The Commerce Department revised 1Q GDP upwards from 3.1% to 3.8% in late June.  Consumer confidence hit a three-year high in June, contrary to the picture the media is painting.  The unemployment rate fell to 5% in June, the lowest level in almost four years.  The housing boom continues strongly.  On the negative side, the Index of Leading Economic Indicators fell for the fifth consecutive month in May.  The bottom line is that overall economic growth has slowed somewhat from the 2004 pace, but growth should still be above 3% for all 2005.  No recession is in sight.

Most analysts continue to believe that the Fed will raise interest rates at least one more time in early August.  I continue to believe there is a good chance the Fed will end its rate hiking cycle in August when the Fed Funds rate is likely to reach 3½%.  If the Fed stops raising rates, this should present another excellent buying opportunity in stocks later this summer.  Actually, stocks have held up amazingly well this year in light of the modest slowdown in the economy, rising short-term interest rates, soaring oil prices and the temporary decline in consumer confidence earlier this year.

More and more equity analysts are coming to the conclusion that stock market returns are going to be disappointing over the next several years at least.  This is the conclusion that BCA came to late last year.  With Treasury bond yields at the lowest point in several years, there doesn’t seem to be a lot of opportunity there either.  So, the question is, how do you boost returns in a low return world?  I will focus on that in the pages that follow.

Specifically, I will revisit two professional money managers, including one who can actually “short” the market during downturns.  While shorting the market is an aggressive strategy, I will show you the benefits of combining a more aggressive strategy with a more conservative one in the same portfolio.  That discussion is on pages 3-6.  I think you'll be impressed!

Finally, I give you my thoughts on what should be President Bush’s strategy in making his two Supreme Court nominations.  In short, he should nominate his most conservative choice first, not second, and force the liberals to spend their war chest now.  See details on page 8.

Introduction

I don’t have to tell you that it has been difficult to make good returns using traditional strategies in the market environment we have been in since late 1999 and the end of the greatest bull market in stocks.  Some nice returns were enjoyed in the bond market over the last two years as yields surprised everyone (yes, everyone) on the downside, but we all know that bond yields aren’t going to zero (0%).   The run in bonds is close to over, as I see it.

The major stock indices have been in a broad, sideways trading range since the beginning of 2004.  As this trading range has persisted, more and more stock market observers are concluding that we may be in a trading range for another year or longer.  While this may or may not be true, it is consistent with the view that we are now in a low return world in the equity and fixed income markets.

In this issue, I am going to tell you what many sophisticated investors and hedge fund managers are doing to make decent returns in this new environment.   As I have reported in recent months, sophisticated investors are increasingly shifting to more “active management” strategies where the money managers have the ability to get out of the markets from time to time, hoping to avoid downturns and waiting for better opportunities to get back in.

The “buy-and-hold” mantra that has dominated Wall Street for decades is slowly losing favor.  The active management strategies that I have recommended over the last 10 years are now being embraced by many who preached only buy-and-hold for years.  Surprise, surprise!

If you are a buy-and-hold investor, and if you want to achieve success in the low return world we are now in, you need to consider some active management strategies.  As you will read below, you should also consider combining active management strategies within your portfolio to help reduce risk and boost returns.  Best of all, you don’t have to be a multi-million-dollar investor to do this.  In fact, if you have only $100,000, you can easily do this. 

Are We In A Perpetual Sideways Market?

As noted above, more and more market analysts are concluding that we are in a sideways equity market that could continue for another year or even longer.   No one knows for sure, of course, but there have certainly been extended periods in the past when stocks went essentially sideways in a broad trading range for years on end.

As an example, let’s look at the period from 1966 to 1982.  During that period, the Dow Jones Industrials went essentially nowhere.  The Dow was in a broad trading range mostly between 700 and 1,000 for 16 years.   If you bought in 1966 and sold in 1982, you made little more than dividends.

Dow Jones Industrials.  Source: Bloomberg

However, if you look closely at the chart, you can see that there were several good buying opportunities AND selling opportunities.  And I’m not talking about picking the tops and bottoms - no one knows how to do that.   But if you bought any time in late 1966 and sold anytime in early 1969, you would have made good money.  If you bought anytime in mid-1970 and sold anytime in late 1972, you would have made good money - and you would have avoided the big dive in the market during the 1973-74  recession.  I could go on, but you get the point - there were several good opportunities to get in and out, and your timing did not have to be perfect.

The problem is, most investors do not know how to identify changes in the trend.  In fact, it’s even worse.  Studies have shown that most investors who try to “time” the markets frequently end up buying high and selling low.  This is precisely why I recommend that you use professional money managers that have sophisticated systems that indicate when the trend is changing, and the discipline to follow their indicators.

Finding A Manager & A System That Works

Most financial advisors will tell you that “active management” strategies don’t work in the stock markets.  And in one sense, they are correct.  For every one active management system that truly works, there are dozens of others that either do not work or do not add value above the fees they charge.  So in general, it is true that many active management strategies don't work.

Yet as I have shown for over a decade, there are some really successful Investment Advisors with time-tested systems for moving in and out of the markets on occasion.

The problem is finding these successful Advisors.  Most of them don’t advertise.  The successful ones we’ve found are scattered all over the country.  We spend hundreds of thousands of dollars a year researching money managers, attending conferences and making “due diligence” trips around the country to visit Advisors in their own offices to check out their performance records, how their particular strategies work, their internal systems and their back-office operations.  The point is, if you have the time and money - and the knowledge to evaluate these managers - you will find some who are truly successful at trading the markets.

So what makes the good ones successful?  There are many things, but the most important is that they have a mechanical system that generates a signal to buy or sell.  The word “mechanical” in this case can mean many things, but the bottom line is that mechanical systems take emotion out of the trading decisions. 

Almost all of the systems we see today utilize computerized software that analyzes market data in various ways to detect changes in the trend.  Some use moving averages; others use technical data; still others use historical data; and others use various other data and indicators that may be helpful in identifying changes in the major trend.  Most of the systems we see incorporate some combination of these indicators and others.  But the most important thing is that their system generates an automated, mechanical signal - and not just some guy’s opinion - if and when there is a major change in the trend. 

The next most important thing is that the manager consistently follows those signals.  It is not uncommon for managers to override their system due to emotional factors and/or unusual events that may be happening in the markets or in the world at large.  In some cases, the use of “discretion” and overriding signals can be a good thing.  Yet if the system is truly a good one, overriding signals can be a very bad thing, in that opportunities for profit may be lost.  In our due diligence process, we investigate carefully whether a manager has overridden his system’s signals in the past and why.

Advisors I Have Recommended This Year

So far this year, I have written about two very successful Investment Advisors that we recently added to our stable of recommended money managers.   In January, I introduced you to Third Day Advisors and their outstanding program.  In April, I wrote about Scott Daly’s Asset Enhancement Program.  Many of you have requested information on these two programs.  In this issue, I want to revisit Third Day and Scott Daly  just as two examples of how you can combine two very different programs to achieve a different risk/reward ratio. 

Third Day, as you may recall, is a more aggressive program.  In addition to buying mutual funds when the market is trending higher, Third Day will actually “short” the market occasionally during market downturns.   So Third Day can be long, short or in cash.  Scott Daly’s program is a more conservative strategy in that it only buys mutual funds or goes partially or fully to cash.

Below are the actual performance numbers, net of all fees and expenses, for Third Day and Scott Daly going back to when Third Day started managing money for the public in November of 2001 through April 2005.

Past results may not be indicative of future results.  See important disclosures enclosed.

As you can see, both Advisors delivered good results over the last 3½ years.   While Third Day had the best upside returns, you can also see that they were considerably more volatile on the downside with a worst losing period (drawdown) of -12.2% versus Scott Day’s worst drawdown of only -1.3%.

Because Third Day is more aggressive, and because they will occasionally short the market, and because they have a relatively short record (3½ years), they are not suitable for all investors, even though they have a higher return.

Now Let’s Put Them Together

Let’s say that you hired both Third Day and Scott Daly 3½ years ago.   Here are the hypothetical results if you had given each of these Advisors $50,000 back in November 2001 and kept it there through April of this year.

In this 3½-year period, the initial investment of $100,000 would have grown to apprx. $165,000.

The hypothetical returns shown above combine the referenced programs into a single portfolio to illustrate what the performance of the portfolio would have been over the stated time period.  The results do not represent an actual portfolio and are for illustration purposes only.  These are past results and are not necessarily indicative of future results.   Please read all of the important disclosures for each Advisor enclosed with this newsletter.

As you can see, if you had money with both Advisors, your returns would have been “smoother” than the ride with Third Day alone and considerably higher than with Scott Daly alone. The average annual return was 15.3% and the worst drawdown was only -6.5%.  I suspect that most investors reading this would be thrilled with that performance over the last 3½ years!

Third Day & Scott Daly Have Low Correlation

One of the factors we consider when we look to combine active management strategies is the level of correlation between the programs.  By correlation, I mean the tendency of one program to go up or down in relation to the other program.  You don’t want to diversify in multiple strategies if they all have a strong tendency to go up and down at the same time.

The good news is that Third Day and Scott Daly have almost no correlation.   They do not tend to make money or lose money at the same time.  We actually have software that calculates the level of correlation.  A reading of 1.0 indicates perfect correlation - they make and lose money at the same times.  In the case of Third Day and Scott Daly, the level of correlation is 0.001 which is about as close to zero as you can get.  So they don’t generally make or lose money at the same times, at least based on their past performance records.

More Information About The Two Programs

Third Day uses a proprietary trading system developed by its founder, Ken Whitley.  During the late 1990s, Ken developed a sophisticated system for trading the Nasdaq 100 Index, initially just to manage his own money.  As noted above, he started managing money for investors in November of 2001.

Normally, we would prefer to see a longer performance record, but if we consider what has happened in the markets since late 2001, Third Day’s system has a lot of experience with very different types of markets.  Just as Third Day began managing money in November 2001, the Nasdaq Index began another very steep decline which didn’t end until late in 2002.  Yet Third Day managed to make 25.3% in 2002, despite the bear market.

The Nasdaq recovered fairly strongly in 2003, and again Third Day did well that year, making 19.5%.  In 2004, the Nasdaq was in a broad trading range, yet Third Day still managed to make 20.3%.  The point is, they’ve done well in three very different market environments.  In fact, Third Day has one of the best absolute returns of any Advisor we have seen over the last 3½ years.

Third Day uses the very popular Rydex mutual funds, so client accounts are established at Rydex, and Third Day is given authority to buy and sell.  And as noted above, Third Day will short the market occasionally by using the Rydex Venture Fund which shorts the Nasdaq with leverage of 2X (200%).  The management fee is 2½% a year, billed quarterly in advance.  The minimum account size is $50,000.

Scott Daly’s Asset Enhancement Program is very unusual in that he has developed a way to minimize losing periods while delivering impressive results on the upside.  For example, from January 1, 2000 to the end of April 2005, the worst drawdown was only 1.3%, even though we were in a bear market until late in 2002.  During that same period, Scott’s average annual return was 14.6%.  On a “risk-adjusted basis,” Scott Daly has one of the best performance records I’ve ever seen.

Scott invests in a wide range of low-volatility mutual funds which are available through Trust Company of America (TCA).  Client accounts are established at TCA, and Scott is given authority to buy and sell.  The management fee is 2½% per year, billed quarterly in advance.  The minimum account size is $50,000.

One question that may occur to some of you reading this is: With these kinds of numbers, why aren't these guys more well known?  Good question.  One reason is that neither of them advertises to any extent.   Through our network of contacts, we were introduced to Ken Whitley a couple of years ago at an industry conference for active managers.  Scott Daly’s name came to us by way of a specialized newsletter we subscribe to that focuses on active money managers.

Another point that may interest you is the fact that both Ken Whitley and Scott Daly have a lot of their own money invested in their programs.   I also have a large amount of my own money invested in these programs as well.  

A Word About Management Fees

Management fees for actively managed accounts are typically in the 2-2½% range per year.  Many investors who first look at actively managed programs balk at the fees as compared to mutual funds and other passive strategies.  When you hire an active manager, one of the primary reasons is to reduce risk. 

Third Day and Scott Daly (as well as the other managers we recommend) have proven that they can significantly reduce risk while also delivering impressive results on the upside.  Remember that in the bear market of 2000-2002, the S&P 500 Index fell over 44% and the Nasdaq plunged over 70%.   Most buy-and-hold investors and “index” fund investors lost about the same amount if they held on during that period.

Yet during the recent bear market, Third Day’s worst losing period was only -12.2%, and Scott Daly’s worst losing period was an incredible -1.3%.   Compare those to the loss of over 44% in the S&P 500 and over 70% in the Nasdaq.  Past results may not be indicative of future results.

Not only are you looking to an active manager to reduce losses during market downturns, you are also paying him to get you back in the market during significant upturns.  A large active manager told me the following a number of years ago (more or less verbatim):

Investors think they are paying us fees to get them out of the market during downturns.  But actually, designing a successful system to get you out of the market is the easy part.  It’s the getting back in part that is much more complicated and difficult to design.  That’s what they really pay us for.

In short, you are paying for expertise that you don’t have but definitely need, especially in a market like we've seen for the last 18 months.  Over time, the real test for active managers is whether they add value (performance) over and above the fees they charge.  Many don’t, but as you’ve seen with Third Day and Scott Daly, they have definitely added value well above the fees they charge.

Reminder: all of the performance figures quoted above are “net” after all fees and expenses were deducted.

Finally, in the spirit of full disclosure, you should know that my company receives a portion of the management fees for accounts that we introduce to these Advisors.  You should also know that they charge clients the same fee, regardless if they came through my company or went to them directly.

There are several advantages to accessing these managers through my company, rather than seeking them out directly.  First, we monitor all of the managers we recommend on a daily basis (I have my own money with all of them).  Second, if we ever revoke our recommendation of a manager, you will be notified immediately.  Third, as one of our clients, you will also receive information on any new managers we find and recommend in the future.

A Buying Opportunity Lies Ahead

Over the past month, I have argued that the Fed may be nearing the end of its rate-hiking cycle, and that this should produce another good buying opportunity in stocks and mutual funds.  Well in June, the president of the Federal Reserve Bank in Dallas made some remarks that support my theory.   He said that the Fed is in “the eighth inning” of its rate-hiking cycle.

While his remark is open for interpretation, I could read that to mean the quarter-point rate hike in June was the 8th inning, and a final one in early August - the 9th inning.  If correct, the equity markets could get quite a boost during the rest of the year.  This is why I believe that now is an excellent time to open accounts with Third Day, Scott Daly and the other equity managers we recommend.

And one last point.  The US economy has surged ahead at a 3-4% growth rate in GDP for the last 18 months, yet stocks have gone nowhere.  Stocks potentially have a lot of catching up to do.  Also, if stocks break out of this long trading range on the upside, we should see a lot of buying come into the market just based on technical (chart) indicators alone.

Conclusions

I chose to revisit Third Day and Scott Daly this month for the following reasons.  First, I don’t know if we are in a perpetual sideways market, and I don’t know if equities will break out of the sideways trading range to the upside in the weeks ahead.  No one else does either.  But as discussed above, I believe there will be a buying opportunity in stocks and mutual funds this summer.

It is precisely this kind of uncertainty that argues for active management strategies and systems that will generate trading signals to follow the market whichever way it goes.

The second reason is that I wanted to demonstrate for you the potential benefits of combining two actively managed programs - in particular a more aggressive program like Third Day along with a more conservative program like Scott Daly’s Asset Enhancement program.  And you can do this even if you only have $100,000 to invest.

On a stand-alone basis, Third Day is too aggressive for some investors.  However, if you combine Third Day with Scott Daly’s program, with its incredibly low drawdowns, then the combination may indeed be suitable for many of you.

Third Day and Scott Daly are two of the most impressive programs I have ever seen in the world of active managers.  I recommend you give them a serious look if you haven’t already. 

I invite you to call us for more detailed information on Third Day and Scott Daly at 800-348-3601 or visit the “Top Performers Page” on our website - www.profutures.com - to see information on all of the equity and bond managers we recommend.

Be sure to read the important disclosures on Third Day and Scott Daly that are enclosed with this newsletter.  Past results are not necessarily indicative of future performance. 

Central Plains Is Back On Our List

I am pleased to announce that we have reinstated our recommendation of Central Plains Advisors.  Some of you will recall that we recommended Central Plains for a number of years.  They have a very long track record in timing the Treasury bond market.  However, in 2002, we became concerned that their multi-year strategy of being long in the T-bond market would subject our clients to high volatility and potentially large losses if long-term interest rates were to turn higher for any reason.  We consulted with Don Peters, the founder of Central Plains, about our concerns and suggested that he consider a more active style of management for this long-term strategy.  At the time, Don was not willing to consider our suggestion.  So we advised our clients to re-evaluate this program and at least consider reducing exposure to this “one-way” strategy, or possibly even moving to other programs.

Yet in mid-2003 and again in 2004, we noticed that Central Plains did exit the market on more than one occasion, going partially or fully to cash to protect profits and potentially avoid large losses - just as we had suggested.  In recent months, we have been in discussions with Central Plains, and they have formally instituted more active management techniques to their strategy.  Given these risk-management changes to their system, I am once again confident in recommending Central Plains to our clients.

Central Plains “Bison I” program invests in mutual funds which hold mainly “zero-coupon” Treasury bonds.  Typically, they use the American Century “Target 2025” fund.  Based on Central Plains’ analysis of the economy, Fed policy, inflation/deflation, etc., they attempt to predict the direction of long-term interest rates and move into and out of (occasionally) the bond market.  Central Plains has a very good long-term performance record, and I am happy to add them back to our stable of recommended Advisors.  For more complete information on Central Plains, call our office at 800-348-3601.  The minimum investment is $25,000.

Supreme Court Justice Sandra Day O’Connor has resigned from the High Court, and Chief Justice William Rehnquist is expected to retire any day now.  There are also rumors that Justice John Paul Stevens (age 85) also wants to retire this year.  So at the least President Bush will have two appointments to the Supreme Court this year and a possible third.  If so, he could have more impact on the Supreme Court than any president in recent history.

President Bush promised that he would appoint conservative judges to fill any High Court vacancies which might occur during his presidency.  Now we are going to see if he will stick to those promises.  I hope he does, but I have some doubts.  But the bigger question is, can he get conservative judges through the Senate?  Liberal groups like MoveOn.org (George Soros), People For The American Way and many others have raised tens of millions of dollars for this fight.  You can be sure that it will be very ugly.

There is a great deal of speculation regarding whether Bush will nominate true conservatives that are strict constitutionalists, or if he will opt for more moderate conservatives such as Alberto Gonzales who is believed to be “pro-choice.”  If Bush appoints pro-choice conservatives, he is likely to have a fairly easy go in getting them confirmed.  However, I believe he should keep his promises and go with true conservatives who are also strict constitutionalists.

Here are four of the most conservative candidates thought to be on Bush’s list of consideration for the Supreme Court vacancies: J. Michael Luttig , US Appellate Judge, Fourth Circuit; Janice Rogers Brown, US Appellate Judge, DC; Theodore B. Olson, former Solicitor General; and J. Harvie Wilkinson, US Appellate Judge, Fourth Circuit.

Of those four, Judges Luttig and Rogers Brown are considered to be the most conservative, but all four are believed to be anti-abortion.  If any of these judges are nominated, the Democrats and liberals will go ballistic!

Many political observers feel that President Bush will go with Albert Gonzales as his first nominee because the Democrats have all but said they would vote to confirm him.  I think this would be a big mistake; I think Bush should hang tough and nominate a true conservative as his first choice; he should make the liberal groups spend all their millions on the first nominee.

Personally, I hope he nominates Janice Rogers Brown as his first choice.  Janice Rogers Brown is a woman (to replace a woman); she is young (56); she is highly respected (nine years on the CA Supreme Court); she is a self-described conservative; she is a strict constitutionalist; and she is black.  But she supports parental notification prior to abortion for girls under the age of 18, so the left despises her.  If Bush appoints her, as I hope he does, the left will go nuclear!  It will be most interesting to see the liberals go after a black woman with her credentials.

By the time you read this, President Bush will probably have announced his first nominee.  If it is Alberto Gonzales, we will know that Bush was not up for the fight.  If he nominates any of the four judges noted at left, then he has decided to stick to his guns and battle it out.  I hope he does!

If Bush goes with a true conservative for the first choice and makes the liberals spend their money fighting the first choice.  They will have less capital to fight the second nominee (and possibly even a third if Judge Stevens retires).  That’s my advice.