seekers and strategies that believe in and want to exploit market inefficiencies and temporary anomalies (which supposedly cannot be done) are in fact the stated forces that cause the markets to become efficient.

In the advanced information technology age we live in, more information is readily available in quasi real-time to more people than ever before. It is not just news or stock quotes, but just about anything about companies, politics, or the economy is available at our fingertips. With such superior communications the markets should be more efficient than ever.

The primary argument against EMH from technical analysts is that many investors base their expectations on information about the past and study the same technical indicators. It is then logical to suggest that past prices do have an influence on future prices. Some even suggest that technical indicators act as self-fulfilling prophecies because they are followed and trusted by so many.

Probably the major flaw in EMH, in our opinion, is that stock prices are not set by a fixed computation of all the data available but by how investors perceive this information. Human psychology is not easily reduced to models and constants. Perceptions change a lot from one individual to another and they can change rapidly. The great tech bubble of the late 1990s or more recently the financial collapse that we have been through last year are perfect examples of how market valuations can get totally out of whack, with the "efficient market" failing to correct monstrous anomalies for prolonged periods of time. Despite the fact that all the information about the outrageous market over-valuation was available to everyone, the market was not efficient, and investors that bet that it would all come crashing down were handsomely rewarded.

Investors are very different from one another. They do not all look at information the same way, or at the same information. Some have access to or can afford better research and smarter analysts than others. Not everyone's risk tolerance is the same. Some bail out at the first sign of trouble, others can take the rollercoaster ride all the way down. Not to mention the diversity in term of time objective among people. A day trader will act quite differently from a long term investor with each of them possibly moving the market in opposite directions from time to time.

In conclusion we firmly believe that past market behavior has an impact on the future because of investor psychology. This is why our Model relentlessly looks for what the market is telling us, and once the trend is clear, we simply follow.

 
A Random Walk Down Wall Street: Completely Revised and Updated Edition
A book by Button G. Malkiel

FAQ of the Week

Question: Should I rebalance my portfolio to equal size positions?

With the World ETF Ranking system we recommend investing in the 5 ETFs corresponding to the Top 5 world indexes, and when you get started this means applying 1/5^th (20%) of the amount set aside for this investment strategy to each of the 5 positions. Due to different returns for the respective markets the 5 positions will grow at different rates, and when time comes to rebalance to the latest Top 5, you may wonder if it is important to also rebalance to equal size positions.

For the results we track and report on our Web site to be easily understandable and verifiable, our calculations always start a new 4 week period with equal size positions. For the investor however, there is no need to match position sizes every rebalancing cycle. Since we enjoy a low periodic turnover of only 20% (meaning that on average only one of the 5 positions changes every 4 weeks), we favor less trading rather than more. Only when positions really become too dissimilar is there a need to equalize position sizes. Where you draw the line is a personal decision each of us has to make. It is ultimately a tradeoff between maximizing returns and lowering risk through diversification. The whole premise of the momentum based World ETF Ranking system is to cut the weaker positions and letting the winners run. Trouble is that once your winning position grows to the point where instead of representing the nominal 20% of your portfolio it becomes 40%, 50% or more, the concentration in one market becomes more exposure than reason would dictate.

Warm wishes and until next week.

The TimingCube Staff