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New All Time highs in Dow - now what?

October 23, 2006

 

If you spend any time watching CNBC these days, you've no doubt seen the flashing orange alerts and special reports trumpeting new all time highs in the Dow Jones Industrial Average Index. We've found their exuberance somewhat comical here in our offices, as it just doesn't seem as relevant or important as when it was happening back in 1999 and 2000.

Why is it that nobody much cares about the Dow at new all time highs? What's missing this time? Well, for starters, I believe very few people are actually invested 100% in the DIA tracking stock which tracks the performance of the Dow Index. Most people instead have a portfolio of stocks which may or may not resemble the performance of the 30 stocks comprising the DJIA Index. So the talking heads on television telling many investors that the Dow is at all time highs is a lot like a Chicago weather man telling locals that it was another bright and sunny day in San Diego.

Perhaps the reason no one is as excited about the Dow hitting a record is because so many investors got burned last time around.

After hitting all time highs in the early part of 2000, the DJIA is up just 7% since then, with nearly all of those gains coming in just the last few months. Compare that small gain with the 50% gain seen in the CSFB Managed Futures Index* over the same time period.

*The managed futures component of the Credit Suisse/Tremont Hedge Fund Index consists of approximately 33 different commodity pools and managed futures account programs.

So while the pundits on television are remarking how impressive the DJIA's rally off the lows seen at the end of 2002 is, and how the sky is the limit now that we've hit new record highs - it only seems prudent to put this rally in perspective and ask what's next? And while we can argue the relevance of the DJIA to individual investor's portfolios, it does remain a pretty good proxy for the overall US stock market in my opinion. .

What's Next?

In looking at what's next, it pays to take a peek back in history to see what type of market environments have followed past historic record high closes, perhaps showing what we could encounter over the next 10 years or so. The two charts below show two extremes in 10 year price action, and highlight just how different a decade can look in the stock market.

The first of the two charts under the 'chart of the week' section below shows what the DJIA did after hitting new all time highs (breaking above 1,000) in October of 1968. Most investors choose not to believe this type of market can happen, but it sure did. The next 10 years were just horrible for stock market investors after the all time highs in 1968, with the DJIA posting a return of -18% over that time period.

On the flip side of the 1970's poor performance is the much publicized 1990's rally. After making new all time highs in July of 1990, the US stock market simply took off, moving from a value of just under 3000 and tacking on nearly three times its value as it passed through 4000, 5000, 6000, 7000, 8000, 9000, 10000 and finally 11,000. When all was said and done, investors had seen a 10 year total return of 286%! Wow.

But - and this is a very BIG but, that rally was followed by a two year drop of 32%, or about 4000 of the 8000 points the DJIA had tacked on in the past 10 years. That kind of drop is exactly what investors are trying to avoid.

The Investor's Wager:

So what is an investor supposed to do at these all time highs? Which way will the stock market go from here? It is really a wager of sorts, betting whether the market will go up or down. But investors are not just betting on its direction, investors also must choose the amount of the wager.

The amount of the wager is represented by the choice of either taking money of the table right now and diversifying some stock holdings into an alternative investments such as managed futures, or letting it ride by not diversifying and keeping a large portion of assets at risk in the stock market.

Luckily for investors having to place this wager, we don't need to know the exact answer to the question of what the market will do from here. All an investor really needs to do is acknowledge the possibility that they can lose a lot of money rather quickly in the stock market (as in 2000 through 2002) or even lose money rather slowly (as in 1968 through 1978).

Once we recognize that possibility, we can build the following decision matrix:

The decision matrix to the right shows the four possible outcomes of the Investor's Wager (assuming stock portfolio performance will mimic that of the overall market, and that the investor diversifies no more than 50% of her overall portfolio away from stocks)

The two possible outcomes for the Diversification decision are 1. making money and 2. the possibility of making money, while the two possible outcomes for the No Diversification decision are 1. making money and 2. the guarantee of losing money.

A sophisticated, logical investor should choose the possibility of making money over the guarantee of losing money every time, and as such should choose the diversification decision over the no-diversification decision every time.

Looking at the investor who chooses to diversify into a non correlated alternative investment like managed futures, that investor has eliminated the worst case scenario from her possible investment outcome no matter what the stock market does. And the best part - the alternative investment may just prove to be a winner in its own right, just as we have seen with the managed futures index posting gains of 50% since March 2000 while the DJIA is up only 7%.

- Jeff Malec

IMPORTANT RISK DISCLOSURE


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Feature | Week In Review: Quiet week ahead of FOMC meeting | Chart of the Week

***Overview***

As noted above, the Dow Jones Industrial Average closed at record highs multiple times last week, moving above the "magical" 12,000 level. Stock futures were not as impressed, with SP 500 futures climbing just 1.30 points for the entire week while NASDAQ futures were down -1.18%! Not exactly a huge rally as the commentators on CNBC would have you believe. Smallcaps also traded lower with Russell 2000 futures falling -0.53% and SP Midcap futures dropping -0.95%.

Elsewhere, trading in bonds and currencies was very slow and choppy for the week as traders await the Federal Open Market Committee’s decision on interest rates this week. Most analysts expect that the FOMC will remain status quo and leave rates steady for at least one more month.

Energy prices continue to move lower despite OPEC’s threats to cut crude oil production. Crude Oil futures fell 1.61% last week as supply continues to outpace demand. Heating Oil futures were also down falling -2.20% while RBOB Unleaded Gas futures remained nearly unchanged for the week. Natural Gas futures moved in the exact opposite direction however, climbing +5.88% last week.

Metals resumed their upward movement last week with Silver gaining +2.44%, while High Grade Copper gained +1.42%, and Palladium climbed +4.61%. Platinum futures were unchanged for the week.

Grain prices continue to be volatile as crop conditions continue to look bad in Australia. Soybean futures led the way last week gaining +2.35%, while Corn was unchanged, and Wheat futures fell -3.90%.

Elsewhere in the commodity markets Lean Hogs fell -2.78%, Live Cattle was down -0.97%, Coffee moved -1.92% lower, while Cotton +0.47% and Sugar +0.52% traded higher for the week.

***Day Trading***

Stock index futures were stuck in a consolidation pattern after the recent run-up and caused problems for day trading systems. On several different occasions, futures opened in one direction and quickly turned around to finish the day unchanged. It’s easy to say in hindsight, but the only way to make money last week would have been to fade the overnight moves and aggressively trail stops.

One system finishing in the black was Epsilon 12/12, which made a mere $13.03 on three trades. Tanker CL had a few winning trades, but ended the week with a loss of -$200, while BetaCon 4/1 ESX had two trades for a loss of -$436.

Elsewhere, RC Success eRL continued its second half of the year struggles losing -$540, Compass SP took its second trade of the month which ended up being a losing trade of -$625, and Kappa Dax didn’t have any luck with the counter-trend approach and lost -$649.63 for the week (it made half that back with a wining trade today).

***Swing Trading***

Last week’s seasonal up trend played perfectly into two of this years top performing system – Seasonal ST eRL earned $1,170 on the week after on two trades and Adaptive US added +$999 on 3 trades. Seasonal ST eRL is up 7.7% for the month and 34.2% for the year based on $20,000 invested, while Adaptive US is ahead 20.4% on the year based on $30,000 invested.

Beyond the above it was a rather slow week for most swing systems as several are currently flat the market. Other results were as follows: Volcano EUR +$230, Mesa Notes +$140.62, , Seasonal ST ES -$10, Delphi eMD -$20, Spartan ES -$75, Jaws Narrowneck -$125, Volcano EURJPY -$214.80, Adaptive Euro -$406, Volcano GBP -$420, Ping Systems –$970, and SC Forex -$1,120.

Looking ahead to this week systems will likely be keying on any potential volatility that may result from Tuesday’s Federal Reserve meeting.

***Long Term***

With the FOMC meeting scheduled for this Wednesday, traditional commodity markets were fairly subdued last week. The upcoming FOMC meeting could have a significant impact in most sectors of the futures markets, as any changes in the posture of the FOMC might make for some interesting markets and trends as the end of the year nears.

Price action in the interest rate sector the past week was mostly sideways to a little lower following a fairly deep correction after most of the sector posted new 30+ month highs to start the month. Some systems are in long positions as Andromeda has open trade profits of +$403.12 in USZ and +$481.87 in TYZ, Aberration has open trade profits of +$481.87 in TYZ and Vivaldi has an open trade loss of -$625 in USZ. Axiom LT closed out a small profit of +$150.00 in TYZ during the past week.

Most of the major currencies posted upside corrections during the past week, but the rally did nothing to threaten b downtrends as it appears foreign investor still favor putting their money in U.S. dollar backed investments due to b corporate growth. Systems with short positions in SFZ and JYZ include Andromeda making +$1737.50 per contract (open trade) and +$2368.75 per contract (open trade), Pegasus making +$1575.00 per contract (open trade) and +$1543.75.75 per contract (open trade). Aberration is short SFZ with an open trade loss of -$725 and Axiom LT is short SFZ making +$1275.00 per contract (open trade).

The energy markets started the week looking to move higher as OPEC stated it would cut daily production, but the tone soon was muted and prices headed back down on thoughts OPEC was just giving the markets lip service with many pundits noting that it was highly unlikely other producing nations would follow Saudi Arabia’s lead to cut daily production. Systems with short positions include Pegasus which is making $+16,160.00 per contract (open trade) and Trend Simplicity which is making +$14,570.00 (open trade) on a short Crude Oil position.

The Grain and Oilseed markets basically remained fixed in their current trends, although corn and wheat did post slight downside corrections. Soybeans rallied some on ideas that end-users would move their protein demand to this sector after the sharp recent increases in corn prices. The cotton market found a little bid for the week, but the b downtrend is still dominate as oversupply and a lack of export business still hang over the market. Systems with long corn positions include Aberration making +$1237.50 (open trade), Andromeda +$562.50 (open trade), Axiom LT +$2187.50 (open trade), and Trend Simplicity +$437.50 (open trade). Systems with short cotton positions are Andromeda +$1300.00 (open trade), Axiom LT +$6360.00 (open trade), Trend Simplicity +$1395.00 (open trade), and Vivaldi +$3450.00 (open trade).

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IMPORTANT RISK DISCLOSURE
Futures based investments are often complex and can carry the risk of substantial losses. They are intended for sophisticated investors and are not suitable for everyone. The ability to withstand losses and to adhere to a particular trading program in spite of trading losses are material points which can adversely affect investor returns.

Past performance is not necessarily indicative of future results. The performance data for the various Commodity Trading Advisor ("CTA") and Managed Forex programs listed above are compiled from various sources, including Barclay Hedge, Attain Capital Management, LLC's ("Attain") own estimates of performance based on account managed by advisors on its books, and reports directly from the advisors. These performance figures should not be relied on independent of the individual advisor's disclosure document, which has important information regarding the method of calculation used, whether or not the performance includes proprietary results, and other important footnotes on the advisor's track record.

The dollar based performance data for the various trading systems listed above represent the actual profits and losses achieved on a single contract basis in client accounts, and are inclusive of a $50 per round turn commission ($30 per e-mini contracts). Except where noted, the gains/losses are for closed out trades. The actual percentage gains/losses experienced by investors will vary depending on many factors, including, but not limited to: starting account balances, market behavior, the duration and extent of investor's participation (whether or not all signals are taken) in the specified system and money management techniques. Because of this, actual percentage gains/losses experienced by investors may be materially different than the percentage gains/losses as presented on this website.

Please read carefully the CFTC required disclaimer regarding hypothetical results below.

HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN; IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULAR TRADING PROGRAM. ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK OF ACTUAL TRADING. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR TO ADHERE TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES ARE MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS IN GENERAL OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL WHICH CAN ADVERSELY AFFECT TRADING RESULTS.