According to the government’s preliminary estimate, Gross Domestic Product rose at an annual rate of 3.1% in the 4Q of last year, well below expectations of 3.5% or better.  Even taking into account a weaker than expected 4Q, the economy grew at the rate of 4.4% in 2004, the best rate since 1999.  And the next two GDP reports for the 4Q could be revised upward.  So, the economy is still on a solid growth track for 2005, although not likely to match last year’s pace.

While I have been guardedly optimistic about the stock markets for the last year, equity prices have gone essentially nowhere.  January’s price action in the broad equity markets has been a disappointment, and there is the real chance that another top is in the making.  A move to a more defensive position would seem advisable at this point.  Of course, if you are invested with one or more of our professional mutual fund Advisors, then you don’t need to take any action.

The bond markets did surprisingly well in 2004, despite my concerns, and they might hold their own this year with inflation expected to remain fairly low.  However, I don’t expect bonds to stage a repeat of 2004 this year.   The US dollar reversed higher since the first of the year, and this resulted in losses by most Commodity Trading Advisors who trade currencies.  While this upward correction in the dollar could continue for a while longer, the longer-term trend in the greenback remains lower.

This month, I feature the newest Advisor to be added to our recommended list.   For years, we have searched for a successful Advisor who uses both long and short positions in mutual funds, with the potential to make money in both bull and bear markets.  We have recently found a real gem in this regard.  In this issue, I will introduce you to Third Day Advisors, LLC which has one of the most impressive performance records we have ever seen.  Third Day has an average annual return of 23.4% over the last three years with a worst drawdown of -12.2%, net of all fees and expenses.  This is a program you should take a serious look at if you are a sophisticated investor.  See pages 2-6 and the important disclosures on Third Day that are included with this newsletter.

Introduction

As you probably know, “hedge funds” have been the rage in investment circles for the last several years.  However, most of these funds require minimum investments of $1 million or more, if you can get in at all.   This week I am delighted to introduce you to a professional money manager that applies some hedge fund-like strategies to mutual funds.  The money manager discussed below is the latest to make it into the select team of successful Investment Advisors that I recommend through our AdvisorLink program.  See performance information on page 4.

For over five years, we have been looking for a mutual fund money manager that has a successful performance record using hedge fund-like strategies both on the “long” side and the “short” side, and who has made money both in a bull market and a bear market in stocks.  I am happy to report that we have now found a money manager who: 1) made money in the bear market of 2002; 2) made money in the bull market of 2003; and 3) who even made money in the choppy, sideways market of 2004.

I strongly suggest that you read on and find out about a money manager that uses widely-known mutual funds in an effort to make money when the equity markets are trending higher AND even when the markets are trending lower.  Let me now introduce you to THIRD DAY ADVISORS, LLC and Ken Whitley , the founder and mastermind behind the system.   Third Day has an impressive performance record which is shown in the table on page 4.

Keep in mind, however that Third Day’s money management system is an aggressive program which uses both long and short positions.  It is therefore not suitable for all investors.  Past performance is not necessarily indicative of future returns.

Third Day Advisors, LLC

Like many active money managers, Ken Whitley began his career in an industry unrelated to financial services and asset management.  Ken graduated from college in 1981 with a B.S. in Computer Science and has spent his career in the fast-paced high-tech industry.  The story of how Ken utilized his extensive knowledge of computer hardware and software to develop an effective money management system is very interesting, so read on.

After working for various employers in the high-tech industry, Ken joined a small software firm in 1989.  When this company’s software product was acquired by Intel Corporation in 1997, an offer of employment came with the deal.  Ken accepted the offer and is still employed full-time by Intel where he is engaged in project and engineering management.

Having enjoyed the fruits of the 1990s high-tech boom, Ken built up a nest egg that he wanted to invest.  He began studying the market in his spare time, and after much trial and error, he developed a sophisticated model for trading the Nasdaq 100 Index.  In November of 2001, Ken completed back-testing this model back to 1995 and concluded that his system indeed had potential.  He then started trading his own money using the signals generated by his system.  The results, as you will see on page 4, have been outstanding, and they have been delivered in three very different market environments.

In 2003, Ken brought in Doug Fisher and his wife Angela as additional partners in Third Day.  Doug, also an employee of Intel, provides marketing assistance while Angela is responsible for day-to-day trading.  Ken and Doug’s money management activities at Third Day have been fully disclosed to Intel management, and they have no objections since their positions at Intel have nothing to do with providing investment advice.

The Third Day Aggressive Strategy

Investors familiar with alternative investment strategies, such as hedge funds, often seek out programs that can go both long and short in the market.   In such programs, the potential for profit exists no matter what the market’s direction.   Unfortunately, many such programs are available only to wealthy investors through hedge funds.  The Third Day Aggressive Strategy allows many aggressive investors the ability to have long and short exposure to the Nasdaq 100 Index.

Ken’s Aggressive Strategy is a proprietary blend of momentum, trend-following and overbought/oversold indicators.  There are six basic indicators that Ken uses to analyze the market, with a number of sub-indicators that also factor into each trading decision.  Each indicator “votes” on whether to be long, short, or neutral in the market.    The model is 100% mechanical, though Ken does reserve the right to override his system’s signals in the case of a national emergency.

The relative strength of each indicator then determines to what extent the Third Day program will be invested in the market.  The investment vehicles used are the Rydex Venture and Rydex Velocity mutual funds.  These funds are part of the Rydex Dynamic class of funds that seek to provide investment returns that correlate to 200% of the daily performance of the Nasdaq 100 Index, with Velocity providing a positive correlation and Venture providing a negative correlation. 

Unlike most mutual funds, the Rydex Dynamic funds also allow Third Day to trade in or out of a fund two times per day, once at 10:45 AM Eastern time and again at the close of business at 4:00 PM Eastern time.

To limit risk, Ken will only allocate up to 75% of an account to any fund position, resulting in a 150% maximum exposure to the Nasdaq 100 market.  However, maximum allocations of 75% are rare.  Historically, Third Day’s allocations are in the maximum range only 12% of the time on the long side, and only 2% on the short side.  The program is projected to be in cash (money market fund) an average of 38% of the time in any given year based on historical performance and back-testing.

When first developed, Ken’s model would issue a trade signal that would last a maximum of three days, which is where the “Third Day” name came from.    This automatic exit from the market also acted as a method of risk control, since the duration of each trade was limited.  However, in the strong stock market in 2003, Ken found that automatically exiting the market after three days left additional gains on the table in many cases.  Thus, he adjusted the model to allow it to stay invested as long as the buy signal is confirmed by his indicators.

The Third Day Aggressive Strategy does not currently employ any traditional stop-loss techniques to automatically exit losing trades.  This is another reason why the program should only be considered by aggressive investors who are comfortable with high volatility and significant periodic drawdowns.

While the Third Day program has been successful in limiting losses, it should not be considered as a low-risk program.  While Third Day’s Aggressive Strategy has had only a –12.18% maximum month-end drawdown to-date, Ken says that his target is to limit drawdowns to no more than -20%.    You should keep this in mind when evaluating this investment for your portfolio.

The short-term trading nature of the Third Day Aggressive Strategy will mean that there will be a significant amount of activity in your account.  In addition, all gains will be short-term in nature, so this program may not be the most suitable option if tax efficiency is a priority.

Performance Evaluation

As noted above, Ken did not start actual trading of his program until the end of 2001, so it has a relatively short actual performance history.  While the track record is just over three years, 2002, 2003 and 2004 provided three very different types of markets to test his strategy.  In 2002, we saw a major bear market in stocks.  In 2003, the market reversed itself and experienced a powerful rally.  then in 2004, we saw a sideway market where long-term trends were hard to come by. 

Many times, strategies that claim to be effective in all types of markets can do well in a bull or bear market, but usually not both.  Even the ones that can negotiate both up and down markets often get whipsawed during sideways markets due to volatility and the lack of tradable trends.

Third Day is one of the very few managers we’ve ever seen who has been successful in all three different market environments - up, down and sideways. Since its inception in November of 2001, the Third Day Aggressive Strategy has proven its ability to navigate different market environments by posting an average annualized return of 23.43%, net of all fees and expenses.  The worst-ever losing period (or “drawdown”) was –12.18% in the bear market of 2002.  See the actual performance history in the tables below for more comparisons and monthly returns.  SEE IMPORTANT DISCLOSURES  INCLUDED WITH THIS NEWSLETTER.

(click charts for larger image)
PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.

While Third Day’s performance is impressive by itself, it’s even more so when compared to the S&P 500 Index’s average return of 6.14% and the Nasdaq 100 Index’s average return of 4.61% over the same period.  While past performance is not necessarily indicative of future results, it’s clear that Ken’s sophisticated model has been effective in dealing with very different market conditions over the past three years.

Low Correlation To Our Other Programs

While performing our due diligence evaluation on Third Day’s Aggressive Strategy, we found that this program has virtually no correlation to any of the other programs offered by ProFutures.  By correlation, I mean the tendency of an investment to go up or down in relation to other investments.

If two investments go up and down together, they are said to be positively correlated.  If one goes up when the other goes down, and vice versa, they are said to be negatively correlated.  However, if an investment's gains or losses are independent of others, then it is said to be non-correlated.  Non-correlated investments are preferred because they have the potential for gain without respect to how any other investment in the portfolio may perform.

So what does this mean to you?  Including non-correlated investments in your portfolio helps to reduce the potential risk of your overall portfolio and may also improve overall performance.  Specifically, this means that if you add Third Day to your other existing investments with us, you add not only Third Day’s outstanding performance, but also additional diversification to your portfolio. 

The Trading Platform

As noted above, Third Day is a small firm and Ken still has his full-time job with Intel.  However, Ken’s location on the West Coast (Pacific time zone) and his outsourcing of “back-office” operations have overcome the usual constraints associated with a small business.  Ken has the benefit of living in the Portland, Oregon area, a three-hour time difference from the East Coast.  As discussed above, the first trading opportunity for the Rydex Dynamic Funds is at 10:45 AM Eastern, which is 7:45 AM Pacific time, before Ken’s workday starts at Intel.  The second trading deadline is 4:00 PM Eastern, which is 1:00 PM in Oregon, during the lunch hour.

The luxury of the time zone differential, however, does not cover the lack of a back-office capability for processing accounts.  Third Day has also covered that base by outsourcing its “back-office” activities and account administration to Purcell Advisory Services, LLC, a company that provides back-office services for small Advisors nationwide.  Purcell Advisory Services handles the account set-up paperwork, reporting, fee billing, etc. while Third Day need only make a call to Purcell each day to communicate the trading instructions.

Since the system is 100% mechanical, all Angela has to do is enter market data and the software produces the actual trading instructions.  If the system gives a signal, either to enter a trade or exit a trade, Angela then confirms the signal with either Ken or Doug, and then communicates the trading orders to Purcell.

Because of this outsourcing, the ProFutures due diligence team also made an on-site visit to Purcell Advisory Services to review their administrative capabilities and internal controls.  We are happy to report that they passed our due diligence review with flying colors.

The minimum investment for the Third Day Aggressive Strategy is $50,000, and the annual fees are 2.5% billed quarterly in advance.  Client funds are held in Rydex mutual fund accounts, and investors have access to their accounts through the Rydex website.  Both Rydex and Purcell Advisory Services issue quarterly statements, and Rydex produces year-end tax reports.

When Tragedy Strikes

One of the most important questions we ask when performing due diligence on an Advisor is to what extent they have someone to back them up should they not be able to fulfill their duties.  In most cases, we have to evaluate a hypothetical back-up plan, but in Third Day’s case, we were able to see the back-up plan in action.

In November of 2004, Ken was called home from a hunting trip due to his wife’s sudden illness.  A few days later, his wife, Jane, died at only 41 years of age.  Jane had, up until that point, shared trading responsibilities with Angela.  During the period of time that Ken was attending to his wife in the hospital, and then making funeral arrangements and spending much more time with their four children, the Third Day back-up system performed flawlessly.  Ken’s partner, Doug Fisher, ran the model and his wife Angela called in the trades.

We have spoken extensively to Ken in the aftermath of his wife’s death to make sure he still wants to commit to continue his money management business.    Ken has told us that he is just as committed as ever to continue Third Day, partly because his wife was an integral part of founding the business, and she would have wanted it that way. 

Experienced investors will recognize that life-changing events, such as a spouse’s death, can have an effect on an Advisor’s continued success.    We recognize this factor and will stay in close contact with Ken in the weeks and months ahead.  However, with the nearly 100% mechanical nature of the system and the proven back-up in the form of Ken’s partners, we feel that the Third Day program continues to be a viable option for our aggressive clients.

Conclusions

The Third Day Aggressive Strategy can be an attractive option for investors who understand risk and want to diversify their portfolios by adding an investment that has both a long and short exposure in the market.  As noted above, the program has an average annualized return of 23.43% since inception, net of all fees and expenses, with a worst-ever drawdown of only –12.18%. 

Yet the most impressive thing about this program is that it has shown outstanding results during the last three years of very different market conditions.  And you can access Third Day for a minimum investment of only $50,000.

Our analysis has also shown that Third Day’s historical returns show little or no correlation to the other Advisors I have written about over the past two years.  Thus, the Aggressive Strategy is an ideal complement to the other actively managed investments offered under the ProFutures AdvisorLink Program.

In conclusion, the Third Day Aggressive Strategy is one of the most impressive programs we have seen in several years.  Normally, we like to see a performance record that is longer than just over three years, but the last three years have seen a bear  market (2002), a bull market (2003) and a sideways market (2004).  And Third Day has had outstanding performance in each of those very different years, averaging over 23% .  (Past results are not necessarily indicative of future results.)  Also, because the system is nearly 100% mechanical (no discretion on Ken’s part), we have more confidence in the program going forward.

If you believe, like I do, that there is a recession in our future, and that the equity markets will face some tough times in the next several years, then I suggest that you take a serious look at Third Day’s very successful program.  Having the potential to make money in a sideways or bear market may prove extremely important over the next few years. 

If you want to learn more about the Third Day Aggressive Strategy, or have questions regarding any of the information provided in this Profile, you can call ProFutures at 1-800-348-3601, or e-mail us at mail@profutures.com.

The Economy Cools A Bit

The government’s advance estimate on 4Q Gross Domestic Product was well below expectations.  The Commerce Department reported on January 28 that GDP rose only 3.1% (annual rate) in the 4Q following the gain of 4% in the 3Q of last year.  For all of 2004, based on this latest report, the economy grew at the rate of 4.4% last year, the best pace since 1999.

Personal consumption spending rose by 4.6% in the 4Q, so consumers continue to spend.  For all of 2004, consumer spending was up 3.8% as compared to 3.3% in 2003.  Government statistics continue to show that consumers have record debt levels, but these figures do not consider home equity or gains in securities and other investments.  The bottom line is that consumers are likely to continue spending and keep the economy reasonably firm again this year.

Business investment spending continued to be robust in the 4Q.  The government reported that capital investment rose 10.3% in the 4Q versus 13% in the 3Q.  Business investment spending is expected to remain strong all this year.

A Bloomberg survey of economists and market analysts conducted in early January found a consensus estimate of 3.6% growth in GDP for 2005.  This is consistent with The Bank Credit Analyst which forecasts GDP growth of 3.5% for this year.  BCA continues to believe there will not be a recession in late 2005 barring some unexpected negative surprise such as another terrorist attack in the US.

In summary, the US economy will remain in positive territory again this year.   Growth is not likely to match last year’s 4.4% pace, but a recession does not appear to be in the cards as the gloom-and-doom crowd promises (over and over again).  Consumers have high debt levels, but the overall net worth picture is much more positive.

Will The Fed Tighten Too Much?

The Fed has made it no secret that they plan to continue hiking short-term interest rates this year.  Since last June, the Fed has raised the short-term borrowing rate from 1% to 2.25% as this is written.  The Fed is expected to raise the key rate another 25 basis points to 2.5% at the next FOMC meeting scheduled for this week.

So far, the interest rate increases have not caused any serious damage to the economy.  As noted on page one, the bond markets actually held up quite well last year despite the short-term rate hikes by the Fed.  However, analysts all over the world are trying to gauge just how far the Fed intends to take short rates.  The consensus seems to be that the Fed will raise rates to 3%.  If so, this round of monetary tightening could be over by mid-year.

The Bank Credit Analyst, on the other hand, believes the Fed is targeting a 4% level in the Fed Funds rate.  If correct, that would mean the Fed will continue to ratchet up short-term rates pretty much all year, and that will not be good news for the equity markets and possibly bonds as well.

Obviously, the Fed will continue to monitor the economy and what’s happening in the stock and bond markets.  Policy will be set accordingly.  Given that this is Alan Greenspan’s last year as Fed chairman, he does not want to go out with the economy in a recession or the equity markets in the tank.  So, as he puts it, the rate hikes will be “measured.”   Even so, BCA predicts that the Fed funds rate is likely headed for 4%, and this is above what Wall Street is currently expecting.

Are Stocks Set To Trend Lower?

As you know, I have been generally positive on the outlook for equities over the last year.  In fact, I have been bullish since just before the war in Iraq began in March of 2003.  If you followed my advice back then and moved to a fully invested position in stocks and/or equity mutual funds, you have done very well.  But if you have watched the market at all, you know that January was NOT a good month for the stock markets.  My optimism is fading fast.

While the economy is expected to remain solid again this year, the equity markets are facing some stiff headwinds.  The interest rate environment is not friendly as discussed above, and the Fed Funds rate is likely to rise more than Wall Street expects.  The US dollar is likely to be lower later this year, and this is also not positive for US equities.  Oil prices remain high and there is still the risk of another spike up again this year.  Corporate profit growth will not match 2004’s heady pace.

Equity prices churned mostly sideways in 2004, ending the year with only modest gains in what was clearly a more positive environment than we see for this year.   Also, this is the third year after the bear market which ended in 2002.  Historically, the S&P 500 only gains about 3% on average in the third year after a bear market low.

So the question is, will stocks churn sideways again in 2005, and maybe edge slightly higher, or could we be seeing another major top in equities?  Obviously, I don’t know for sure, but price action so far this year is NOT encouraging.  

At the very least, the downside risk in equities is higher now than it was in 2004, and last year was not a banner year.  Given this outlook, readers who are overweighted in equities are advised to reduce holdings just ahead, especially if prices recover somewhat after the beating in January.

BCA’s forecast is that the equity markets will continue to be choppy for most of this year and ease moderately lower.  They do not expect a major bear market.  They believe some sectors will do reasonably well, even in a choppy to lower environment.  Their favorite sectors are energy, health care, consumer staples and telecom services.  Sectors they recommend you avoid are technology, financials and consumer discretionaries.

The Argument For Active Management

Given where we are in the economic cycle and the interest rate cycle, there are no really attractive asset classes to buy.  Stocks are vulnerable, bonds are vulnerable, real estate is frothy, metals have topped out and currencies are very volatile.  It is precisely these kinds of uncertain times when active, professional management is in order.

“Active” management, in this case, refers to professional Advisors with time-tested systems that can move them partly or fully to cash if market conditions so dictate.  Some of the managers we recommend will “hedge” their positions using short funds, rather than sell out positions.  If the equity markets turn lower this year, you need that kind of active management.

In the case of Third Day Advisors, you have a program that has a record of “shorting” the market during downturns in the equity markets.   Third Day uses certain Rydex funds which go up when the market goes down.  While this is an aggressive strategy, and therefore not suitable for all investors, Third Day has delivered outstanding results over the last few years in an up market, a down market and even the sideways market of 2004.  (Past results are not necessarily indicative of future results.)

If you are a sophisticated investor, I highly recommend you check into Third Day for a portion of your equity portfolio.  Call us at 800-348-3601 for more details and account paperwork.  You can also see information on Third Day and all of the Advisors we recommend at www.profutures.com .