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 again posted modest gains this week. Trading turned out to be fairly quiet Monday as investors looked ahead to the Federal Reserve's decision on interest rates due the next day. Stocks finished the session slightly lower on light volume, with the S&P 500 posting a 1.3% daily loss. The market experienced a sizable rebound on heavy volume Tuesday. Most of the gains occurred in the last 90 minutes of trading, after the Fed announced its unprecedented decision to set the funds rate between 0 and 0.25%, marking the first time in 50 years that the funds rate is below 1%. Obviously pleased to see that the Fed is ready to pull out all the stops to jump start the ailing economy, investors bid up stocks, sending the Nasdaq Composite 5.4% higher. Despite Wednesday's announcement by Morgan Stanley that it had lost a staggering $2.3 billion in its last fiscal quarter, stocks managed to retain most of their gains of the previous session. Weakness returned to the markets on Thursday, as a steep drop in oil prices caused the energy sector to sell off, resulting in a 2.1% daily loss for the S&P 500. Reversing course, stocks initially traded higher Friday morning after the U.S. government announced its plan to provide domestic automakers with a $17.4 billion lifeline. Most of the gains evaporated by day's end, however, with the Dow Jones Industrial Average even finishing in the red. Trading volume for the session was very high, as Friday marked the expiration of December options and futures.

The Nasdaq 100 (QQQQ) and Russell 2000 (IWM) respectively gained 0.61% and 3.86% on the week while the S&P 500 (SPY) was basically unchanged. All 3 ETFs remain located below both their 50-day and 200-day exponential moving averages (EMAs).

For its part, our World portfolio posted a 0.58% gain this week. The portfolio consists of the 5 top-ranked world ETFs as of December 5, 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

Bonds and the stock market

The TimingCube service and model have always focused primarily on the stock market but at the same time we have long been diversification advocates and we fully recognize the merits of investing in a variety of asset classes. When our stock market trend following system has us in cash, as it presently does, looking at spicing up the returns over cash or money market funds is only natural. It is when investors assume that there is a set and predictable relationship between the stock market and other asset classes, bonds in this instance, and devise investment strategies on that basis that they enter dangerous territory. The study of correlation between bonds and stocks is a key issue when it comes to asset allocation, risk management and hedging decisions. That both the stock and bond markets are currently moved by economic events of historical proportions and that just this week the Fed brought its benchmark funds rate down to near zero only makes this topic timelier.

In order to level the playing field we first need to review a few bond basics. Bonds are debt obligations and are also referred to as fixed-income securities. They are how companies, municipalities, states and the U.S. federal government borrow money to finance their activities and projects. A bond comes with a fixed interest rate (to be paid by the issuer) and a maturity date at which the loaned funds, the bond principal, are to be returned. Bond maturities (for U.S. Treasuries) range from a 1 month Treasury Bill, or T-Bill for short, to a 30 year government bond. The interest rate and therefore the price of bonds are primarily a function of credit quality and duration, but they are ultimately set by the perception of investors and other market forces.

As depicted in Chart 1 below, bond yields (the interest rates they pay) have over the years seen large fluctuations associated with economic cycles, but they have been in a general decline for the last 30 some years. The yields shown are for the 3-Month U.S. Treasury bonds which have gone from 8% in 1990 to 0% this week. Shorter maturities have even dipped below zero, indicating that some investors are willing to pay for the safety of their principal.

Chart 1: Long term swings and decline of U.S. Treasury yields



Another basic aspect of bonds we need to understand is that yields and prices have a high negative correlation, meaning that they consistently move in opposite directions. Chart 2 below tells the tale better than any explanation. In this view we plot the yield (red line) and price (blue line) of the 5-Year U.S. Treasury bond and the mirror image is unmistakable. As the interest rate has decreased from above 3.6% in June of this year to under 1.26% yesterday, the price has shot-up accordingly.

Chart 2: Bond price and yield move in opposite directions



Coming back to this week's main topic we find that surprisingly little is known about the correlation between bond and stock market returns. In statistics, correlation measures the relationship between two entities. A correlation of +100% (+1.0) means that the two entities move in perfect tandem with each other. A correlation of zero means the relationship between them is totally random and a negative correlation indicates that they move in opposite directions. Common wisdom uses the following rules of thumb: 1) interest rate increases go hand in hand with falling share prices and rate cuts are good for stock prices, and 2) bond prices move inversely to their yield, therefore bonds and stocks are positively correlated, i.e. they generally tend to go up and down together. Most of the research we find on this subject relies on empirical data since 1970, or more recent, which explains the general conclusion. Chart 3 below confirms that from 1970 to 2000 the correlation factor between bonds and stocks have been in the range of 20% to 60% indicating levels of positive correlation. A look at earlier data reveals that correlation turned negative in 1932 and again from 1955 to the mid sixties. To the puzzlement of many, there has also been negative correlation since 2000.

Chart 3: Rolling 5-year bond-stock correlation


Source: Ibbotson

The bottom line is that contrary to popular opinion, bond-stock correlation may change sharply across time and economic conditions. In times of economic turmoil investors become more risk averse and plow money into what they perceive is safe. Despite the 2008 federal budget deficit rising to a record $1 trillion, according to the just released "Financial Report of the United States Government", demand continues to increase as investors flee risky assets around the world and put their cash into U.S. bonds paying, in some cases, nothing in yield just to ensure the return of their principal. Instead of shunning U.S. debt paper, investors can't get enough Treasuries. Foreign central banks and other institutions are accumulating Treasuries at the fastest pace since 1988, according to the Federal Reserve.

Regardless of massive deficits, debt and an economy in recession, the U.S. government retains its near bulletproof credit rating and therefore its debt obligations are considered virtually risk free. As the Fed reiterated in its statement this week that it was looking at the possibility of buying long-term Treasury bonds, what many are beginning to call a "bond bubble" continues expanding with no end in sight. Whether or not the Fed actually does such a thing is immaterial at this point - the very suggestion that they are going to do so is enough to actually accomplish their intentions. With support like that below the market, the path of least resistance is higher.

We do not know how long the bull market in Treasuries will last or how long the negative correlation between bonds and stocks will persist, but we know that any attempt to time bonds with our stock market based signals will end up in tears.

FAQ of the Week

Question: Are most bond ETFs comparable?

The answer is a resounding NO!

During an active Cash signal, bond ETFs present the potential for better returns than cash or money market funds. Before going further we need to stress that unlike cash, the value of bonds can fluctuate, which means that at times they have a negative return. Just because long-term Treasury bond funds have been on fire over the last few weeks does not mean it will continue forever.

To get back to the question at hand, we offer Chart 4 below as proof that all bond ETFs are not created equal. The chart plots the relative performance of four bond ETFs over the last 3 months. On the plus side, ranked in descending performance order, we have three U.S. Treasury bond funds: TLT, IEF and SHY. They are the iShares Lehman Treasury Bond funds with maturities of 20+ years, 7-10 years, and 1-3 years respectively. The long-term Treasuries in TLT, the best bond ETF for now, have gained better than 30% in 3 months, a rare occurrence for bonds caused by an investor flight-to-safety. Besides the stock market, another place investors have been fleeing from in the midst of the financial crisis is junk bonds, and we charted HYG (the iShares iBoxx High Yield Corporate Bond fund) which lost over 15% in the same timeframe.

Chart 4: Not all bond ETFs are created equal



If you must seek the higher returns of bonds, please exert caution in choosing your ETFs and watch the yields for any sign that they are headed back up again, as this will signal the end of the current moon-shot.

Warm wishes and until next week.

The TimingCube Staff