| Model Portfolios: | December | Y-T-D | 12 Mos. | 4 Years | 8 Years |
| Performance Xtender | -0.1 % | 9.9 % | 9.9 % | 81.9 % | 398.0 % |
| Max Xtender | 2.2 % | 23.8 % | 23.8 % | 148.9 % |
1123.1 % |
| Compared to Traditional Strategy: | |||||
|---|---|---|---|---|---|
| Buy and Hold (S&P 500 Index Fund) | 1.3 % | 13.6 % | 13.6 % | 70.1 % | 28.5 % |
Dear Subscriber,
This issue of the newsletter includes the following:
Monthly Tracking Report: Get an update on the current performance of our Model Portfolios compared with a traditional "buy and hold" strategy as measured by the S&P 500 Index.
Performance Analysis: Read a detailed explanation of Model Portfolio performance covering the different times frames presented in the Monthly Tracking Report.
Market Commentary: This month we focus on two indicators of market momentum that show the S&P 500 reaching a long term over-extended extreme which has usually triggered serious corrections in the past.
Model Portfolio Allocations: Check the most current portfolio allocations for our Model Portfolios. (Note that allocation changes are announced by email in a separate Trade Alert.)
Performance Analysis
Market Rally Continues Into Yearend
The S&P 500 index continued in rally mode, advancing 1.3% for the month of December. But momentum slowed and the market appeared ready to rollover into a correction as the Nasdaq 100 dropped -1.9% in value for the month and the small-cap Russell 2000 index moved sideways, barely breaking even.
Four Year Performance Graph (As of Dec. 29, 2006)
Results in the Performance Xtender model : This model is our most sophisticated strategy for growth investors who have a moderate risk tolerance, having experienced a maximum peak-to-valley loss ("maximum drawdown") of only -8.5% in the past 7 years. [Editor's Note: compare this to a -45.1% maximum loss experienced by a "buy and hold" investor in an S&P 500 index fund]. The model under-performed the S&P 500 Index this year, having been adversely affected by losses taken in two sector investments earlier in the year.
But after short-term setbacks in the past, this model has always bounced back strongly and provided a superior level of performance along with excellent long-term risk management. Over the longer term, this model has excelled in providing the strongest ratio of return relative to risk. Looking at the past 4 years which encompassed most of the recent bull market, the model accumulated a total return of 81.9% compared with a 70.1% gain for the market. Looking at a longer, 8-year period ... that incorporated a severe bear market ... the model gained a total return of 398% compared with a Buy and Hold investor who would have earned a total return of only 28.5% holding an index fund tracking the S&P 500. The reason the difference is so substantial is because of the model's ability to avoid losses ... and even make money ... during the bear market periods while beating the market handily during the bull markets.
- Performance Xtender 8-year Compound Annualized Return: 22.2% per year
Results in the Max Xtender model : This is our riskiest strategy because it uses leverage to magnify returns during both strong bull markets and bear markets. Yet it has experienced a maximum peak-to-valley loss ("maximum drawdown") of only -31.5% in the past 7 years. [Editor's Note: compare this to a -45.1% maximum loss experienced by a "buy and hold" investor in an S&P 500 index fund]. The model gained 2.2% in December and has beat the market by 75% over the previous 12-month period. Over the past four years, the model produced a cumulative total return of 148.9% during what has been a bull market period. Looking at the past 8 years, this model has generated a cumulative total return of 1123.1% compared with the market which has done little better than break-even at a total return of only 28.5%. The reason the difference is so substantial is because of the model's ability to avoid losses ... and even make money ... during the bear market periods while substantially out-performing the market during bull market periods.
- Max Xtender 8-year Compound Annualized Return: 36.7% per year
Market Commentary
Is a Correction Coming?
Executive Summary: Our models reacted to renewed deterioration this month in many technical indicators and pro-actively reduced stock market allocations. Until late December, the models were fully invested and fully participated in this strong rally. The question for the market now is whether it can hold onto these new highs, consolidate and continue to move ahead. However, our longer-term indicators show the market has reached an extreme degree of overextension in the face of deteriorating statistics measuring a decline in the internal "health" of the market. There is a strong liklihood now of some kind of correction beginning soon.
Have you heard someone say recently that the stock market is "overbought"?
They are referring to a technical condition in the market where the demand for stocks becomes temporarily exhausted after a period of positive upward momentum in prices. An overbought condition needs to be relieved somehow ... either through a period of sideways churning or through a correction in prices that restores investors' appetite for stocks.
While many commentarists right now are saying the market is overbought, they generally mean it in the context of the current rally that began in August. A longer term perspective, however, shows that the market has reached an overbought condition on a much larger scale.
The longer term chart of the S&P 500 index shown above displays the progress of the current bull market since it began in early 2003. Based upon a reading of our two favorite "overbought/oversold" momentum indicators, the stock market has reached an important threshold ... a degree of overextension that like a rubber band has typically caused a recoil.
- The 4 Standard Deviation Band Indicator: We like to use a standard deviation band around a 45 week moving average to identify the extreme limits of major moves in the market. We have found that a band representing 4 standard deviations is the most reliable in identifying important stopping points for market extremes in both bullish and bearish directions. We are there now as the S&P 500 index is once again touching the upper band.
- The RSI Momentum Oscillator: This indicator has also done a good job historically of identifying when the market reaches an extreme overbought or oversold condition. You can see on the chart that this indicator just recently moved into extreme overbought territory (inside the red circle). The previous instance of this extreme condition is highlighted by the green circle.
The last time both indicators converged at these extreme levels was early 2004 after a 12-month dynamic rally. The extreme overbought condition needed to be relieved ... and it was relieved by a severe correction (see the 9-month sequence outlined by two blue lines). It took nine months before the market could recover and exceed the previous high. Now, three years later, the market has returned to the same kind of extreme. This analysis suggests to us that, at the very least, the market is primed for another serious correction.
Furthermore, since this bull market has grown "old" by any historical definition and rather "infirm" (as shown by the deterioration of many of the market's technical statistics), we are inclined to believe that the market may be at the final momentum peak for this bull market cycle.
We can zoom in for a closer look at the market by examing a shorter-term chart based upon "daily" closing data. Up close, we can see how carefully the recent rally has hewn to a straight up-trend line, a characteristic of dynamic rallies. However, it is clear that momentum has slowed. In fact the True Strength Index (in blue), which is a very sensitive indicator of momentum, shows that the market reached a momentum peak (on a shorter-term scale) around November 1. Even though market prices have continued to churn ahead since then, the momentum has slowed and the S&P 500 index shows signs of rolling over.
Given the expectation that we are probably near a temporary peak, if not a final peak, in the progress of this bull market, the next market signal of significance for us will be a break of the market's recent up-trend line. Such a trend line break will shout "correction coming" to many market analysts and should initiate a period of topping action where the market tries, but cannot, exceed its previous highs. Then the intermediate trend should reverse and throw the market into a correction, if not a determined downleg of a new bear market cycle. A perfect example of this occurred at the market's last major trend-break that you can see on the longer-term "weekly data" chart above. Notice the green trend line supporting the market's 2003 rally ... and then the sharp trend-break in early 2004. You will see that after the trend-break, the market attempted to return to the postive trend. But the effort failed and the correction continued in earnest.
The Models Stick With the Trend: It is interesting to note that our market commentary has had a decidedly bearish slant over the previous year ... and here we are today with a bull market that refuses to die! But in spite of our bearish commentary, our Model Portfolios have maintained a largely bullish posture throughout ... and we have captured the market's appreciation as a result. It illustrates one of the core benefits of following our Model Portfolios -- their ability to follow and stick with the primary underlying trend of the market.
While our models are quantitatively tracking and analyzing a battery of market risk factors, their allocation logic is designed to stick with the trend. Only in extreme instances of perceived high statistical risk do our models trigger a move against the underlying trend (as they did one week ago).
From your own perspective as an investor, following models such as these can help you reconcile the constantly conflicting views of different market gurus, economists and advisors. They provide a very disciplined method of investing in the face of ongoing uncertainty. The parameters and action triggers built into our models' mechanical logic is based upon statistically-relevant patterns that have proven a high degree of reliability over decades of market history. In a nutshell, the models provide the investor with an "edge" with which to face off against market uncertainty. The timing of the models is not always perfect. However, the mechanical logic recovers quickly from mistakes, cutting losses short ... and letting profits run.
Recommended Model Portfolio Allocations
Model Portfolio: 'Performance Xtender'
(A model portfolio that invests selectively in stock market index funds, plus certain market sectors such as Energy, Gold and Real Estate, and in an Inverse Fund ("Bear Fund"), depending on current market trends for each type of investment. The allocation mix is designed to beat the market significantly during both bull and bear markets with only a limited risk of volatility.)
... Portfolio as of Dec. 29, 2006 ...
| Current Recommended Portfolio Allocations | Rydex Funds | ProFunds | ETFs | |||
|---|---|---|---|---|---|---|
| Allocation | Ticker | Allocation | Ticker | Allocation | Ticker | |
| LargeCap Stock Fund | 70% | RYZAX | 70% | BLPIX | 70% | SPY |
| Corporate Bonds, or Money Market |
Money Market Funds: 30 % | |||||
Model Portfolio: 'Max Xtender'
(A model portfolio that invests selectively in stock market index funds and in an Inverse Fund ("Bear Fund"), depending on current market trends for each type of investment. During strong market trends ... either bullish or bearish ... the model uses up to 2-to-1 leverage to magnify returns. The allocation mix is designed to beat the market substantially during both bull and bear markets but with a relatively high risk of volatility.)
... Portfolio as of Dec. 29, 2006 ...
| Current Recommended Portfolio Allocations | Rydex Funds | ProFunds | ETFs | |||
|---|---|---|---|---|---|---|
| Allocation | Ticker | Allocation | Ticker | Allocation | Ticker | |
| Lev'd LargeCap Fund | 50% | RYTNX | 50% | ULPIX | 150% | SPY |
| UnLev'd Large Cap | 50% | RYZAX | 50% | BLPIX | - | - |
| Corporate Bonds, or Money Market |
ETF Investors: Note that the SPY position is margined 1.5 to 1. | |||||
