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

Market Update

It has been a very quiet week on Wall Street as the main indexes were little changed over the 5-day span. Stocks showed their resilience Monday as an afternoon rally erased most of earlier losses, allowing the Nasdaq Composite to recover from a 1.7% intraday deficit. After the close, Texas Instruments said that demand for semiconductors is improving and boosted guidance for the current quarter. The news helped technology stocks outperform during Tuesday's session, yieding the tech-heavy Nasdaq Composite a 1% gain. Financial stocks were little changed despite the announcement by 10 major banks that they are ready to repay $68 billion the government had lent them as part of the TARP plan. Fears of inflation and higher interest rates caused the main averages to drop for most of Wednesday's session but a late-day rally allowed stocks to retake much of the lost ground. The turnaround occurred after the release of the Fed's beige book showed that the deterioration of business activity is abating. In other economic news, the government said Thursday that May sales increased by 0.5% over April numbers and that weekly jobless claims came in lower than expected. Stocks finished the day with modest gains before an uneventful session Friday saw the main indexes remain almost unchanged. The Dow Jones Industrial Average's modest 0.3% daily gain was still good enough to push the index into the black for the year.

The Nasdaq 100 (QQQQ) and Russell 2000 (IWM) respectively lost 0.35% and 0.79% on the week, while the S&P 500 (SPY) did slightly better with a 0.56% gain. All 3 ETFs remain located above both their 50-day and 200-day exponential moving averages (EMAs).

For its part, our World portfolio posted a 0.69% loss this week. The portfolio consists of the 5 top-ranked world ETFs as of May 22, which marked the beginning of the current 4-week holding period.

Our current Buy signal remains in effect.

Trend Timing School

How to build your portfolio

In our recent article on "Managing your money" (weekly update sent on 5/29/2009) we enumerated the key activities involved such as setting objectives, the selection of strategies, and risk/reward management. Another critical task mentioned was portfolio allocation. Our portfolio is simply the group of all our assets, and a sad reality is that most of us never consciously think about and select the asset allocation that makes the most sense for us. As life happens we somehow end up with a collection of assets, and the mix is most likely not optimal.

For example, few people ever make the conscious decision of investing 20%, 30% or more of their assets (together with more borrowed money) in real estate. Yet that is exactly what most home owners do. Yes, we all need a place to live, but in certain areas and during certain periods, real estate can be a lousy investment. Many of us, after a heavy down payment and mortgage payments, feel that after all these years this money invested in the stock market would have grown to much more than the price of our home. On the other hand there are also many who have refinanced their homes (with subprime loans for some of them!) and taken out their equity to spend it on SUVs and other ephemeral goods, and who will probably soon regret not having kept that "real estate allocation". But we digress.

Before getting into allocation proper it might be useful to ask why we need asset diversification in the first place. Simply put, diversification is the key ingredient in any risk management strategy, and we have been taught not to place all our eggs in one basket. The idea behind asset diversification is that non correlated asset classes do not go through market cycles together and that the losses in one class will be offset by gains in others, thus reducing overall portfolio risk.

Yes, by necessity we are all involved in asset allocation in order to best serve our specific circumstances and the need to satisfy different and sometimes conflicting objectives. For example, anyone of working age should save and set aside a safety buffer in cash or other liquid and readily accessible vehicle as contingency for a job loss. How much you set aside depends on numerous personal factors such as being single or providing for a family, years to retirement, your spending habits, how long a period of time you estimate could be required to find another job, etc. Other commonly accepted asset allocation strategies would be for someone in their younger earning years to assign a large percentage of assets to equity investments for long term growth and a small fraction to fixed income, versus a retiree who would reverse that distribution to maximize income generation and limit risk. This type of asset allocation is justified and is a must for everyone.

The amount of wealth we have can also dictate or at least curtail our allocation strategy choices. For example a retiree with just enough money to generate the income necessary for living cannot take any risks and is forced to assign everything to income generating investments. A wealthier retiree with a bigger cushion is likely to be more aggressive with his/her investments, be allocated more heavily into stocks and be willing to accept the associated risks to their capital. Wealthier investors are also more likely to allocate a portion of their portfolio to other asset classes such as collectibles (fine arts, jewelry, etc.), commodities, and precious metals.

The aspect of asset allocation we generally take exception to is the part that relates to the moneys we have left after the safety net, the income generation requirements and other necessities have been taken care of. It is how we allocate the money we are ready to put to work on our long term wealth building endeavors. For that portion of their portfolio, buy and hold investors use asset allocation as a risk management technique. Diversification has always been a vital corollary of buy and hold investment strategies. The theory is that by holding on to stocks through thick and thin you need to reduce how much of your portfolio is exposed to that downside risk. You place the balance in other assets such as income generating investments which help offset losses in equities during downturns and bear markets.

This view has permeated much of the financial industry. A good example of this is found in the numerous "asset allocation calculators" or other "portfolio management tools" available from various sources. Their questionnaires require personal information such as age, risk tolerance, investing experience, etc. The output invariably includes a pie chart with colored slices proportional to the percentage allocated to each asset class. If you use your broker's tools the asset classes are likely to be restricted to investments they offer, and typically includes:

• Large cap equities
• Small cap equities
• International equities
• Fixed income
• Cash or equivalent

The flip side of such diversification and traditional asset allocation is that while it softens the effects of losses in some asset classes, it also averages down your portfolio's return. The returns of the best performing assets are guaranteed to be watered down by the others. As Trend Timers we do not see how taking a position in bonds, for example, is proper protection against a severe correction or bear market. Yes, we always recommend against non-diversified investments, single country or currency approaches, but we first and foremost do not recommend holding a long equity position through a severe down turn.

This is why we have always preferred our asset allocation dynamic and strategic rather than static. We are invested in stocks during all meaningful up trends, and not invested in stock (or short the stock market) during the larger corrections and bear markets. In addition, the World ETF Ranking pinpoints the markets with the strongest momentum and the most likely to outperform. Thanks to these directional and targeting indicators, however imperfect, we can lean towards the "concentration of force" principle instead of averaging down with fixed asset allocations.

FAQ of the Week

Question: What is the impact of currency movements over the valuation of international ETFs?

Currency fluctuations affect both the returns and the volatility of international investments, including international ETFs.

For a U.S. investor, it is the relative valuation changes between the U.S. dollar and the local currency in the country you invest in which matter. Relative currency valuations also explain some of the differences observed between international stock market indices and the ETFs that track them. A stock market index is calculated on the basis of the price of all its component stocks in local currency, and is never converted or traded. That international index will only reflect equity gains or losses, nothing else. An international ETF on the other hand is an international investment which is traded in U.S. dollars on a U.S. stock exchange. The valuation of the ETF begins much the same way as the international index, on the basis of the price of all its component stocks in their local currency, but then it gets converted into U.S. dollars.

Thus, the total return of the investment when measured in U.S. dollars is equal to the equity returns in that particular country times the currency return.

As always, a picture is worth a thousand words. Looking at Brazil and Chart 1 below as an example, we can see that over the last 3 months the Brazilian Real to U.S. dollar exchange rate (Yahoo!Finance ticker BRLUSD=X) has gained about 20%, which means that the U.S. dollar lost 20% of its value against the Brazilian currency during this short period. This gain in value of the Brazilian Real over the greenback is also reflected in the share price of the Brazilian ETF which has outpaced the index it is tracking, the Sao Paulo Bovespa index. There are other differences between the ETF and the index, such as the fact that the ETF actually follows another index, the MSCI Brazilian Index, but the currency fluctuations are the largest contributor to the discrepancies. It is clear from the graph below that the Brazilian ETF combines the growth of the Brazilian market and the rise of the Brazilian currency against the US dollar: A double win for us!

Chart 1: Currency impact on international ETF performance (Brazil example)

EWZ = iShares MSCI Brazil ETF

^BVSP = Bovespa Brazil index

BRLUSD = Brazil Real Vs US$

The point is that you can observe the currency relationship with all country/currency combinations. Had you looked at Japan instead of Brazil, you would see that the U.S. dollar stayed about flat in value compared to the Japanese Yen (Yahoo!Finance ticker JPYUSD=X) over the last 3 months, and that accordingly, the Japanese ETF stayed in-line with the Nikkei 225 index.

For subscribers now scratching their heads wondering if they need to adjust the ETF ranking based on currency discrepencies, we want to tell them not to worry. Our ranking is computed based on the historical US dollar value of the various ETFs (not their underlying foreign indexes), consequently the currency effect is automatically factored in, giving us the best combination country/currency. A nice and easy way to shelter yourself against a falling dollar.

Warm wishes and until next week.

The TimingCube Staff