Stock Market Basics

Introduction

There are some concepts you must clearly understand in order to learn market timing principles. Many of you can probably just scan this section because it is rather basic. However, please don't skip it altogether because you will miss information that is built upon later in the tutorial.

The Stock Market

The stock market is where shares of stock are traded. A share of stock is an ownership share in a corporation. For example, assume XYZ Inc. has issued 100 shares of stock. If you own one share, you actually own a 1.0% stake in XYZ Inc. Shares of stock issued by large U.S. corporations are publicly traded at stock markets or stock exchanges. The prices of these shares are constantly changing as they are determined solely by supply and demand. Anyone with money can buy shares in these corporations by simply setting up an account with a stock broker and submitting a purchase order. The order is electronically transferred to the stock exchange, where the order is executed.

Stock Market Indexes

A stock market index is a number computed from the prices of a group of stocks. It is computed daily to gauge the movement in the market for that day. Here are some examples:

Dow Jones Industrial Average (DJIA)

The DJIA is computed by adding all the daily stock prices of a group of 30 major U.S. corporations and dividing that total by a number called the divisor; this is called a price-weighed method. This divisor will change whenever one of the 30 companies declares a stock split. A company will split its stock when the price becomes high, making it more affordable. By changing the divisor, the index value is unaffected by stock splits.

The DJIA has two disadvantages as compared to other types of indexes:

• It consists of only 30 stocks
• Higher priced stocks affect the index more than lower priced stocks.

S&P 500 Index

The S&P 500 doesn't have the disadvantages of the DJIA. It is made up of 500 stocks. The total market value of each company is computed and summed. A company's market value is simply the share price times the total shares outstanding. The sum of all 500 companies' market values is then divided by a divisor. The result is that each company influences the index based on its total market value rather than its share price. This type of index is a capitalization-based index.

NASDAQ 100

Like the S&P500, the NASDAQ 100 is capitalization-based. It consists of 100 high tech, financial, and other growth companies that are traded on the NASDAQ Stock Exchange.

Stock Mutual Funds

A stock mutual fund is a portfolio of stocks that has been purchased by a fund manager using money that has been invested by many individual investors. At the end of each trading day, the total value of the portfolio is determined and divided by the total number of outstanding shares, resulting in the current share price. All new investments the fund has received prior to that market close (4:00 p.m. EST) are exchanged for shares in the fund using the share price. The fund manager then invests the new investment capital.

For example, assume that before the market close on Thursday, November 10, 1991, you invest $1000 in a mutual fund called XYZ Fund. At the close on this day the fund has the following portfolio:

Amount	Company	Value	Total Value
1000 shares	ABC Inc	$25/Share	$ 25,000
1000 shares	DEF Inc.	$35/Share	$ 35,000
1000 shares	GHI Inc.	$45/Share	$ 45,000
1000 shares	JKL Inc.	$55/Share	$ 55,000
$30,000	Cash	-	$ 30,000
Total	-	-	$190,000

At this time the fund has sold 20,000 total shares. This results in a share value of $9.50 per share. Therefore, your $1000 investment will buy 105.263 shares of the fund and there will now be 20,105.263 total shares outstanding. Note that 105.263 new shares were created, but the value of each share is still $9.50 per share ($191,000 / 20,105.263 shares). The next day the fund manager will invest the new $1000 as he so chooses. When you decide to sell your shares, the price per share you will receive is the computed share price at the next market close.

There are some big advantages to investing in mutual funds:

• If you invest in "no-load" funds, there is no commission on your purchase or sales of fund shares. As the fund manager buys and sells shares, the fund is charged commissions, but they are charged at a smaller institutional rate and absorbed by the entire fund.
• Small investments are properly diversified in many different stocks.
• You have a professional manager who is highly skilled at picking individual stocks and managing the fund. In exchange for this management, the fund is charged a fee, usually around 1-2% per year. This is how the mutual fund company makes money.
• You can easily determine how much risk you are taking based on the type of mutual fund you have invested in. For example: aggressive growth funds, will go much higher in rising markets and much lower in falling markets than conservative stock funds.
• With a single phone call, you can transfer money between different types of funds within the Mutual Fund Family. Most families contain aggressive growth stock funds, conservative stock funds, bond funds, money market funds, and many other types of funds.

If you choose mutual funds as your trading vehicle, the most important decision you must make is your timing of buy and sell decisions. The ULTRA Market Advisor 4 for Windows is designed to help you make these decisions.

Stock Market Movement

Most stocks move with the market. For example, if the general market is in a downtrend (a bear market), even stocks that are fundamentally excellent values, will trend downward. In fact, aggressive growth mutual funds whose portfolios consist of professionally selected stocks get absolutely devastated in bear markets. Many investors, who are not able to sit by and watch their funds lose 40-50% of their value actually end up selling out at exactly the wrong time. Whether you invest in stocks or funds, it is absolutely necessary to know when to be very conservative about your stock market investments.

Positions

Your position is based on which way you are betting the market will go. We refer to these positions as long, short, and cash.

Long Positions

If you buy stock or mutual fund shares hoping they will increase in value, you have taken a long position.

Short Positions

If you believe the market will fall, you can profit by selling short. This is referred to as a short position. Selling short is selling borrowed shares of stock or shares of a mutual fund, hoping to some day buy them back at a lower price and return them to their owner. For example, assume you borrow 100 shares of XYZ Corp. and sell them for $5 per share. You will receive $500 proceeds from the sale. At some later date, XYZ Corp.'s stock has dropped to $3 per share and you decide to buy the shares and return them to the person you have borrowed them from. This is called short covering. To repurchase the shares you will have to pay $300. Since you received $500 on your short sale, and paid $300 to cover your short, you have gained a $200 profit on the trade. This is a very common transaction. A stockbroker who will charge you a commission handles all of the details.

Mutual funds can be shorted through most discount brokers but it really doesn't make much sense. In a bear market the wise short seller will short stocks that are likely to go down the most. But, during a bear market the mutual fund will hold stocks that they think are likely to go down the least. So, it doesn't make much sense to short a group of stocks that a professional stock picker believes will be least effected by the bear market.

Cash Positions

If you are not short selling when you believe the market is going to fall, you will simply sell your long position and place the proceeds in an interest bearing account. This is a cash position.

Buying On Margin

If you buy stocks or mutual fund shares from a broker, you can leverage your purchases. That is, you can borrow money from your broker and buy more shares using your cash and the cash you have borrowed. The amount of cash you must provide is governed by the margin requirement that the U.S. Federal Reserve sets. For example, currently the margin requirement is set at 50%. Therefore, whenever you buy stock or funds you can borrow an additional 100% from your broker bringing your maximum invested position to 200% instead of 100%. When you purchase shares on margin, you must pay your broker interest on the borrowed capital.

Mutual Funds can be purchased on margin at most discount brokers such as Jack White & Company.

Beta

Beta is a measure of volatility of a trading vehicle such as a mutual fund. The general market as measured by the S&P 500 is considered to have a beta of 1.0. Stocks or funds that gain more than the general market in bull markets and lose more in bear markets have betas of greater than 1.0. Conservative funds and stocks may also have betas that are less that 1.0. For example, assume you invest your money in an aggressive growth fund that has a beta of 1.5. If the S&P 500 gains 10%, this fund should gain 15% (1.5 X 10%). If the S&P 500 loses 10%, this fund should lose 15%.

Stock and Mutual Fund

Picking Rarely Works. In 1997, most investors believe that the market will always go up with only very minor corrections of less than 10%. This would eliminate the need for timing the market and would make an investors only job deciding which fund or stock will go up the most. Pick up a copy of any high circulation investment magazine. Month after month they have headlines that read, "10 Stocks that will go up..." or "The 5 Best Funds..." The entire investment industry is built on analysis that attempts to reveal the next Microsoft. There are some big problems with this approach:

• Investors are not properly diversified. Based on bad advice, people invest too much capital into certain individual issues hoping for a big score. The bad advice did not include when to sell the issue so temporary profits eventually are closed out as losses.
• Analysts can rarely beat the SP500 with the stocks they pick. Often, throwing darts at the financial pages beats the best stock pickers in America. I'm sure you've seen articles about monkeys, widows, and children that beat the experts. It's a wasted effort. If you want to pick the next Microsoft, your best bet is to find a company in your town that is very profitable, run by outstanding people and has a fabulous potential future. When it goes public, invest a small amount of money and forget about it.
• No matter what you read in advertising material, most investment newsletters under- perform the SP500. Investment newsletters tout all the great stock picks they make. They ignore the bad ones and the total portfolio gain. The Hulbert Financial Digest tracks newsletter writers advice and very few beat the SP500. Many newsletter writers even lie about their Hulbert rankings in their advertising material.
• Growth mutual funds rarely beat the SP500. Picking the best fund is very difficult. As you add stocks to a portfolio, it becomes highly correlated with the SP500. So, a growth fund that invests in SP500 type stocks will basically replicate the SP500 over time. Since mutual funds pay commissions and are charged management fees, almost all end up under performing the SP500.
• Beating the SP500 for short periods of time is easy. So you want to beat the market. Pick a fund that has a beta greater than the market and as long as the market is rising you'll beat the SP500. An aggressive fund that invests in high-tech companies is a great example. Unfortunately, even in bull markets these funds get hit hard when the tech stocks are out of favor.
• Funds that beat the SP500 in rising markets will get hammered in falling markets. High beta funds work both ways. In a falling market high beta funds will lose more than the SP500. This is why it's so hard the beat the SP500 without market timing over longer periods of time.
• Picking funds give investors a false sense of security. The mutual fund industry has successfully convinced investors that they will become wealthy by buying their funds and holding them forever. Every mutual fund advertisement you see touts recent performance as proof. What they don't tell you is what happens to their funds in sustained bear markets. They don't tell you that the buy and hold method is emotionally impossible and that most investors bail out of their funds at exactly the wrong time. They don't tell you that their bottom line depends on the buy and hold investor. Every time someone sells out of a fund, it costs the fund company money. They certainly don't tell you that their phone system cannot handle panic selling. In a crash scenario, you will be unable to sell your funds because you won't be able to get through to a representative.

Time Magazine summed up the dilemma well in their January 15, 1996 issue:

"86% of the most popular mutual funds did worse than the Standard and Poor's 500 index in 1995. This is more proof that the national pastime of picking the winning mutual fund is a wasted effort. Most people would be better off buying the so-called index fund that give them a guaranteed average return."

The only problem with this advice is that an "average return" can be very negative. Bear markets can easily cause SP500 index funds to drop 30-40% in value. Investors cannot emotionally handle riding out losses like these.

Rydex Mutual Funds

One mutual fund company (Rydex) offers some truly cutting-edge mutual fund products. They specialize in Index Funds. Index Funds attempt to replicate the performance of stock market indexes such as the S&P 500.

Unlike almost all mutual fund companies, Rydex does not limit the number of times you switch in and out of their funds. Rydex can be reached at 800-820-0888. We believe that investing should be as simple as possible.

Therefore, we base our historical timing results on models of two Rydex mutual funds.

• Rydex Nova Fund. This fund gives you 150% of the return of the S&P 500 Index. It's an aggressive fund that guarantees that you will beat the market. We have S&P 500 Index historical data all the way back to 1942. So, we can model this fund for the last 56 years.
• Rydex URSA Fund. This fund gives you -100% of the return of the S&P 500 Index. In other words, if the S&P 500 goes down 10%, URSA will gain 10%. This unique fund gives you the opportunity to profit in bear markets without shorting stocks or funds.
• Rydex OTC Fund. This fund gives you 100% of the return of the NASDAQ 100 Index. This index has been around since 1983 so we can model this fund for the last 14 years.

Trying to pick the best performing fund is an unnecessary complication. The Rydex funds are really all you need to beat the S&P 500 year after year, a feat that very few funds can do. However, these funds are very aggressive. Without market timing, you can lose a lot of money very quickly.

Spend Most of Your Time Deciding WHEN to Buy Instead of What to Buy.

Do you really think that the wealthiest and smartest investors in the world are actually buy-and-hold investors? Individuals who have built multi-million dollar fortunes are not big on losing money. Sure, they may ride out losses on venture capital type investments just as a business owner wouldn't sell his business because of temporary losses. But, the majority of their portfolios are protected from bear markets with hedging strategies which is simply market timing.

Your goal should be to incrementally move from a 100% cash position to a margined 200% invested position based on the probability that the market will rise. Until you have a developed a sound strategy for doing this, don't spend time deciding what to invest in. Simply invest in an index fund.

Bear Markets and Buy-and-Hold Strategy

Bear Market History

A Bear Market is usually defined as a market that loses 15% as measured by a stock market index such as the Standard and Poor's 500 Index (SP500) which consists of the stock prices of 500 U.S. corporations.

Bear Start (1)	Bear End (2)	Bear Length (Years) (3)	Prior Bull Length (Years) (4)	SP500 Loss (5)
Sep 1929	Jun 1932	2.8	-	-86.2%
Jul 1933	Mar 1935	1.7	1.1	-33.9%
Mar 1937	Mar 1938	1.0	2.0	-54.5%
Nov 1938	Apr 1942	3.4	0.6	-45.8%
May 1946	Jun 1949	3.1	4.1	-29.6%
Jul 1957	Oct 1957	0.3	8.1	-20.6%
Dec 1961	Jun 1962	0.5	4.2	-28.0%
Feb 1966	Oct 1966	0.7	3.7	-22.2%
Oct 1968	May 1970	1.6	2.0	-34.0%
Jan 1973	Oct 1974	1.8	2.7	-48.2%
Sep 1976	Mar 1978	1.5	1.9	-19.4%
Nov 1980	Aug 1982	1.8	2.6	-27.1%
Aug 1987	Dec 1987	0.3	5.0	-40.4%
Jul 1990	Oct 1990	0.3	2.6	-21.1%
Averages	-	1.5	3.1	-36.5%

The table above details all of the Bear Markets over the last 68 years. As you can see from the table:

• The average decline in the S&P 500 during the Bear Market (Column 5) is 36.5%.
• The average length of the rising market (Bull Market) before the Bear Market began is 3.1 years. (Column 4)
• The average length of a bear market is 1.5 years. (Column 3)

Our current bull market is 6.9 years old (as of 9/1/97). The second longest in the last 68 years. Obviously, we are far overdue for a major bear market.

Growth Mutual Funds Will Stay Fully Invested Throughout a Bear Market.

Here's Why:

• A Mutual fund's primary concern is keeping your money within the mutual fund family. In order to accomplish this they must outperform the S&P 500 and other mutual funds in bull markets.
• The worst possible scenario for them is to miss a major bull market. Investors will simply move their money to other fund families. Therefore, mutual funds will NEVER hold large cash positions. They will be FULLY INVESTED AT THE VERY TOP of every bull market.
• As long as the S&P 500 and other mutual funds are going down, they are perfectly comfortable losing your money in a bear market. Their attitude will be that the market will turn and the funds will rebound.
• If you are uncomfortable with your bear market loses the mutual fund will recommend that you move your money to a more conservative fund. Thereby, keeping your money within the mutual fund family. And, guaranteeing that you become conservative at the exact worst time, at the bear market bottom just when you SHOULD become aggressive again.
• By the way, moving your money from aggressive funds to conservative funds is MARKET TIMING, plain and simple. You can either be very bad at it, (like the example above), or very good at it. Your choice.

Bear Markets Take All Mutual Funds Down Severely.

• A single stock can certainly move contrary to the S&P 500. But, the more stocks in a portfolio, the more likely the portfolio is to replicate the S&P 500 Index. In fact, the Dow Jones Industrial Average, which consists of just 30 stocks, is highly correlated with the S&P 500 Index.
• Growth and aggressive growth mutual funds will go down MORE than the S&P 500. These funds invest in highly volatile stocks, which outperform the S&P 500 in both directions. In bull markets they go up more than the S&P 500 and in bear markets they go down more than the S&P 500.
• Mutual funds must also absorb overhead such as advisory fees, management fees, and advertising costs. In order to outperform the S&P 500 plus overhead they must invest aggressively. This aggressiveness pays off in roaring bull markets but results in large losses in bear markets.
• In an average 35% S&P 500 bear market most growth funds will lose 50% of their value.

The Buy and Hold Timing Method

The Buy-and-Hold strategy is a dream come true for the investment business. Mutual fund companies love it because you give them your money and never take it away or move it. This keeps their costs low and their profits high.

Buy and hold is actually timing. You have to buy at some point and you do have to sell at some point. Without realizing it, buy and holders will use some sort of random timing method to time these purchases and sales.

Buy and Hold Investors have been VERY lucky so far.

• We are experiencing the second longest bull market in the last 68 years.
• This is not the time to hope for more luck. Rather, this is the perfect time to devise a strategy to hold on to the bull market's gains and profit further if the bull market continues.

Why buy and hold doesn't work over the long run.

• The market can easily move sideways or down for periods of 10 years. Market timers can do very well during sideways periods. Buy-and-holders can lose money for 10 years.
• Bear markets are too painful to ride out with significant amounts of capital.
• Bear markets are insignificant when you have only $10,000 invested, but what about a hard earned portfolio of $200,000. Every time the market falls 5% you've lost $10,000. After a few months of "market correction" the market is down 30%. You've lost $60,000. The pressure to sell out and save your remaining $140,000 will be very difficult to resist.
• Most people give up and sell out very near the bottom. That's what emotions will do for you. It's very easy to say you'll ride out a bear market while the market is soaring, but almost impossible when the market is crashing and all you hear from the media is how the market is going down to zero.

The Main Problem with Buy-and-Hold is Drawdown.

There is a very big problem with the Buy and Hold Strategy that just isn't discussed much anymore, Drawdowns. A drawdown is an "unrealized loss".

For example, assume that at some point your total account value is $50,000. Then the market falls a bit and your account value drops to $45,000. You have just suffered a 10% drawdown. (Drawdown = Loss divided by starting account value.)

Now assume that the stock market skyrockets for a few years and your account grows to $200,000. Then, we get an average bear market of 35%. Your account will lose $70,000.

You won't know where the losses will end. Everyone will be so negative on the future of stocks that the temptation to sell everything will be irresistible. Unfortunately, most investors will sell out very near the bottom and miss most of the ride back up.

This is the problem with Buy and Hold. It's easy to stick with when the market is rising but impossible when the market is falling. If you think you're different and can ride out a bear market you'd better think again about how emotionally painful it will really be.

General Market Timing Principles

Stock Market Timing

What is Market Timing?

Market timing is simply the act of selling a portion of your stock market positions to a risk-free interest bearing account when odds favor a significant stock market decline. There are very few advisors that do not use some degree of market timing.

• Individuals use timing. Most just don't realize it. Every investment has to be bought at some point and sold at some point. The so-called "buy-and-hold" investors end up using a very bad timing strategy based purely on emotions.
• Mutual funds may hold 10-15% cash positions sometimes. But they can't risk under performing their competitors by being only partially invested. (They would rather lose money for their clients if everybody else were losing money, than under perform in a bull market.)
• Conservative advisors recommend stock positions of 0% to 100% based on their market perceptions.
• Aggressive advisors will recommend positions from 100% short to 200% long using margin.

Timing has some huge advantages.

• It's easier to accept small losses. Taking periodic small losses will not cause you to give up on the stock market. On the other hand, a 35% drawdown on your account will definitely have you doubting your strategy.
• With timing, much of the time you are invested in risk-free cash. Your money is safely earning interest and you get a break from market induced anxiety.
• You have a strategy. Without a strategy, you'll always be thinking, "Shouldn't I educate myself and get a strategy?" This question will especially haunt you when the market has turned against you. The temptation to sell everything until you HAVE a strategy will be enormous and irresistible.
• Many timing strategies have drastically outperformed buy-and-hold.

Random Timing Methods Do Not Work.

Most investors use random timing methods. To make their timing decisions they use

• Hot tips.
• Random advice from magazines or TV.
• Conflicting expert advice.
• Emotion and greed.

This is the type of timing that never works over the long term and gives market timing a bad name. It's driven by emotion and greed and always results in buying high and selling low.

The analysts on TV and Magazines may very well know what they are talking about. But, analysts can change their opinions quickly. For example, you see a well respected expert on CNBC say that he see the market going much higher for the rest of the year. So, you feel confident about your existing positions and may even add to them. However, after a couple of weeks this advisor could easily reverse his opinion. You'd probably never even know. Your emotions will force you to follow another bullish advisor's opinion, as you desperately want the market to go higher. Following this type of random advice is a very bad strategy.

Unproven Timing Methods Rarely Work.

Using unproven methods for market timing is a close relative to random timing methods.

• Investment books are full of unproven timing methods that completely fall apart when actually tested against historical data.
• Don't trust a theory or method unless you have proof that it actually works over a long period of time.
• Developing theories or methods that are profitable over a few years time are very easy to construct. But take that theory and run it against historical data from the '70s and most will fail miserably.

Mechanical Timing Methods

Mechanical timing means that you develop a strategy for timing purchases and sales of investments that does not require any type of expert analysis. A mechanical timing system simply generates buy and sell signals that you follow without question. Mechanical timing methods can be backtested against historical data to ensure that they are historically profitable. This is the type of timing systems that are contained in The ULTRA Market Advisor 4 for Windows. Each of the 47 individual systems generate 100% mechanical buy and sell signals using mathematical relationships based on various data inputs such as stock market data or interest rates. If a timing theory can't be represented in some mathematical form that can be back-tested by a computer, there's really no way to know if it is REALLY historically profitable. For example, you could use a stack of historical charts to test manually drawn trendlines, but no matter how hard you try to avoid it; the results will be skewed based on what you know about the future.

Expert Timing Methods

An expert makes decisions based on everything that he knows. As you can probably imagine becoming an expert is very difficult. An expert can do very well timing the market versus a mechanical method because:

• There are certain types of analysis that are very difficult to represent in computerized timing models such as support / resistance, trendlines, chart patterns, and news.
• Computers also have trouble weighing all the different types of analysis and coming up with a composite decision.
• Experts can weigh all the evidence, come up with a plan with contingencies if things don't go right. This is very difficult for computers.
• Experts can change their methods and strategies. Computers are stuck with their strategies once they are programmed and released.

Most experts utilize mechanical timing methods to help them make decisions. They will then sometimes override the mechanical methods based on knowledge that can't be represented with computer modeling.

"Same Day" Versus "Next Day" Trading

This is a very important concept.

Mechanical timing methods operate on stock market closing data. This data is only available AFTER the market closes. You can't act on buy or sell signal based on this data until the next trading day. With mutual funds, you always get the price at end of the NEXT market close.

Most stock market timing advocates tabulate their historical results assuming that they can get the closing price on the SAME DAY as the buy or sell signal occurs. We call this SAME DAY trading. Tabulating results based on SAME DAY trading is misleading.

SAME DAY trading can be approximated by using PRE-CLOSE stock market statistics. For example, at Rydex Mutual Funds you have until 2:45 PM CST to enter your trade to get the price at the end of that day. It is possible to use 2:30 PM CST stock market data and then enter your trade before the 2:45 PM deadline.

NEXT DAY trading means that you use the actual closing stock market statistics to generate your buy and sell signals. Then, you just casually enter your trade sometime before the market closes the next day.

Here's some advice gained from years of testing and experience:

• If your model trades infrequently (less than 3-4 times a year) there isn't much advantage to SAME DAY trading. Especially not when considering the extra commitment involved.
• Timing Systems that trade very frequently can be extremely profitable on a SAME DAY theoretical basis, but performance drops off significantly with NEXT DAY trading.
• PRE-CLOSE breadth statistics such as NYSE Advances and Declines are much closer to the actual closing numbers than price such as the S&P 500. The S&P 500 can move drastically in just a few minutes but breadth statistics change very slowly.

Market Timing Pitfalls

You need to be careful when deciding on a market timing strategy, as there are many pitfalls. Here are some that you should be sure to understand.

• Even excellent systems go through periods where they under perform the market. It's a fact. If you expect to beat the market every single month of the year using timing, get ready for disappointment. Outperforming the market on a quarterly or yearly basis is much more realistic. Here's a very common example, a system stays invested during an 8% drop of about two weeks. Just as an inexperienced user will give up on the system and sell out, the market turns and rallies 25%. Or, a system misses an important bottom and the market rallies 8%. Has this system stopped working? Who knows? Many different scenarios could emerge. This could be a bear market rally. Or, the system may enter later just before a more important market rise. And so on. The bottom line is to be slow to pick systems and equally slow to give up on them.
• Some systems are just theories and never worked. In years of designing and testing systems, I'm amazed at the large number that do not work when tested. Some common indicators and systems are of absolutely no value whatsoever. A good rule of thumb is to assume that an indicator or system is worthless unless you have proof otherwise.
• Depending too heavily on a single timing system. Timing systems are not perfect. Sometimes they temporarily under-perform the market. Some simply stop working. This is why it is imperative that you do not rely too heavily on a single system. Instead, you should pick a number of good systems and devise a strategy based on the set of systems that move you incrementally in and out of the market.
• Assuming the "best" system is the one that has the highest historical return. Your search should be for the system that has, "The best probability of performing well in real-time." The "Best" system also depends on the individual, SAME DAY vs. NEXT DAY, Frequency of trades, etc. Assuming a system that performs well with SAME DAY trading will also perform well with NEXT DAY trading.
• Curve Fitting. This is adding complexity to a system in order to produce better and better historical results. For example, A simple system that is profitable but only 60% of its trades are winners. You notice that many of the "bad" signals occur near the beginning of the month so you filter those out by adding complexity that brings your accuracy to 70%. As you add complexity you can continue to improve your historical record to 90% accurate. However, the complicated system is much less likely to reproduce the 90% accuracy than the simple system was to reproduce the 60% accuracy.
• Optimizing over an entire set of data. Timing systems should be developed using a period of data and then tested over an out-of-sample period to get a pseudo-real-time test of the system.
• Testing a system over too short a historical period. It is very easy to design systems that perform well over short periods in history. Most will however fall apart in out-of-sample periods and in real-time. The longer a system performs successfully in historical-testing the greater the odds of real-time success.

Many investors are now using strategies that are only tested back to 1988. This period in history is a very easy one for which to develop a strategy. It has been a period of unprecedented upward movement with very low downside volatility. An extremely rare period in stock market history. Basically, any trend following strategy that stayed invested 80% of the time worked very well. However, many of these strategies will fall apart dramatically when the market enters a more normal period of cyclical bull/bear markets with more downside volatility.

Out Of Sample Testing

During proper construction of a timing system, not all of the historical data is used during the construction process. Some of the historical data is reserved for testing the system in a pseudo-real-time test called out-of-sample testing. Out of sample testing is important to insure against excessive curve fitting.

For example, assuming you have 55 years of historical data, you may reserve the oldest and newest 10 years of data for an out-of-sample test of the completed system. The only problem with this method is that you may have personal knowledge of the latest 10 years and you may use it in the construction process without realizing it.

You can avoid this possibility by using the latest 15 years of data to construct the system and then use the earlier 40 years to run an out-of-sample test. This allows you to construct your system based on recent market action and use the earlier data to make sure the system doesn't bankrupt itself in a long out-of-sample test during different market conditions.

In any case, the longer the out-of-sample test, the better. Be wary of any system that is not tested against out-of-sample data.

Market Timing Systems vs. Futures Trading Systems

Market Timing Systems vs. Futures Trading Systems

There's a very big difference that many investors do not understand.

Market Timing Systems

Market Timing Systems (MTS) generate buy and sell signals that are profitable with little or no leverage. They are usually designed to trade and out-perform the S&P 500. In order to for a MTS out-perform the S&P 500 it must do two things.

1. It must not miss out on big stock market rallies.
2. It must be out of the market (i.e. in cash or short) during market crashes or for much of a sustained bear market.

The MTS doesn't need to be perfect in order to outperform the S&P 500. In fact, a perfect MTS has never, nor will ever, exist.If an MTS can do these two things it will be very successful when traded against stock mutual funds.

Any MTS that is profitable against the S&P 500 will be more profitable against aggressive growth mutual funds such as Rydex NOVA or Rydex OTC.

If a MTS fails to ride a big stock market rally, your account will simply gain interest from the cash account. If a MTS fails to be out of the market during a market crash, your account will lose value but you won't be completely wiped out.

A MTS can also be very well represented with historical testing. For example, mutual fund trading can be perfectly modeled due to the fact that the price you receive when buying or selling a fund is that of the next close. In fact, you can very accurately model S&P 500 Index funds for many decades historically.

Futures Trading Systems

Futures Trading Systems (FTS) are very different. For this discussion I'll talk about S&P 500 futures. A FTS attempts to capture small price moves with highly leveraged. investments. Losses must be kept small and closed out quickly. While there certainly are Futures Trading Systems that have been profitable in historical testing and in real-time usage, there are some major problems when it comes to the historical results of many of these systems.

The Historical Testing Periods of Futures Trading Systems is Usually Very Limited.

In fact, most that I've seen only go back a few years. This is not nearly enough testing to ensure that the model will not WIPE YOU OUT when this roaring bull market ends.

The 1990's have been an easy period for which to design a strategy that makes a hypothetical fortune in S&P 500 futures. (There's only been one minor bear market and the rest of the time it's been straight up.) However, take that same system and run it against a more normal market period and it will completely fall apart. If you get caught in a market crash holding S&P 500 futures positions you will be devastated very quickly. Most of the Futures Trading Systems now being sold will eventually fail miserably and their users accounts will likely be wiped out.

Remember, with futures one bad trade can erase your entire account. Believe it. It happens all the time. I remember a few years ago, reading about a well-known CTA's S&P 500 futures fund that was traded with a system. It posted a 97% loss in one month. Obviously, they switched to a new system.

The Historical Testing of Futures Trading Systems is not an Accurate Model.

Most of the historical results I've seen make major assumptions that are simply not acceptable. When you see, "$100 per trade for slippage and commission", get very worried. There is simply no way to know exactly what price you would have actually received during a real trade. Futures prices change constantly. You can't test against actual tick-by-tick futures prices because the data series would be massive. Even then, the data has to be adjusted because of contract expirations.

There are also other considerations such as lack of liquidity, and bad order fills that cannot be represented in historical models.

When you see impressive historical results for Futures Trading Systems remember that they are just an estimation. In real-live trading during the historical period the system may or may not have actually been profitable.

Futures Trading Systems are Really not Very Accurate at Timing the Market.

Here's a simplistic way to look at it. Assume that a Futures Trading System gains 50% in a year. If the leverage is 10 to 1, (i.e. $10k controls a $100k contract), the trading system actually only captured a market move of around 5%

Now assume a Market Timing System (MTS) gains 20% in the same year without leverage. Which system actually timed the market better? If the Market Timing System had been trading with 10 to 1 leverage, it would have gained 200%!

I'm certainly not advocating using Market Timing Systems to trade futures. They do not contain tight mechanisms to cut losses short. In other words, a mild 10% correction in the S&P 500 (which is totally acceptable to a Market Timing System) turns into a 100% loss with 10 to 1 leverage.

Finally,

Never forget that most futures traders lose money. Depending on whom you ask only 5% to 30% end up with profits in a given year.

Specific Stock Market Timing Systems and Strategies

Stock Market Timing Methods

Admittedly, we can't afford to give away all of our research to you. But, since you've made it this far we want to be sure that you leave with some valuable information about stock market timing techniques.

Stock Market Seasonality

The stock market has very important seasonal tendencies that every investor must know. December and January are far and away the best months of the year for the stock market. Actually, as you'll soon see the bullish period runs from late November to early January.

September is easily the worse month of the year. Surprisingly, the next worst month of the year is February as the stock market has seen MANY major tops occur in January. October, which most investors are deathly afraid of, is actually in the middle of the pack as far as performance is concerned.

Don't dismiss these tendencies. They are based on 56 years of stock market history. Why they occur is really unimportant but they do make some sense.

Since the stock market has a historical upward bias, at the end of the year many investors will have gains in their positions. If they can put off selling these profitable positions until the next year they can put off the capital gains tax that they owe for a year. This reduction in selling during December could be the reason for the December/January bullishness.

The September bearishness could be due to the fact that summer is over, everybody's back at work, commuting traffic is at it's peak, winter's coming, etc. Just a lot to be negative about.

The Pre-Thanksgiving Buy Signal.

Here's an example of a market timing strategy that has worked for decades. It's very simple: You BUY on the Monday before thanksgiving and SELL on the third day of January.

The following table details all of the signals and the gains versus the SP500 with a beta of 1.5 modeling the Rydex Nova mutual fund.

Sell Date	Gain Sell	Date	Gain
01/05/43	+8.48%	01/06/70	-0.68%
01/05/44	+7.94%	01/06/71	+14.44%
01/04/45	+9.08%	01/05/72	+20.29%
01/04/46	+0.35%	01/04/73	+5.02%
01/04/47	+10.38%	01/04/74	-2.70%
01/06/48	-0.89%	01/06/75	+4.88%
01/05/49	-0.49%	01/06/76	+6.40%
01/05/50	+8.03%	01/05/77	+3.17%
01/04/51	+7.07%	01/05/78	-3.95%
01/04/52	+7.85%	01/04/79	+5.24%
01/06/53	+6.25%	01/04/80	+3.30%
01/06/54	+4.80%	01/06/81	-0.21%
01/05/55	+8.67%	01/06/82	-2.99%
01/05/56	-0.90%	01/05/83	+8.65%
01/04/57	+4.54%	01/05/84	+2.49%
01/06/58	-1.82%	01/04/85	+0.53%
01/06/59	+12.45%	01/06/86	+7.71%
01/06/60	+8.02%	01/06/87	+3.23%
01/05/61	+7.08%	01/06/88	+9.82%
01/04/62	-2.26%	01/05/89	+7.77%
01/04/63	+10.81%	01/04/90	+7.21%
01/06/64	+6.82%	01/04/91	+0.78%
01/06/65	-1.94%	01/06/92	+17.03%
01/05/66	+1.98%	01/06/93	+3.32%
01/05/67	+2.83%	01/05/94	+2.75%
01/04/68	+6.07%	01/05/95	+0.67%
01/06/69	-5.65%	01/04/96	+5.24%
-	-	01/06/97	-1.86%

Over the period 1943 to 1997 this simple system would have resulted in the following:

• Total trades:55 (75% Winners)
• Maximum Drawdown: -13.9% on 12/11/80 (Far less than the maximum drawdown on the S&P 500 over the same period of -48%.)
• Total Gain: 13,285%
• Compounded Annual Return: 9.2% (The S&P 500 gained 8.7% annually over the same period.)
• Percent Invested: 11.1% (The rest of the time it is invested in a risk-free interest bearing account earning the Commercial Paper Rate which is a good model of a money market account.)
• CAR while invested: 47.5% (While invested, your account appreciates at an incredible 47.5% annual rate.)

The following table details all signals and gains versus the NASDAQ 100 with a beta of 1.0 modeling the Rydex OTC Fund.

Sell Date	Gain
01/05/84	-0.20%
01/04/85	+2.15%
01/06/86	+5.86%
01/06/87	+3.16%
01/06/88	+17.16%
01/05/89	+8.34%
01/04/90	+0.58%
01/04/91	+5.23%
01/06/92	+19.03%
01/06/93	+6.85%
01/05/94	+7.42%
01/05/95	-2.75%
01/04/96	-1.43%
01/06/97	+3.90%

Over the period 1943 to 1997 this simple strategy would have resulted in the following:

• Total trades: 14 (79% Winners)
• Maximum Drawdown: -11.6% on 12/4/87 (Far less than the maximum drawdown on the NASDAQ 100 over the same period of -40%)
• Compounded Annual Return: 11.2% (The NASDAQ 100 gained 16.8% annually over the same period.)
• Percent Invested: 10.7%
• CAR while invested: 57.6% (While invested, your account appreciates at an incredible 57.6% annual rate.)

The DRTB Stock Market Timing System

DRTB is a simple weekly system. It only requires one computation over the weekend. All mutual fund trades are then performed before the market close on Monday. DRTB uses two pieces of data, the 90-day Treasury Bill yield (TB) and the Federal Reserve Discount Rate (DR).

Formulae

D = DR - TB

S = 9 week exponential smoothing of D which is compute with the following formula.

S = S(L) + 0.2 * (D - S(L)); Where: S(L) = S(Last week's value). * = Multiplication.

Buy Signal Buy

when S > 0;

Sell Signal Sell when S < 0;

Historical Results

This simple timing strategy has gained 16.4% annually against the S&P 500 with a beta of 1.5 (modeling the Rydex Nova Fund) from March 1942 to Sept. 1997. This is double the return of the S&P 500 over the same period. 80% of the trades were profitable and the largest loss was only 7%. Drawdown was substantially reduced versus the S&P 500's 48% drawdown in 1974.

Against the NASDAQ 100 from March 1983 to Sept. 1997 (modeling the Rydex OTC fund), this strategy gained 16.5% annually with 11 trades. 100% of the trades were profitable. Maximum drawdown was only 18%, far less than the 40% drawdown the NASDAQ 100 suffered in 1987.

The T87 Stock Market Timing System

The T87 Stock Market Timing System was published in the August 1997 issue of Technical Analysis of Stocks and Commodities Magazine (TASC). This system is an example of one that requires a computer to compute, as you'll see from the complicated formulae below. (This system is included in The ULTRA Market Advisor 4 for Windows.)

T87 is definitely one of the best performing systems we cover. Since 1/1/96 it has gained 92% vs. the S&P 500 with a 1.5 beta (modeling Rydex Nova) with only a -8.7% maximum drawdown. That gain computes to a 51.1% compounded annual return (CAR)!

T87 Formulae

Data

A = NYSE Advances, D = NYSE Declines, NH = NYSE New Highs, NL = NYSE New Lows, UV = NYSE Advancing Volume, DV = NYSE Declining Volume, SP = Standard & Poor's 500 index close.

Formulae

XNL = 3 day exponential moving average of NL

HNL = Highest XNL in last 40 days.

LNL = Lowest XNL in last 40 days.

RNL = HNL - LNL;

NLS = (((XNL - LNL)/RNL)*100.0)-50;

NLS_LAST = NLS value for previous trading day.

XNH = 3 day exponential moving average of NH,

HNH = Highest XNH in last 10 days.

LNH = Lowest XNH in last 10 days.

RNH = HNH - LNH; NHS = (((XNH - LNH)/RNH)*100.0)-50;

ADR = A/D;

ADRV = UV/DV;

DAR = D/A;

DARV = DV/UV;

DARV_LAST = DARV on previous trading day.

SP_LOW = lowest SP since last sell signal.

SP_HIGH = highest SP since last buy signal.

Buy Signals

(NLS <= 0) and (NHS >= -10) and (SP > SP_LOW * 1.0125) and one of the following is true.

1. (ADR >= 1.2 for 2 days out of 4 days) and (ADR >= 1.0 for 4 days out of 4 days).
2. (ADRV >= 7.5)

Sell Signals

(NLS >= 30) and (NLS - NLS_LAST < 30) and (NHS <= 0) and (SP < SP_HIGH * 1.0125) and one of the following is true:

1. DAR >= 1.9 for 3 days out of 4 days.
2. DAVR >= 10 and DAVR_LAST >= 2.2.
3. DAVR >= 2.2 and DAVR_LAST >= 10.

T87 Historical Results

The T87 Stock Market Timing System has an impressive historical record. During its development, T87 was optimized over the period 1/1/87 to 12/31/95. The periods 4/3/78 to 12/31/86 and 1/2/96 to 8/1/97 are the two "out-of-sample" periods (OOS). Table 2 details the historical results over the three periods and over the entire history.

As you can see T87's historical performance has been outstanding in the both of the "out-of-sample" periods. In fact, the Compounded Annual Return (CAR) was higher in both of the out-of-sample period than in the period over which T87 was optimized.

The T87 Stock Market Timing System vs. SP500 (Beta =1.5 modeling Rydex Nova). Next Day Trading

	4/3/78 to 12/31/86 (OOS)	1/2/87 to 12/31/95 (Optimized)	1/2/96 to 8/1/97 (OOS)	4/3/78 to 8/1/97 (Entire history)
Trades / year	1.6	1.0	1.5	1.25
Winners	64.3%	100%	100%	80%
Largest Gain	+72.7%	+63.8%	+37.3%	+72.7%
Largest Loss	-11.14%	0%	0%	-11.14%
Average Gain per Trade	+14.7%	+22.8%	+24.7%	+19.6%
Maximum Drawdown	-25.4% on 8/12/82	-18.0% on 12/4/87	-8.7% on 4/11/97	-25.4% on 8/12/82
82 CAR	+23.5%	+22.4%	+51.1%	+25.0%
CAR while Invested	+26.3%	+24.9%	+57.0%	+28.03%
SP500 CAR	12.2%	10.7%	30.6%	+13.1%
SP500 Maximum Drawdown	-27.1% on 8/12/82	-33.5% on 12/4/87	-9.6% on 4/11/97	-33.5% on 12/4/87

The ULTRA Market Advisor 4 for Windows Gives You the Power to Model a Leveraged Rydex NOVA / URSA strategy With Margin Interest and Commissions Taken Into Consideration.

Here's an example of how to model T87 buying Rydex NOVA on margin upon buy signals and Rydex URSA on sell signals using the ULTRA Market Advisor 4 for Windows:

First, you create a Composite Definition File.

@SYS
T87,1
@ALL
0,-100
1,+200
@END

Basically, the Composite Definition File above simply takes a 100% short position when T87 is on a sell signal and a 200% long position when T87 is on a buy signal.

To model a leveraged Rydex NOVA / URSA, you run the Composite Definition File above with the analysis setup as:

• Trading the S&P 500, Next Day. (Next Day trading is necessary when trading Rydex funds through a discount broker because trades must be entered a couple of hours before the market close.)
• Long position beta =1.5, short position beta =1.0. (This models the Rydex funds. Nova has a 1.5 beta and URSA has a -1.0 beta vs. the S&P 500.)
• Deduct trading commission of 0.2%. (This is $50 for a $25k account which models trading Rydex funds through Jack White & Company)
• Deduct Margin Interest from Positions > 100%. (Half of a 200% position will be charged margin interest.)
• Margin borrowed at Commercial Paper plus 2%. (Comparable to Jack White's margin interest rate.)

This simple composite consisting of just T87 produces a 40.2% compounded annual return since 9/1/88 with only a 24.2% maximum drawdown. Since 1/1/95, this strategy has an amazing record. A compounded annual return of 97% with only a 14% maximum drawdown!

However, since 1978 this strategy shows a 36% annual gain with a painful 62% maximum drawdown in 1982.

This example demonstrates the dangers of testing strategies over short time periods that don't represent various types of markets. Looking at the results since 9/1/88 this strategy looks fantastic, but looking at the results since 1978 shows its serious weakness during the '81-'82 bear market during which a 62% drawdown probably would have resulted in you giving up on the strategy.

Simple Market Timing Composite Strategies

Why use multiple timing systems?

Diversification of Strategy

Some timing systems temporarily under perform the market. Some simply stop working. Often the best performing system in one year will be a loser the next year. And so on. This is why it is imperative that you do not rely too heavily on a single system.

Instead, you should pick a number of good systems and devise a strategy based on the set of systems. The majority of your systems will continue to outperform the market and make up for the few that do not perform well.

Another huge advantage of using multiple timing systems is that drawdowns are minimized. A fine timing system may experience a 20% drawdown during real-time trading. If you are only using that one system and you are trading Rydex Nova (which returns 150% of the SP500 return), your drawdown will be 30%.

On the other hand, if you are using five timing systems and one experiences a 20% drawdown, your total account drawdown due to this system will only be 4%. Each of your timing systems will experience their individual drawdowns at different times thereby drastically reducing your overall account drawdown. This drawdown reduction makes sticking to your strategy easier.

Implementing A Timing Strategy With Multiple Timing Systems.

At ULTRA we call multi-system strategies, Composite Strategies. Developing a Composite Strategy isn't difficult. But, finding the perfect combination that will perform the best in real-time is not possible since the future is unknown.

Here's a step by step method for developing a strategy.

How often do you want to analyze the market?

There are basically three viable options.

1. Weekly. You can do very well making your trades on a weekly basis with very little time investment. You can perform your analysis over the weekend, make your decisions and ignore the market until the next weekend.
2. Daily (next day). You can increase your returns by analyzing the market each night and making your trades before the end of the next trading day. This allows you to use some systems that trade too often for weekly use.
3. Daily (same day). This strategy is the most difficult to implement but may be worth the effort if you manage a large amount of capital. To implement this method you have to use numbers that are "near-close" at 3:45 PM EST and make your trades before the market closes, or the same-day trading deadline of your mutual fund company.

Determine how many systems to use to make your decisions.

For example, if you have $100,000 to invest you may want to use 10 timing systems to give you proper strategy diversification.

Determine how to allocate your capital to each system.

The simpliest case is linear allocation which would simply assign 1/10th of your capital to each system. Your possible overall positions would be 0%, 10%, 20%, 30%, 40%, 50%, 60%, 70%, 80%, 90%, 100% invested depending on how many of your timing systems were on buy signals.

With ULTRA's Historical Analysis (Composite) feature, you can model any combination of systems with no limits on complexity..

Determine which systems to use.

Now it's time to pick your systems. There are a few criteria to consider:

• Total return. Obviously you want the pick systems that have performed well historically.
• Drawdown. Since you are diversifying with multiple systems this is not as important as usual. Some very good systems have high drawdowns because of a single missed top somewhere in history. A failure of one sell signal should not disqualify a system from consideration.
• Frequency of trading. This is very important. Some systems trade too often to be used effectively for weekly trading. Some, such as MCO-ST are only suitable for Same-Day trading.

Choose your investment vehicle.

As I've said before I consider this choice secondary to your timing strategy. It's very easy to find funds that outperform the market when the market is rising. Here's some ideas:

• Use an index fund such as Rydex Nova which returns 150% of the return of the S&P 500. (Rydex 800-820-0888). Highly recommended.
• Another good option is Profunds (888-776-3637). They offer even more leverage against the S&P500 and NASDAQ 100 in both directions (long/short). ·
• You could use trendline analysis of the Nasdaq 100 index vs. the S&P 500 Index (NDX-RS). Switch to an Nasdaq 100 index fund when the OTC-RS breaks above a horizontal or downtrending resistance line. Switch into an SP500 index fund when horizontal support or an upsloping support line is violated. Be careful with steep sloped lines. They are less important than more gradual or horizontal lines. This type of analysis isn't mechanical, but is highly effective at predicting whether or not the Nasdaq 100 will outperform the market.
• Another option that we highly recommend is to have multiple strategies each trading different assets based on your personal risk exposure.

As you can see, implementing a multiple timing system composite strategy can be a bit involved. However, you can rest assured that a simple strategy of 10 weekly stock market systems with linear allocation, invested in Rydex NOVA is far more sophisticated than 99% of investors and most professional money managers.