****Performance has been updated through 5/12/06 - please read through the following disclaimer and find the updated figures at the end of the post.

Before I discuss Hedgefolios performance, I want to cover myself with some cautionary language.

So here goes:

Nothing in my performance quoting is intended as an advertisement or in any other way meant to encourage anyone to subscribe to Hedgefolios. That part is easy given that Hedgefolios is entirely free right now, but when I start accepting subscriptions - the same nonsolicitation clause will apply. Regardless, you should be very hesitant to rely on any newsletter’s performance figures unless they are audited or verified by an outside party. To be as transparent as possible and remove any question of Hedgefolios credibility, I am hoping to have audited performance figures by the end of 2006. Until then, you need to be aware that any performance figure on Hedgefolios is NOT in compliance with the CFA’s AIMR Performance Presentation Standards and does not net out any transaction costs such as commissions or management fees. They are not a total return calculation as I do not include dividend yields or any compounding factor. These performance figures cover a hypothetical portfolio of the entire Hedgefolios stock universe with an equal weighting of each security. The calculation is simply the cumulative total of all gains and losses from the signals during the period in question.

All this being said and under those parameters, Hedgefolios performance for stocks:
2005, the Hedgefolios performance was +19.99% vs. +3.00% for the S&P 500 index
2004, the Hedgefolios performance was +31.19% vs. +9.00% for the S&P 500 index

As the year goes forward, I will update this post periodically to let everyone know how Hedgefolios is doing.

UPDATE: Hedgefolios stock performance for 2006 year-to-date (through 5/12/06 close) was +9.58%. Over the same time period, the S&P 500 index was +3.44%.

Luftblasen, Burbujas, Bulles, Bolle, Bolhas, Bellen. For all the international visitors to Hedgefolios, I thought I would use some words you might recognize in your native language. For all the English speakers, you can either learn those words or just look at many of the international ETF symbols that I cover. They all mean “bubbles” to me.

Don’t get me wrong… I love international ETFs and I don’t hate bubbles (until they pop.) And even though I am not overly impressed with Modern Portfolio Theory, international ETFs are tremendously important portfolio management tools for effective diversification. The global economy is here to stay and the US markets will continue to decline as the primary storage area for global wealth. International markets offer significant investment opportunities and since they have low correlations to the US market, they have the potential to contribute substantially to overall portfolio performance. That’s the good part.

HOWEVER, in my opinion, they are a problem waiting to happen and I am not hearing any commentary about it so I am going to try to sound a warning bell. I like to write about topics that are being ignored and this is one of them. So, I will lay out my concerns and as usual, trust that you will make up your own mind.

1) There is limited history on the international ETFs since most of them just turned 10 years old in March. Except for long standing bourses (Germany, United Kingdom, France, Japan, etc.) many of the foreign stock markets and especially those in the emerging economies are still in their infancy. For that matter, so are many of the companies that make up their NAVs.

2) Pull up all these on 10-year charts and you will see a highly repetitive pattern. For those that existed before the first quarter of 2003, they traded sideways to down from their inception to that point. Then, since this current rally took off, they all have increased dramatically. Of the 26 international ETFs in Hedgefolios, the average gain for the past three years is 160%, with a low of 60% (EWM) and a high of 480% (EWZ). For comparison purposes, the S&P 500 only went up 47% over the same period.

3) Putting #1 and #2 together, I see a situation where these ETFs have not had much experience with adversity. Since the money started pumping in over the past few years, they have done nothing but go up - and go up a lot. Usually, the downsides of untested scenarios are pretty ugly.

4) Speaking of money pouring in to chase top performers and forming bubbles….According to AMG Data, the first quarter of 2006 had $52.6 billion of net inflows into internationally-focused mutual funds and ETFs compared to $21.1 billion into domestic equity funds, a ratio of 2.5-to-1. Note that there were actually $5.5 billion in net cash outflows for domestic ETFs and inflows of $8.4 billion into international ETFs. I will be watching for a slowdown in these fund flows and suggest that when that happens, it will likely be the topping point.

5) Asset allocation models are increasing their bias to international. The more I read commentary from financial advisors, the more I hear about putting 20% to 30% of your portfolio in international stocks. I always get nervous when I hear one asset class getting too much attention.

6) If you like to buy ETFs because you think they provide economic diversification - that is a dangerous assumption. Many of these countries have economies that are highly concentrated in certain sectors (such as basic materials). This explains some of the reasons that the returns have been so high, but should also give investors a reason to consider what will happen on the downside.

7) Some betas for international ETFs are quite high and look more like the QQQQ beta than the SPY beta. Unfortunately, many people fall in love with high betas in ascending markets and forget their amplifying effects in downtrends.

8) The typical international ETF is highly concentrated. So if you think you are getting away from company-specific risk with a basket of stocks, think again. Look up the composition on ETFConnect.com and you will see that it is very common that the top 5 holdings make up almost 50% of the fund’s assets.

9) Many ETFs are full of a few large cap companies and the rest are small caps. If you are a large cap investor, you really should evaluate whether these funds match your investing profile. Or at least you should be prepared to knowingly ignore your cap preference.

10) Valuations are not what they used to be. One of the arguments for investing in international ETFs over the past few years is that they had low PEs compared to the S&P 500. With the aforementioned runups in their prices, that argument is no longer valid as the PEs are as high or higher than the index. Besides, I am always suspicious of the transparency and comparability of accounting methods in other countries and really don’t know what to make of their valuation metrics. In summary, I have a hard time believing that international ETFs are value plays.

11) In my opinion, most investors that buy international ETFs haven’t thought much about the preceding points. They are buying because it’s the thing to do and has worked so well. Mostly, they remind me of daytraders in 1999 who were trading purely on momentum-based technicals and didn’t care about fundamentals or even know what the companies did. That works until it doesn’t and then it hurts real bad.

12) The primary reason these ETFs have done so well has much more to do with trading supply and demand and not the underlying performance of the companies. As more money comes in, the fund sponsors put it to work to buy the underlying securities. This is a self-fulfilling circle which provides an underlying bid to any sellers. There just hasn’t been much reason to sell and when there is selling, there has been an ever-increasing demand for these stocks to support the ETF inflows. As I mentioned before, when that slows it could signal the top.

13) I still worry about country-specific risks with these funds - namely political risk and economic risk which is largely captured in exchange rates. By the way, these international ETFs benefit from a declining US dollar and you really need to be an expert in international economics, forex and geopolitics to stay ahead of these impacts. For most people, that is a bit tough to follow.

14) Lastly, I worry greatly about the liquidity of international ETFs. Low liquidity actually feeds the increases but if there are redemptions, I suspect the reverse will be true and the pace of a decline will make it tough to exit. The only example I have to substantiate that fear was with EWM and the Malaysian currency crisis in 1998. Look at the chart and you will see what can happen when there is a liquidity crisis with ETFs.

Note that I have UP signals on all 26 international ETFs that I cover. In the past, whenever I gave a few down signals, I was rarely correct. I expect that I will be wrong a few more times. I am trying not to bet against them, but I am ready to do so every week. I don’t know when the international ETF bubbles will pop (if you believe they exist), but it will happen and when it does, I expect it to be painful. If nothing else, I hope this post will encourage you to do more research on this topic.

In my pursuit of going forward in these markets, I look back much more than I look ahead. If I had to choose between a crystal ball and a rear view mirror, I am picking the rearview mirror. I know, I know ….. if you are in the markets, you are supposed to say that you look forward not backward (makes us sound so smart!) I have heard that once or twice. I have heard how the markets are this great discounting mechanism and yet, I don’t find it quite so perfect and it’s not very reliable.

If the market is such a great discounter of future events, then how good was it in March 2000 or for that matter, how about February 2003? Relative to stock prices, how has the market done with handicapping changes in oil, gold, copper, and the Fed Funds Rate? If you asked all the forward-looking experts on June 30, 2004 (the start of the Fed’s rate hike sequence), how many would have been able to forecast two years ahead and come close to a 400% increase in the Fed Funds Rate, or a 100% increase in oil, or a 55% increase in gasoline, or a 75% increase in gold or a 200% increase in copper. None did or we would be hearing how brilliant they are.

But for the sake of my rant, let’s say some modern day Nostradamus had gotten these right. I really doubt that he or she would have been able to predict that all the market indices would be up - Dow (11%), S&P 500 (16%) and the Nasdaq (13%) - over that period given those other price changes. But that’s what we did. It’s fact and it’s 20/20. For those of you that say “who cares” or “so what”, please tell me what your forecasts are for the next two years for all those same prices. And while you are at it, tell me how certain you are. To that, I would say “who cares” and “so what” and thanks for all that you do to make the market. So while I agree that the market tries to discount everything from macroeconomics to geopolitics to individual company decisions in order to come to an agreement on prices, they are just a bunch of SWAG(scientific wild-assed guesses). In my pursuit of being perfect on signals, I use as many tools as I can to make sure my guesses are better than everyone elses. Many of those tools have a lot more to do with looking back at the facts from the past and a lot less to do with predicting future errors.

If you haven’t had enough of the FOMC trade and related discussions, then there is room for at least one more comment on this subject from me. Don’t worry - it’s not another rant about the absurdity of the One and Done market moves. (I will keep my latest repetitive thoughts to myself.)

During this weekend’s review of signals, I struggled with the number of recent changes I have made that were turned into losers by last Friday’s rally. I hate being wrong but even more than that, I hate being wrong so quickly. However, the longer I stared at the charts and looked at the related fundamentals, the more conviction I have that almost nothing substantial has altered the original reasons for those decisions. As mentioned in recent posts and highlighted during my interview last Monday with Bloomberg Television, the Hedgefolios Timing Indicator is still showing a downward bias and risk to the market and it affects my willingness to change signals. So if you look at the MANAGE section this week, you will see a relatively low number of signal changes. I decided to sit tight and reevaluate based upon the initial knee-jerk reaction and subsequent 2 1/2 days of trading that will follow tomorrow’s Fed rate decision.

There is about 22 hours of calm before the FOMC commentary is released and I intend to relax and take some time away from analytical pursuits. While I hope I am wrong, I expect the second half of this week to be the most volatile trading environment of the year so far. I am especially concerned about the ETFs and related signals given that they will likely be used to rapidly position sector and market bets until individual equity stakes are made.

My guess for tomorrow is that any vague commentary that will allow the bulls to extrapolate “confirmation” of an end to rate hikes will be taken advantage of. They will continue to do that until it stops working. If the language explicitly states (I doubt it!) that this was the last increase for now, all the better for the bulls and in my opinion, for the market’s sanity. On the other hand, if neither of those scenarios plays out - I expect to see a downward move that will be tough to hold back.

As I looked through the signals this weekend, I was struck by an abnormally high incidence of stocks exhibiting extreme reversals - in both directions. Stocks that had been on pretty long upward runs like PLT and ADBE were taken to the woodshed for missing earnings estimates or providing disappointing guidance. Getting punished during earnings season is not remarkable but the number and size of these moves really caught my attention. The primary reason I am sensitized to it now is the equal number of stocks that had huge moves in the opposite direction, many of which on slightly better than expected earnings. In a healthy market, stocks are not so mispriced from one day to the next. The last time I remember seeing this phenomenon was six years ago, and while it’s probably an unfair comparison, it was worth noting. In summary, I am seeing much more pent up volatility in this market than the indicators are showing and it has gotten worse since I wrote the Yellow Light post a month ago.

Over the past few years, hedge funds have garnered a lot of attention from investors, competitors and politicians and with all that attention comes the claim that the SEC hasn’t done enough to regulate them. However, hedge fund envy isn’t so high right now because the average performance last year was not significantly better than owning an index or mutual fund. And other than the occasional attempt to blame hedge funds for all that is evil in the markets (oil speculation, short selling, etc.), the attack is on a bit of a hiatus. However, it’s only a matter of time before we once again hear the calls to clamp down.

I find all of this to be unnecessary and ridiculous. First of all, the accredited investor rules have been around since the Securities Act of 1933 and they have served us well (if it isn’t broken….). Typically, we get securities legislation such as Reg FD and Sarbanes-Oxley to protect the little guys. I’ll deal with my thoughts on those laws in a future post, but suffice it to say that I find little evidence that any of this good-intentioned regulation has benefitted small investors or for that matter, big investors. As it relates to hedge fund regulation, I am not sure that any investor class needs additional protection. All we need to do is enforce the existing rules that professionally managed hedge funds do not accept non-accredited investors.

The hedge fund world has expanded dramatically and per David Shaw’s interview with Bloomberg’s Pimm Fox, the returns of 8,000 hedge funds managing over 1 trillion dollars are expected to find it increasingly difficult to outperform the general market. Last year’s average returns and the liquidation of over 800 hedge funds is evidence enough of how difficult hedge investing can be. Yet, we still see a tremendous amount of capital being thrown into hedge funds and a ton of “Hedge Fund Wannabes” - investors who want to be in the club even though they are not qualified.

Part of the problem with regulation in this area is that there is no exact definition to the term “hedge fund” and it is undefined in federal / state securities laws as well as at the SEC. For the sake of this post, I will define it as a pool of invested capital that employs various strategies such as leveraging long and short positions in multiple asset classes such as domestic and international equities, debt instruments, currencies, futures, options, commodities, etc. in an attempt to reduce risk and increase return. As complex as it sounds to create a hedge fund - it isn’t, and that is why I feel that the calls for regulating professionally managed hedge funds that serve accredited investors is misplaced.

Note to the SEC and any politicians that are listening - anyone can be a hedge fund investor! With a broadband internet connection and a few thousand dollars, you can become your own hedge fund manager 24 hours a day until your investment disappears. All the tools are there to meet my previous definition of “hedge funds” -
- online brokers to rapidly trade long and short equity positions (on margin if you want);
- international exposure via ETFs and ADRs;
- bets on debt via bond ETFs;
- online brokers to trade calls and put options (highly leveraged instruments by definition);
- forex platforms that allow you to trade with 100:1 leverage ratios;
- commodity exposure through ETFs…….

And while I am in no position to tell people what to do, it seems to me that if you don’t meet the “accredited investor” requirements, you should assume there is a good reason for that rule. However, since we cannot turn back the progress in trading platforms and financial instruments, and I don’t see how to effectively regulate Hedge fund Wannabes, I wish everyone luck. I expect that investors will do what they want, so if you are tempted to trade in areas that used to be the exclusive territory of specialists, please educate yourself as much as possible. I don’t doubt that there are individuals that could or do outperform hedge fund managers and specialists, but the odds are not favorable and no amount of regulation will change that.

Listening to Sen. Durbin on “Meet the Press” on Sunday and Sen. Dorgan this morning on CNBC was concerning. During his appearance, Senator Durbin said,

“I mean, the bottom line is this: If you do not tax these corporations at this level they will continue to run up the profits to sky heavens.”

And later he said,

“But it also means two other elements we shouldn’t overlook: punishing profiteering. All the market forces not withstanding, if the oil companies still insist on these outrageous profits, the consumers will lose and the American economy will lose.”

In a country that is supposedly based upon capitalism, I find Senator Durbin’s comments to be contrary to that fundamental underpinning of our country, and sadly, I find the masses of Americans who are piling onto this philosophy even more disturbing. Creating “separate and unequal” tax policies for any particular industry (or companies within an industry) just chips away at capitalism and when that happens, inevitably “consumers will lose and the American economy will lose.” The concepts that profits are evil and taxation should be used as a punishment to change an industry’s behavior are scary.

Senator Dorgan echoed the danger of energy company profits this morning on CNBC and he even has a handy calculator of “windfall” profits on his website. For as long as I have heard this term, I have never seen anyone willing to define what an “excess” profit is so I credit Senator Dorgan for being so bold. He suggested that windfall profits are those in excess of $40 per barrel. Do you realistically see $40 per barrel as a baseline for the future?

Specifically, his legislation imposes a 50% excise tax on the “windfall profits” of major integrated U.S. oil companies. I find it interesting that only big oil companies are being singled out. I guess small oil company profits are not “outrageous” even though they may be more profitable on a percentage basis than the integrated oil companies. Which begs the next question - how do you define “big”? But enough of the fine details, the other troubling aspect of this bill is hearing Senator Dorgan explain how his windfall profit tax is different than the last time Congress took this step which actually resulted in lowered production. A provision of this bill would exempt windfall profits from the tax if they were used to increase oil and gas supplies, renewable fuels and domestic refining capacity. This is the part that is supposed to assure you that these taxes will actually force the companies to do what the politicians want them to do. The last part of the bill is about as close to Robin Hood behavior as you can get. The revenues of this bill would be returned in the form of a rebate check sent to each individual American taxpayer over 16 years old. Giving away this money to people whether they actually drive a car or not is “outrageous” to me.

I doubt any windfall profits legislation will be passed by the Congress, much less signed by President Bush. However, the fact that it has gotten so much serious consideration should cause all of us to reflect on what we are willing to sacrifice - an extra dollar per gallon at the pump or capitalism.