February, 2006 Newsletter

Monthly Performance Tracking Report ( Total Return as of January 30, 2005 )

Model Portfolios:	January	Y-T-D	12 Mos.	3 Years	7 Years
Performance Xtender	9.3 %	9.3 %	21.1 %	81.7 %	343.2 %
Max Xtender	7.6 %	7.6 %	14.3 %	135.9 %	684.9 %
Compared to Traditional Strategy:
Buy and Hold (S&P 500)	2.5 %	2.5 %	9.3 %	49.6 %	0.1 %

Performance Analysis

Continued Advance in January

The market continued to rally in January, advancing 2.5% on the S&P 500 average. So far, the bull market trend remains intact and our Model Portfolios have been positioned to take advantage.

Three Year Performance Graph (As of January 30, 2005)

In the Performance Xtender model : This model is our most sophisticated strategy for growth investors who have a moderate risk tolerance. The model portfolio gained 9.3% during January, largely on the strength of sharp jumps in two sector investments: gold and energy stocks (see current portfolio allocations below). Over the past 12 months, the model has gained 21.1%, more than double a simple Buy and Hold strategy. Looking back over the past 7 years, the Performance Xtender gained a cumulative total return of 343.2% in comparison to Buy and Hold which barely broke even during the same period. The model's 7-year total return translates into a compound annualized growth rate of 23.7% per year ... this during a period of years that included a severe bear market (2000 to 2002).

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. It gained 7.6% during January, handily beating the market's gain of only 2.5%. Over the past 12 months, the model has beat the market return by over 1.5 times; and over the past 3 years, it has beat the market by over 2.5 t imes. Looking back over the past 7 years, a period of time that encompassed a complete bear market cycle as well as a bull market cycle, the Max Xtender model gained a cumulative total return of 684.9% -- a figure which translates into a compound annualized growth rate of 34.2% per year.

A Chart of Comparative Performance During the Most Recent Bear Market

Bear Market Performance: We published a version of the above chart in last month's newsletter showing a comparison of our models' bear market performance compared with a Buy and Hold strategy. A subscriber wrote to ask that we show how a traditional "asset allocation" strategy would have performed during the same period. The main purpose of an asset allocation approach is, of course, to reduce the overall risk in a portfolio. Did the traditional approach, using unchanging, fixed allocations, work as well as our models to protect against losses during the bear market?

• To address this question, we simulated the performance of a very common portfolio mix that is recommended to many average investors. It consists of fixed allocations of 30% Large Cap stocks, 30% Small Cap stocks and 40% bonds.

The results above show that the asset allocation strategy did a better job of protecting against losses than a simple Buy and Hold strategy -- it managed to keep losses to only about 12%. However, when compared with our models, the asset allocation's fundamental weakness comes to light ... mainly that in order to reduce the overall level of portfolio risk, the asset allocation strategy has to maintain a constant allocation to bonds and/or cash which necessarily sacrifices the potential for higher returns.; and it also has to maintain a constant allocation to stocks even in the face of substantial losses and long periods of underperformance which further dilutes its ability to deliver higher returns and magnifies the degree of losses.

• By comparison, the Max Xtender model generated a compound annualized growth rate of 26.7% during the bear market period.
• The Performance Xtender model did almost as well, generating a 23.1% annualized compound growth rate.

Another aspect of a strategy's performance that you should take into account is the level of volatility over time. Looking at the above chart from this perspective, you can see that a traditional asset allocation strategy does reduce volatility compared to a simple Buy and Hold strategy -- the pink line on the chart is smoother, and shows less variability than the line representing a Buy and Hold strategy.

But our more advanced Performance Xtender strategy was even less volatile than the asset allocation approach. You can see on the chart how smooth the blue line is over time compared with the pink line. (However, note that our Max Xtender strategy uses up to 2-to-1 leverage for "controlled speculation". It is therefore inherently more volatile by design. But because this model has delivered such a high return, it can provide certain investors with a very acceptable ratio of return relative to volatility risk.)

In conclusion, a traditional asset allocation strategy does offer some benefits to an investor when compared with a simple Buy and Hold approach. However, the advanced logic built into our Model Portfolio strategies significantly out-performs asset allocation in terms of either (1) generating higher returns over time, (2) reducing the magnitude of portfolio losses and/or (3) reducing the level of overall portfolio volatility.

• Bottom line, our strategies deliver a much stronger "risk-adjusted return" both during good times and bad.

Market Commentary

Bull Market ... or Bear Market Trap?

Since it is the beginning of the year, we thought it would be a good time to widen our perspective and look at the big picture ... let's assess where this stock market is in terms of longer-term market cycles.

Looking at the past 10-year history (as in the chart below of the S&P 500 average), we know that the bull market cycle of the 1990's ended in the year 2000 and was followed by a 2 1/2 - year bear market. Then, a new bull market was launched in late-2002/early 2003 ... over three years ago.

• The big picture question is: Is the new 3-year bull market just the beginning of a much longer-term bull market cycle (similar to the extraordinary 1980's/1990's bull market)? Or, is this bull market really a "bear trap" that will prove to be just a 3-year bullish interlude within a much longer-term bear market cycle that began back in 2000?

A Chart of the U.S. Stock Market

There are different ways in which to approach this question analytically. For example, many "fundamental" analysts argue that the U.S. stock market's price valuation remains too high historically speaking. They expect the market will have to undergo a deeper and longer-term correction to bring stock valuations down to where they will be attractive enough to trigger a new long-term bull market cycle.

The Long-Term Downtrend Remains Unbroken: We look at the markets from a "technical analysis" perspective. What we see technically is that the market remains today in a longer-term downtrend because the current bull market has still not pushed prices back above their peak in the year 2000.

The Current Bullish Cycle is Aging: And, this bull market is now longer in duration than the typical bullish cycle of the past 100 years. One must ask: What powerful economic forces exist today that could fuel a much longer-term bullish cycle like we had in the 1982 to 2000 period of massive growth?

Challenged by Strong Headwinds: The powerful economic forces existing today are more negative than positive. Global competition is driving up commodity related costs, putting a huge new drag on economic activity.

We can see this economic drag graphically in some of the market sectors we follow. Take energy for example ... the chart above of energy and oil-service firms shows the dramatic bull market underway which parallels the ramping up of crude oil prices.

• Interestingly, the energy market bottomed out in mid-2001, not too long after the stock market topped out in 2000.

We already know that the stock market's longer-term downtrend remains unbroken since the peak in 2000. At the same time, the energy market has done the reverse and has launched a huge, new bull market.

• Historically, energy prices have tended to move in the opposite direction as the stock market.

Gold is another market that tends to move in the opposite direction as stocks. As you can see from the above chart, gold stock prices bottomed about the same time in 2000 as stock prices peaked. Gold launched a huge, new bull market when stocks were sliding into a bear market cycle.

Since gold is seen as a sensitive indicator of inflationary expectations, you have to wonder what this bull market in gold is all about since inflation has been under control in this country. Part of its rise in price can be explained as simply a repricing of gold in US dollar terms since the value of the dollar has dropped markedly over this same period. But beyond this explanation, the new trend in commodity price inflation must be the culprit behind the rise in gold.

Here is a mutual fund that invests globally in the stocks of firms that are sensitive to commodity prices. The global boom in commodity prices becomes fully apparent when you look at this chart.

• How long will it be before this tremendous rise in commodity-related costs translates into much higher consumer inflation in the U.S.?

We know from history that higher rates of inflation are deadly for the health of stock markets. And the prices of gold and commodities are forecasting stiff headwinds ahead. The cost of energy is just one such "input cost" to our economy that can have a significant, negative ripple effect.

The Signs Point to a Renewal of the Bear Market Cycle: The prices of gold, energy and many other commodities bottomed about the same time the stock market peaked in 2000. For the past three years, the stock market has been rising in the face of the continued bull markets in gold, energy and commodities. This type of pattern has not persisted for long in the past; and we would expect it to be resolved either by seeing a capitulation in the stock market or a reversal of commodity price inflation that sends the prices of oil, gold, steel, cement, and copper tumbling back down.

Which scenario do you think is more likely? Clearly the hyper-charged economic engines in Asia and other emerging markets are the primary force behind the inflationary trend in commodities. It doesn't seem very likely that these economies will slow down by very much any time soon.

So we can readily see the strong headwinds faced by our economy and the stock market. We also know that the 3-year bull market we have experienced since late 2002 is getting old. It is not only old by historical standards but it is also showing the typical signs of deteriorating health experienced by every bull market before it rolls over. As a result, it would seem much more likely that the current bull market will end relatively soon ... and then we will be talking about a renewal of the bear market cycle that began when stock prices peaked out back in 2000.

Sell Now or Sell Later? If you buy into this analysis, then the natural question is whether you should sell out of your stock portfolio now or later. But please understand that by following any of our Model Portfolios, you no longer need to ask such a question. The models are designed to follow the market's action closely ... so you don't have to. So, as long as this bull market remains intact, the models will maintain a significant exposure to the stock market and participate in the continued price appreciation. But when the bullish trend ends, the models will reduce, and then fully exit, their stock market exposure in order to lock in the profits from the past three years. And the models will posture themselves to take advantage of the bear market and make some money.

If the analysis offered above turns out to be all wrong and the stock market evolves into another mega-bull experience similar to the 1990's, you will be no worse off by following one of our models. Again, the reason is simple: Our models follow the market's trends. They let the market do the talking. You needn't worry about anyone's fundamental analysis of the economy or the market, because the model will simply follow the market and make sure you participate in the upside and avoid most of the downside.

What could be simpler than that?

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.)

Current Recommended Portfolio Allocations	Rydex Funds		ProFunds		ETFs
	Allocation	Ticker	Allocation	Ticker	Allocation	Ticker
Gold Stocks Fund	20%	RYPMX	15%	PMPIX	20%	GLD
MidCap Stock Fund	40%	RYAVX	40%	MDPIX	40%	MDY
SmallCap Stock Fund	20%	RYAZX	20%	SLPIX	20%	IWM
Energy Stock Fund	20%	RYEIX	15%	ENPIX	20%	XLE
Corporate Bonds, or Money Market	Money Market Fund: 10% if using ProFunds; Also for ETF investors, we recommend using a gold stock fund rather than the ETF 'GLD'.

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.)

Current Recommended Portfolio Allocations	Rydex Funds		ProFunds		ETFs
	Allocation	Ticker	Allocation	Ticker	Allocation	Ticker
Lev'd SmallCap Fund	50%	RYTNX	50%	UAPIX	100%	IWM
Unlev'd MidCap Fund	50%	RYAVX	50%	MDPIX	50%	MDY
Corporate Bonds, or Money Market	ETF Investors: Note that the MDY position is un-margined and IWM is margined 2-to-1. Rydex Investors: Note that Rydex does not have a leveraged SmallCap fund so we have substituted RYTNX.