We have been monitoring and reporting on the performance of our single signal as applied to three major market indices (the Nasdaq 100, Russell 2000, and S&P 500) for almost a year now. The motivation to consider multiple indices is clearly one of diversification as we wrote in our March 19, 2004 "The power of diversification" article. Having a Model and a signal that truly represent the broad market trend gives us the opportunity to apply them to any number of investment vehicles, domestic and international. When asked how one should allocate money between various indices we generally responded "one third each", partially because we are so smart, but probably more importantly because we did not know any better . Having just completed additional research, we may now have a more educated answer.

The reason indices exhibit varied results has to do with the fact that they represent different slices of the market which at times can behave better or worse than the market at large. While everything tends to fluctuate, some characteristics remain fairly constant. For example, the high concentration of high technology companies present in the Nasdaq 100 makes it generally the most volatile index. The S&P 500, with its constituting large-cap companies, looks tame in comparison. The Russell 2000 which has many more companies, including numerous small and mid-cap firms not found in either of the other indices, looks a lot more like the broad market and tends to act more like the Wilshire 5000. To add to the confusion, the indices go through alternating phases of strength and weakness called market or sector rotation. More often than not, smaller companies will lead the economy out of a recession and, accordingly, their stock prices begin to rise early in the cycle, followed by the high-tech rich Nasdaq, and trailed by the larger manufacturing companies.

There are many factors to consider in the search of a "better investment". On our end we continually and relentlessly hunt for weaknesses and seek prospects to enhance our market Model. Given that the signals are what they are, the rest of us have a chance to optimize the system to fit our own individual preferences and expectations by selecting a particular index or blend of indices. The decision as to which is better comes from a very personal tradeoff between risk and reward. For risk there are many measures such as volatility, maximum drawdowns, standard deviations and Sharpe Ratios, to name a few, which we will cover at length in a future issue.

This week we focus on the respective returns (reward) of our three preferred U.S. indices and compare their performance, individually, and in blends. The table below includes 15 years of backtesting using the Long and Short Strategy, which covers 41 trades - an average of a little under 3 trades per year. All indices follow the same signal and, for the two blends listed, the weighting is readjusted at every trade to be fifty/fifty or one third each, respectively.

The obvious conclusion from the data is that by far the Nasdaq 100 delivered the highest absolute returns over the 3 and 15-year periods. The S&P 500 clearly lags in performance. A more interesting discovery is that the Russell 2000 demonstrates the best correlation with our Model of all indices, and sports the highest percentage of winning trades by a statistically significant margin (90% of trades are winners). The direct impact is that the Russell 2000 helps increase the winning trades ratio of both blends. The indirect contribution of the Russell 2000 is that the overall risk, as expressed by the various measures expressed above, is significantly lower with the blends than the Nasdaq by itself.

The lesson we draw from all this is that many conservative long-term investors would be best served by a blend of Nasdaq 100 and Russell 2000 in equal measures. We feel that the slight compromise in performance is a small price to pay for the substantial reduction in volatility and drawdowns, which is what most investors experience and suffer from. On the other hand, nothing will prevent our more aggressive friends to remain steadfastly loyal to the Nasdaq 100, and nothing but the Nasdaq 100, and apply a good measure of leverage to boot!

1989 to 2003 Performance of Indices and Blends, Long and Short Strategy

Yes, indirectly. We have arranged for Managed Accounts tracking the TimingCube strategies and signals to be made available from MARKETTREND ADVISORS. For details see the Managed Accounts page.
Note: The original answer was replaced with this one after the November 5, 2004 Managed Accounts announcement.

Warm wishes and until next week.

The TimingCube Staff