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 week for the history books, marked by tremendous volatility. During the first part of the week, investors faced what looked like a complete meltdown of the global financial system. In just a few days, the Federal Reserve had to provide an emergency $85 billion loan to prevent insurance giant AIG from collapsing, Lehman Bros. filed for bankruptcy and Merrill Lynch saved itself from a similar fate by agreeing to be bought by Bank of America. Even the announcement that world central banks were teaming up to provide markets with $180 billion in added liquidity did not restore confidence, and by mid-day Thursday, the S&P 500 was sporting a 9.4% loss for the week. Panic was almost palpable and was illustrated by a new 5-year high for the Volatility Index. And then, as things looked at their worst, news surfaced that the government was planning to create an entity that would acquire the bad debt and illiquid assets from troubled financial institutions to restore their balance sheets. This proved to be a huge relief to investors, as the markets turned on a dime to close with big gains, the Nasdaq Composite rebounding 4.8% on the day. Friday morning, the SEC announced that it was placing a temporary ban on the short-selling of 800 financial stocks to alleviate some of the pressure the sector has been facing. Together with the announcement of the government rescue plan, the news helped restore optimism to the markets and the main indexes posted solid gains for the second day in a row, the S&P 500 finishing 4.3% higher.

Despite the outsized volatility we experienced this week, the V-shaped action resulted in respective weekly losses of 1.22% and 1.56% for the Nasdaq 100 (QQQQ) and the S&P 500 (SPY). The two indexes remain located below both their 50-day and 200-day exponential moving averages. The Russell 2000 (IWM) fared much better: it gained 3.81% on the week and is now situated above both its EMAs.

For its part, our World portfolio posted a 0.98% gain this week. The portfolio consists of the 5 top-ranked world ETFs as of September 12, 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

Economic indicators and market cycles

One of the favorite sources of news and discussion topics in the financial media is the economy and speculation about its future health. Everyone knows that economies, whether local, national or global, repeatedly go through boom and bust cycles. These business cycles affect all of us to some degree but many in the investment community pay particular attention to them because of a fundamental belief that as the economy goes so goes the stock market. As shown in the chart below, there is little doubt that economic and market cycles are somehow linked and that they influence each other, but we do not believe that many of the much touted economic indicators can be used by investors to accurately and reliably forecast the future of the stock market.

Economics, often referred to as the "dismal science" since Thomas Carlyle coined the term in the nineteenth century, are really the study of how society behaves in the struggle between unlimited wants and limited resources. Today, an entire industry thrives on the creation, monitoring, reporting and interpretation of a multitude of economic indicators such as employment, consumer sentiment, inflation, interest rates, inventories, price of raw materials food or energy, trade deficits and many more. The Commerce Department, the Labor Department, academic institutions and numerous think tanks crank out an endless stream of numbers. Econometrics then applies statistical theories to economic ones for the purpose of forecasting future trends. While much of this is way above our heads, the complex web of causes and effects between the multitudes of variables in society is backed by much research and for the most part seems quite logical. Most of us can follow simple scenarios such as growing unemployment negatively affects consumer sentiment, which in turn reduces their level of spending causing increased inventories. The reduced demand for goods causes prices to drop and manufacturers to slow down production and so on and so forth.

The disconnect occurs when trying to interpret all of this data in order to issue stock market forecasts. As with all market interpretations the result is highly dependent on the interpreter's point of view, the market context, and the then prevailing investor psychology. Depending on these conditions the same set of economic data can lead to diametrically opposed conclusions, which helps explain why so many respected expert forecasts are dead wrong. This is best illustrated with practical examples.

Example 1: Higher interest rates are bad news for the stock market, and vice versa
Or are they? Despite the fact that the interest rates have been relatively low for several months, this did not have any positive effect on the stock market lately. On Tuesday, in the wake of the market meltdown that occurred after the 158 -year-old Lehman Brothers Holdings Inc. filed for bankruptcy and the sale of Merrill Lynch to Bank of America, the Federal Reserve was expected to lower interest rates. Instead, they held their key interest rate steady, and against all expectations, the market rallied on the news. The interpretation being that the economy was not so dire, lower rates would have meant a much more desperate situation... And then the news spotlights focused on AIG, with pundits predicting an international disaster if a salvation plan could not be reached quickly. On Wednesday morning, the US government steps in again to bail out the giant with an $85 billion package, "good" news? or at least on the short term? Unfortunately this sent mixed signals and the market reacted with its own way to this decision, instead of pushing higher the rally that started on Tuesday, this triggered another huge sell-off. This illustrates that one economic event can have numerous interpretations and that interest rates cannot be considered reliable economic indicators. And sometimes, what Mr Bernanke or Paulson say or do not say is more important than what they do.

Example 2: War is good for the economy and the stock market
While this theory has long ago been proven to be fundamentally flawed by economists, investors and politicians hold on to the myth. The simplest way to explain this one is with the "Broken Window Fallacy". The story goes something like this: a punk throws a rock through a storefront window which has a visible set of consequences. The shop owner has to pay the glass maker $1,000 to fix it. This $1,000 causes the glazier to purchase more raw materials from other merchants and hire employees to make the window, who in turn can spend their new earnings. The logical conclusion is that the punk, far from being a vandal, is actually an economic benefactor to society. Economists then like to point out that he has actually caused a net decline in the economy. Instead of having a window and $1,000 the store owner now only has a window. He could have spent the $1,000 to buy a suit, so he would have a window and a suit, and the $1,000 he paid for the suit would have generated the same economic boon as when he paid the glass maker.
In similar fashion the war has to be funded by a combination of reduced spending elsewhere, higher taxes and/or higher debt, all of which are bad for the stock market.

Example 3: Rising unemployment is bad news for the stock market
Or is it? Research tells us that it depends on which phase of the economic cycle we are in. Announcements of rising unemployment tend to be good news in economic expansions during which investors worry more about interest rates. News about higher unemployment reduces the risk that the Fed will increase interest rates. The same exact news will on average be perceived as bad news during an economic contraction during which investors tend to be more worried about corporate dividends and equity risk premiums which can be negatively affected by layoffs.

Now that we better appreciate the difficulty in using economic leading indicators to forecast the stock market we can also point out that in fact the stock market itself just happens to be one of the most reliable leading indicators of the economy's future direction. Not the other way around. In mysterious ways the stock market anticipates what is coming. A bear market always reaches its bottom while the recession is still worsening, well before economic recovery begins. The falling interest rates and prices provide the consumer a glimmer of hope which in turn triggers the next bull market cycle and in turn a recovery begins. As the economic recovery gains steam, prices start inching up, the Fed raises interest rates all over, and consumer expectations start declining as the stock market peaks. And so on.

As Trend Timers we prefer to watch the market itself for clues of what it is doing. Following the market trend is may not be easy but it is far more reliable than reading economic tea leaves.

FAQ of the Week

Question: As a foreign investor is your system for me?

Many foreign subscribers do not have access to the investment vehicles we list on our website pages or are required by local regulations to invest all or a large percentage of their holdings in local securities. More often than not there is a way to apply our signal profitably anyway.

We have frequently written about the tight correlation that exists between our signal and major world markets (for example, read "The Trend is contagious" in the June 11, 2004 Weekly Update or "Correlation of world stock markets" in the March 14, 2008 issue). For obvious reasons we cannot track all world markets on a daily basis. This has consistently shown that our signal applied to a local stock market index would have significantly outperformed a Buy and Hold strategy.

The trick is to find a local investment vehicle such as a mutual fund or an ETF equivalent that tracks your country's primary stock market index.

Warm wishes and until next week.

The TimingCube Staff