Got an e-mail from newsletter reader JP a few days ago regarding the proper use of sell stops as it pertains to my trend tracking methodology. While this topic has been discussed before in my Reader Q & A section on 2/2/2007, it nevertheless is an important point which bears repeating. Here’s what JP ran into when the markets tanked during May/June 2006:
“My question is regarding an international small company fund which responds well to your timing signal for domestic funds. Since this fund is in a 401K Principal Separate account, it does not have a symbol. I have downloaded 5 years data into excel spreadsheet and plotted a chart with 195 days sma (Simple Moving Average).
Based on your last domestic sell signal (5/17/06) or 10% stop loss, I would have got out at much higher price than waiting for the price to cross 195 days sma. But looking at the chart, I would have had difficult time to execute, since price was above 195 days and the sma was ascending. Even if I did get out on 5/18/06, I would be lost as to when to get back in.
Once you are stopped out, how do you decide or what criteria do you use to re-enter?”
There are a few things to address.
First, the fund you are referring to is of an ‘international’ orientation and you are using my domestic TTI (Trend Tracking Index) to make the sell decision; you need to use the international TTI.
Second, you should base your sell decisions on 2 things. If the international TTI drops below its own long-term trend line, that is the time to get out or 2. If the price of your fund drops 7% or more off its high that is a sell as well. Whichever condition (1 or 2) happens first, that is your trigger point.
If condition 2 happens, and the market subsequently turns around and rallies again, we will have been caught in a whipsaw. At that point, we are in no man’s land, have to re-group and find a new entry point. That is the price we have to pay occasionally to be able to avoid the big down turns and watching your portfolio go down the drain.
In your situation, I would have waited to re-enter until the fund has made a new high and taken that as a validation that the long-term uptrend has resumed.