From The Mail Bag: Investing Q and As

With the markets having more or less aimlessly meandered for most of this year, I have tried to focus on the many details of trend tracking, which has prompted some newsletter subscribers to write for clarification.

One reader had this to say:

Many thanks for sharing your thoughts and for the wonderful service.

When the sell signal materializes for the domestic TTI, why can we not interpret it as a buy signal for SH or SDS or other short ETFs? If you have a TTI for short ETFs, will it not show a buy signal?

Many thanks for your clarification.

You are correct. If you look at section 11 of last week’s StatSheet, you’ll see that this is in fact the idea. We try to take advantage of the short side, if the domestic TTI has broken below its long-term trend line and the Short Fund Composite (SFC) has broken above its own line. As of last week, that had not been the case. The graph in section 11 also illustrates the most recent short Buy cycle, which ended up being a whip-saw signal.

In my advisor practice, we did not participate in that short Buy. I have to caution you that this is one area where it pays to be late for the party.

Personally, I want to make sure that a bear market has in fact established itself before jumping on the band wagon. If you are more aggressive than I am, you can allocate a small portion of your portfolio to bear funds/ETFs, but you need to work with a sell stop just as you would on the long side.

Another reader had this question regarding the hedging of his portfolio:

As I understand this, if I have a diversified equity portfolio of about $200,000 I should buy $200,000 of SH? How should the foreign funds be hedged, when necessary?

Yes, for a widely diversified domestic equity portfolio, you could hedge $200k with $200k of SH or, alternatively with $100k of SDS. They key here is to test your hedging thoughts by running various scenarios to see how the hedge would have worked.

For example, in my advisor practice, before deciding on the hedge I ended up using, I tested various market environments for different time periods. Here are some of the ones that I examined:

From 3/28/08 to 4/25/08 when the S&P; 500 gained 6.31%
From 5/30/08 to 6/20/08 when the S&P; 500 lost 5.86%
YTD to 6/20/08 where the S&P; 500 lost 10.22%

That would be a bare minimum. I actually went further and tested every year this century along with major up trends as well as the bear market. Testing is what will give you some idea as to the validity of your hedge. While I don’t know how your situation will work out, I can guarantee you that you’ll be surprised by the results.

I have not done any recent work in the international markets, since they’ve been in a sell mode as of 11/13/07. However, if you look at the bear market section 11 of my StatSheet, you’ll find ETFs specializing in the short end of the international arena (EFZ, EEV) as well. The key here too is to do some testing before you apply your ideas to your portfolio.

Keep in mind that there are many complex hedging strategies available; however, my preference is too keep it simple, effective and understandable.