The Commerce Department reported that 1Q GDP rose at an annual rate of 4.8%, about in line with pre-report expectations, following the disappointing 1.7% increase in the 4Q.  The rebound in the 1Q was highlighted by a 5.5% increase in consumer spending.  Consumer confidence jumped to the highest level in four years in March, despite the latest spike in energy prices.  With the exception of housing, most of the other economic reports for March were also favorable.

Yet the Bank Credit Analyst continues to forecast a slowdown in the economy over the next 2-3 quarters.  BCA expects GDP growth to slow to the 3% range, or perhaps a bit lower, but no recession.  The Index of Leading Economic Indicators fell in February and March, which supports the prediction of a slowdown.  I also expect soaring gasoline prices to have a negative effect on consumer spending, which accounts for apprx. 70% of GDP.

It remains to be seen if the Fed will end its rate hiking cycle after the May 10 FOMC meeting.  New Fed chairman Ben Bernanke made some interesting comments in his recent congressional testimony.  We will analyze some of those comments in the pages that follow.

The major stock indexes continue to march higher.  This strength could continue later this year, especially if it becomes clear that the Fed has stopped raising interest rates.  Thus, investors may want to remain fully invested in equities.  But the risks are high and rising, and this is why I recommend having most of your equity investments with professionals who use “active management” strategies that can exit the market or hedge positions if conditions change.

This month, we revisit Third Day Advisors LLC.  I first introduced clients and readers to Third Day in January 2005, and they have continued their impressive performance since then.  Third Day is unusual in that they will go long or go short depending on their signals.  I think sophisticated investors should seriously consider this program.

Introduction

In this issue, we take a look at the economy in light of the latest Commerce Department report showing that 1Q GDP rose by a solid 4.8% (annual rate), following the tepid rise of only 1.7% in the 4Q.    The latest GDP report was in-line with pre-report expectations.  While 1Q GDP was quite strong, there are other indicators that suggest growth will slow somewhat in the next 2-3 quarters.

My view that the economy will soften, at least mildly, in the next several months is consistent with the latest forecasts from The Bank Credit Analyst.  I will summarize BCA’s latest May report and their analysis and market recommendations in the pages that follow.  It’s always good to know what Martin Barnes and his fellow editors at BCA see coming down the road.

We will also consider what the Fed is likely to do in light of the latest economic reports and statements made last week by the new Fed chairman, Ben Bernanke.  The minutes from the March 27/28 FOMC meeting suggested that the Fed may end its rate hiking cycle at the upcoming May 10 policy meeting, but with the strong 1Q GDP report, it remains to be seen if the Fed will take a breather.

The stock markets have managed to move to new recent highs as I have suggested over the past year or so, and I expect the equity markets will continue to guardedly progress on the upside.  But risks continue to rise, especially if the economy slows down in the next 3-6 months, and certainly if the Fed decides to continue with more interest rate hikes.

Given the increasing risks in the stock markets, I believe it is even more important to have a portion of your equity portfolio managed by professionals that utilize “active management” strategies which have the flexibility to move to cash, or hedge positions if market conditions change for the worse.  Given that economic and market risks are rising, I will update you on the performance this year by Third Day Advisors, one of the professional money managers I have recommended in the past in these pages, and one of the few that utilizes both long and short strategies.

That is a lot to cover in one issue, so let’s start with the economy, the Fed and BCA’s latest forecasts from their May report.

The Economy - Big Rebound In The 1Q

The Commerce Department reported last Friday that Gross Domestic Product jumped 4.8% (annual rate) in the 1Q, following growth of only 1.7% in the 4Q of last year.  The 1Q estimate of 4.8% was consistent with pre-report estimates.  The jump in the 1Q was primarily attributable to an increase in consumer spending.  According to the GDP report, consumer spending jumped 5.5% in the 1Q, versus only 0.9% in the 4Q.

The Consumer Confidence Index jumped strongly from 102.7 in February to 107.2 in March.  That puts the Index at the highest level since May 2002.  This was much higher than expected, especially in light of the explosion in gasoline prices.  With gas prices above $3.00 a gallon in some parts of the country, and rising, I expect to see consumer confidence and spending go down at least modestly in the next few months.

In other economic reports, orders for durable goods jumped a surprising 6.1% in March.  The unemployment rate dipped back to 4.7% in March from 4.8% a month earlier.  New home sales surprised on the upside, up 13.8% in March, after falling 10.9% in February. However, even with the large jump in March, new home sales are still over 11% below the peak last July, and the inventory of new homes for sale is up 24% from a year ago.

The Index of Leading Economic Indicators (LEI) has declined for the last two months in a row.  The LEI declined 0.1% in March and 0.5% in February.  This is a good indication that the economy will slow down somewhat in the next several months.  Most economists have revised their estimates down to 3-3.5% growth in GDP over the next 2-3 quarters.

Is The Fed Just About Done?

As noted above, the minutes from the March 27/28 Fed Open Market Committee (FOMC) suggested that the Fed may raise interest rates one more time at the May 10 policy meeting, and then go on hold.  If the Fed raises rates by another quarter point on May 10, that will put the Fed Funds rate at 5%.

Investors and market analysts were encouraged to see the hint in the FOMC minutes that the rate hiking cycle could come to an end after May 10.  However, new Fed chairman Ben Bernanke was quick to warn that there are no guarantees. 

Speaking before the congressional Joint Economic Committee last week, Bernanke warned: “Of course, a decision to take no action at a particular meeting does not preclude action at subsequent meetings.”  This was Bernanke’s way of letting the markets know that the Fed will not hesitate to resume raising rates in the future, especially if inflation should increase. 

As for the Fed’s current read on inflation, Bernanke said: “To support continued healthy growth of the economy, vigilance in regard to inflation is essential. The outlook for inflation is reasonably favorable, but carries some risks.”  It is still widely believed that the Fed wants to see the “core rate” of inflation (minus food and energy) to be around 2%.  For the 12 months ended March, the core rate was 2.1%, down from the previous month.

Bernanke told the committee that the Fed’s forecast is for a moderate slowdown in the economy during the balance of the year.  He noted: “The prospects for maintaining economic growth at a solid pace in the period ahead appear good, although growth rates may well vary quarter to quarter as the economy downshifts from the first quarter's spurt...  It seems reasonable to expect economic growth to moderate to a more sustainable pace as the year progresses.”   

The bottom line is, it remains to be seen if the Fed will go on hold following the May 10 FOMC meeting.  While most everyone agrees that the economy will slow down to a more sustainable pace in the months ahead, it has not yet shown many visible signs of a cooling off so far this year, except in the housing sector.  Yet, as noted above, I do believe that the latest spike in energy will make a dent in consumer confidence and spending, especially this summer.

BCA’s Latest Forecasts

BCA agrees that the US economy is in for a slowdown over the next 2-3 quarters.  They do not, however, believe we are headed for a recession, especially if the Fed goes on hold following the May 10 FOMC meeting.  BCA’s view is that inflation will moderate slowly once the economy begins to slow down, so the Fed should be able to go on hold after May.  Of course, that remains to be seen.

BCA continues to believe that stocks will move higher during the balance of the year, and they continue to recommend above-average holdings of stocks (or mutual funds for most of us).  BCA believes that bond yields have over-shot on the upside, and that yields will come down, perhaps significantly, when the economy shows clearer signs of a slowdown.  For now, however, they continue to recommend neutral positions in bonds.

Interestingly, in the latest May issue, the editors had some commentary regarding the recent explosion in metals and commodity prices.  Given their view that the economy will slow down, and that inflation will peak and turn modestly lower, the editors are not big believers in the current runaway bull markets in metals and several other commodities.  In fact, they believe that the huge run-ups in metals and certain commodities have been driven by widespread speculation rather than a huge change in the supply-demand fundamentals.  They say: “Commodity prices have overshot on the upside, and are thus vulnerable to a sharp setback.”  I agree.

Stocks Hit New Highs In Returns & Risk

Despite soaring oil and gasoline prices, the stock markets have been extremely strong.  The Dow Jones is now at the highest level (above 11,000) since early 2000 at the peak of the bull market.  The S&P 500 is now above 1,300, the highest level since early 2001.  The Nasdaq is also at its highest level since early 2001, but is still far from its meteoric highs set in early 2000.

Several factors are driving stocks higher today.  Profit margins and earnings growth for most companies are strong and improving.  Valuations are generally reasonable, especially given the current levels in bond yields.  Despite repeated interest rate hikes by the Fed, the monetary environment is still accommodative by historical standards.  If the Fed goes on hold after May 10, this should be yet another positive development for the equity markets.

Yet while equities have a lot going for them, the risks are clearly increasing.  Perhaps the easiest risk to identify is simply the fact that the markets have already risen significantly.  The Dow Jones is up almost 50% from its low in early 2003, and the S&P 500 is up over 60% from its low at the same time.  Given the magnitude of these gains, it will not take much to spark a significant market correction on the downside. 

There are other market risks that are increasing as well.  Bond yields have risen significantly so far this year, which is not good for stocks.  The strong rallies in precious metals and other commodities send an inflation warning (although these markets seem to be driven more by speculation than an actual increase in inflation).  The war in Iraq is not going well.  There is talk of a US and/or Israeli attack on Iran.  Any of these factors could short-circuit the gains in the stock markets, at least temporarily.

I could easily see a scenario in which stocks continue to gain ground leading up to and just after the next FOMC meeting on May 10.  While it is widely expected that the Fed will go on hold after May 10, there is no guarantee that will happen.  In any event, we will not see the minutes from the May FOMC meeting until late June.

By late June, however, it could also be clear that the economy is slowing down.  So the news could be dominated by this factor, rather than optimism that the Fed has decided to go on hold.  Thus, we could see a significant correction in stocks this summer, if not even sooner.  One way or the other, now is a very difficult time for those who are on the sidelines, or are under-invested, in equities.  And based on our conversations with prospective clients, a LOT of investors are still on the sidelines.

Jumping into the stock market now is much like buying gold now.  Many investors believe that gold is going to go higher over the next couple of years, but gold has already soared around 50% in just the last year or so.  Thus, it is a difficult - and risky - decision to get in now.  The same is true of stocks and equity mutual funds.

This is one of the main reasons I recommend that you use professional money managers for a significant portion of your investment portfolio.  While no Investment Advisor is perfect, the successful ones have systems that are designed to get them into the market when trends emerge, whereas individuals may hesitate and miss strong moves entirely, or get in late and then suffer losses.

In the current high risk equity environment, sophisticated investors may want to consider a professional manager that employs both long and short positions depending on market conditions.  In the pages that follow, we will look at one very successful manager who does just that.

Professional Money Managers

As you know, ProFutures specializes in identifying successful professional money managers through our AdvisorLink® Program.  Each year, we spend a large amount of money searching for money managers.  We subscribe to databases that track money managers.  We attend conferences where money managers tend to gather.  And we are contacted directly by many money managers each year.

We do our own “due diligence” on the money managers we recommend.  We check out their performance to see if the numbers they claim are consistent with what actually occurred in client accounts.  We check out their system to see how it works, and how it has done in different market cycles.  And we check out their staff to see if they can handle additional growth in assets under management.

All of this requires an on-site visit to the money manager’s offices.  We do not recommend any money manager until we have had time to pay them a visit in person and check out their operations.

Lastly, we do not recommend any money manager that I don’t have my own money with.  I have my own money invested with every money manager and investment program we recommend.  Monitoring my accounts is one way we track the managers’ performance on a daily basis.

Active Management Strategies

In particular, we are fond of “active management” strategies in which the Advisor can move to the safety of cash (money market) or hedge long positions should market conditions warrant.  We also recommend certain Investment Advisors that actually “short” the market from time to time, using some of the inverse mutual funds that make money when the markets fall.

As discussed above, as the markets move higher, risks increase.  Volatility also tends to increase as the markets move higher in price, and this is generally true of all freely-traded markets, not just stocks and bonds.

While great advances in technology and the Internet have made market forecasting much more sophisticated, unexpected events can turn markets on their ear, especially in the post 9/11 world.

For all these reasons and more, I want a significant portion of my assets invested in actively managed strategies that have the flexibility to move to the safety of cash, or hedge their positions, if market conditions change abruptly.  I also want a portion of my portfolio invested with money managers that can short the market from time to time.

Third Day Advisors LLC

In January 2005, I introduced clients and readers to THIRD DAY ADVISORS, LLC and its founder, Ken Whitley.  I recommended Third Day to more aggressive investors who wanted both a long and short strategy in their equity portfolio.  In early June of last year, I again wrote about Third Day and suggested that it was not too late to get onboard.  Third Day continues to outperform the equity markets and most of its peers.  But what is most impressive about Third Day’s performance is that Ken has been successful in up, down and sideways markets in stocks. 

As I pointed out last year, Third Day: 1) made money in the bear market of 2002; 2) made money in the bull market of 2003; and 3) even made money in the choppy, sideways markets of 2004.  I am also happy to report that Third Day continues its winning ways in 2006, easily beating the Nasdaq and the S&P 500 Index for the year.  I analyze Third Day’s actual, net performance history on the next page.

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Performance Evaluation

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.  Thus far, this has not been the case with Third Day.

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 20.64% as of March 31, 2006, net of all fees and expenses.  The worst-ever losing period (or “drawdown”) was -12.18% in the bear market of 2002.  Keep in mind that these are actual results, after all fees and expenses were deducted.

While Third Day’s performance is impressive by itself, it’s even more so when compared to the S&P 500 Index’s average annual return of 6.5% and the Nasdaq 100 Index’s average annual return of 4.5% over the same time period.  Third Day’s sophisticated model has been effective in dealing with very different market conditions over the past several years.

How Third Day’s Strategies Work 

Third Day’s Aggressive Program is focused on the Nasdaq 100 Index and, as noted above, will go both long and short depending on its signals.  Third Day’s Aggressive strategy is a proprietary blend of momentum, trend-following and overbought/oversold indicators.  There are nine indicators that Ken uses to analyze the market and factor into each trading decision.  Each indicator gives a daily signal on whether to be long, short, or neutral in the market.   The model is 100% mechanical (systematic), though Ken does reserve the right to override his system’s signals in the case of a national emergency.

The investment vehicles used in the program are the Rydex Velocity (long) and Rydex Venture (short) mutual funds.  [As of May 1st, these funds were renamed the Rydex Dynamic OTC and the Inverse Dynamic OTC to be more descriptive.] 

Both funds are designed to track the Nasdaq 100 Index.  Both funds use leverage and 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.  Because of the leverage in these two funds, Third Day Aggressive is never 100% invested. 

Unlike most other mutual funds, these Rydex funds 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.  Ken Whitley believes this ability to trade twice a day is a big advantage.

Our analysis has also shown that Third Day’s historical returns have little or no correlation to the S&P 500 Index, as well as many of the other Advisors featured in our AdvisorLink® Program.  Thus, Third Day may be an ideal complement to buy-and-hold asset allocation strategies, as well as other actively managed investments offered by ProFutures.

Best of all, Third Day’s minimum investment requirement is only $50,000, at least for now.

For more information about Third Day Advisors and Ken Whitley, and account applications, you can call us toll free at 800-348-3601, or you can visit our website at www.profutures.com and read our online Advisor Profile for additional details. 

Obviously, I like Third Day a lot, especially given the performance record and the long and short element to the program. I think sophisticated investors should seriously consider this program.  It is an aggressive strategy and is therefore not suitable for all investors.  As always, past results are not necessarily indicative of future results.  Be sure to read the IMPORTANTDISCLOSURES on the following page.

IMPORTANT DISCLOSURES

ProFutures Capital Management, Inc. (PCM), Third Day Advisors, LLC, and Purcell Advisory Services, LLC are Investment Advisors registered with the SEC and/or their respective states. Information in this report is taken from sources believed reliable but its accuracy cannot be guaranteed. Any opinions stated are intended as general observations, not specific or personal investment advice. This publication is not intended as personal investment advice. Please consult a competent professional and the appropriate disclosure documents before making any investment decisions. There is no foolproof way of selecting an Investment Advisor. Investments mentioned involve risk, and not all investments mentioned herein are appropriate for all investors.

PCM receives compensation from the Advisors in exchange for introducing client accounts to the Advisors. For more information on PCM or any other Advisor mentioned, please consult PCM Form ADV II, available at no charge upon request. Officers, employees, and affiliates of PCM may have investments managed by the Advisors discussed herein or others.

As a benchmark for comparison, the Standard & Poor’s 500 Stock Index and the Nasdaq 100 Index (which include reinvestment of  dividends) represent an unmanaged, passive buy-and-hold approach. The volatility and investment characteristics of the S&P 500 and the Nasdaq 100 or other benchmarks cited may differ materially (more or less) from that of the Advisors. Historical performance data represents actual accounts in a program named Third Day Aggressive Plan, custodied at Rydex Series Trust, and verified by Theta Investment Research, LLC.

Purcell Advisory Services utilizes research signals purchased from Third Day Advisors, an unaffiliated investment advisor. The signals are generated by the use of a proprietary model developed by Third Day Advisors. In all cases, performance histories reflect a limited time period and may not reflect results in different economic or market cycles. Statistics for “Worst Drawdown” are calculated as of month-end. Drawdowns within a month may have been greater. PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.

Investment returns and principal will fluctuate so that an investors account, when redeemed, may be worth more or less than the original cost. Any investment in a mutual fund carries the risk of loss. Mutual funds carry their own expenses which are outlined in the fund's prospectus. An account with any Advisor is not a bank account and is not guaranteed by FDIC or any other governmental agency.

Returns illustrated are net of the maximum management fees, custodial fees, underlying mutual fund management fees, and other fund expenses such as 12b-1 fees. They do not include the effect of annual IRA fees or mutual fund sales charges, if applicable. Individual account results may vary based on each investor's unique situation. No adjustment has been made for income tax liability.

Performance for other programs offered may differ materially (more or less) from the program illustrated. Money market funds are not bank accounts, do not carry deposit insurance, and do involve risk of loss. The results shown are for a limited time period and may not be representative of the results that would be achieved over a full market cycle or in different economic and market environments.