Heading South

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The markets continued to stumble yesterday as downward momentum accelerated. Much has been written about a potential market top and one of the more interesting observations and references was made by Mish at Global Economic Trends in a post titled “Multi-year Stock Market Top could Be In.”

With yesterday’s action, several sell stops were triggered, and the affected holdings will be liquidated today. The position of the Trend Tracking Indexes (TTIs) relative to their long-term trend lines is as follows:

Domestic TTI: +7.14%
International TTI: +11.18%
Hedge TTI: +0.54%

Over the past month, continued reader feedback regarding sell stops was a topic of great interest. A few days ago, reader Bob had this to say:

Market is getting a bit testy right now. I noticed that my holding in Russell 2000 ETF is down 5.69% from its high today.

My question is do you recommend using 7% or 10% stop for this type of holding since its Beta is 1.19 compared to S&P; 500 per Morningstar?

Another though I had was to use a stop of 8.5% (7% x 1.19) to account for its increased volatility. In fact I am considering doing this for all of my holdings. It is easy to do & follow with spreadsheet I have set up. I would probably round all exit calculations to the nearest 0.5% (as I did above) to make it easier to follow in the sell zone.

While that is a different way of applying the sell discipline, it does not really matter. My preference is to use the 7% rule for all domestic and international funds and 10% for the more volatile country and sector fund arenas.

You should use whatever approach you are most comfortable with. In the bigger scheme of things, using any type of sell stop discipline is better than using none at all.

Remaining exposed to the whims of the market place with no clear exit plan has proven to be disastrous in the past and may very well be the downfall for many investors again in the future.

Reader Sell Stop Question

Ulli Uncategorized Contact

As the markets begin to show signs of weakness, questions about the sell stops keep coming in. Here’s one from a reader asking for clarification:

You also suggest selling a fund if it has dropped more than 7%from its most recent high. My question is, if a most recent high occurred in May this year and the fund/ETF is down more than 7% now since May, do you still consider it a sell? What if it was bought since May (maybe shouldn’t have)?

It’s not the recent high, or the high since May, that a fund/ETF has made that’s important. It’s the high that was made since you bought it that counts.

When using a trailing stop loss, which will limit your losses and/or lock in your gains, only the price action, which occurred after your purchase is of any relevance. To be clear, what a fund/ETF has done in the past in terms of price movement maybe a consideration in your selection process, but has nothing to do with the execution of the sell stop discipline.

Once you have made the purchase, only then will the tracking of the closing prices going forward form the basis for your exit points—not before.

Front Runners

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Seeking Alpha featured an interesting piece called “How Traders Are Front-Running ETFs:”

Another aspect of exchange-traded funds (ETFs) coming to the fore lately is front-running. That’s the practice where traders buy ahead of large orders from ETFs and short sell ahead of large sell orders. They scalp profits by flipping their newly acquired long positions back to the ETF at higher prices and closing their short position at lower prices. The ETF ends up paying more to buy securities and receiving less to sell; in effect, traders have transferred profits from the ETF to themselves.

The practice has been a fixture of ETFs since they were first invented. Any time an index maker announces a change to the underlying index it is an all-points bulletin that the ETF fund will be entering the market to buy the added securities and sell the deleted ones. In the case of broad-based ETFs, the extent of the profit transfer likely isn’t too significant because the index changes usually affect just a small portion of the basket.

But the story changes as one departs from plain vanilla, broad-based ETFs. Of note, the more markets are sliced and diced into smaller slivers for ETFs to track, the more likely index changes will become significant in relation to the index basket. And, in turn, so does the opportunity for front-runners to transfer returns from ETF holders to themselves.

This is one of the reasons why I never place sell stops ahead of time as “stop orders.” I don’t want to get stopped out because of alleged front running activities or simply other intraday market noise.

I suggest you do the same by using “day-ending closing prices” only to see if any sell stop has been triggered. If it has, only then do I enter my order the next day.

This avoids intra-day whip-saw signals and simplifies my tracking. In other words, I treat ETFs like mutual funds in that, for sell stop purposes, only one price per day exists.

No Post

Ulli Uncategorized Contact

Due to my travels back from Germany, there will be no post today. Regular posting will resume on Tuesday.

Sunday Musings: Dead Men Walking

Ulli Uncategorized Contact

Despite the market’s sharp rebound off the March lows, I have questioned the fundamental reasons on which this alleged economic recovery was based.

To me, it was nothing but government stimulus along with wishful thinking that supported this move into the stratosphere. What happens when the stimulus ends?

My concern has always been that a recovery, such as we’ve seen, can never have staying power unless it is accompanied by job growth. While job growth is considered to be a lagging indicator, I simply can’t see any job creation because of rampant overcapacity in most industries.

One hedge fund manager has similar concerns in “Hedge manager Sprott sees trouble when easing ends:”

When so-called quantitative easing by central banks ends, the world economy may slip back into trouble, Canadian hedge fund manager Eric Sprott warned on Tuesday.

Toronto-based Sprott called Citigroup, Fannie Mae, Freddie Mac, and General Motors “dead men walking” in late 2007. On Tuesday, he said the U.S. government is the new dead man walking, partly because it may struggle to keep borrowing enough money if the Federal Reserve stops buying Treasury bonds.

Sprott’s Canadian hedge fund, Sprott Hedge Fund LP, is up more than 400% since inception in 2000 as it rode a surge in gold prices and shares of gold miners and other raw materials companies.

Bank bailouts and other dramatic efforts by central banks have stopped the world “going into the abyss,” Sprott said during a presentation at the Value Investing Congress in New York.

The “granddaddy” of all those bailout efforts is quantitative easing, in which central banks in the U.S. and the U.K. especially buy government bonds to keep interest rates low, Sprott said.

The U.S. government has raised roughly 200% more by selling bonds this year, versus last year, Sprott noted. Through the end of the second quarter of 2009, he said the only major buyers of these government bonds were central banks.

“When quantitative easing ends, what’s going to happen?” he added, noting that there are already two clues to answer that question.

When the U.S. government’s cash-for-clunkers program ended, car sales slumped. Meanwhile, as the end of the government’s first-time homebuyer incentive approaches, recent data suggest weakness building again in the housing market, Sprott said.

Roughly 35% of all homes bought in the U.S. recently were purchased through the incentive program. If it is not extended, December home sales could slump 25%, Sprott estimated.

Sprott remains concerned about banks and other financial institutions in the U.S., because he thinks they remain too leveraged.

Banks leveraged roughly 20 to 1, have about 5% of equity supporting mostly paper assets. If those assets fall by more than 5%, the institutions are effectively bankrupt, Sprott said.

I agree with his assessment. While there is nothing about the potential outcome you and I can do, it helps to be aware of the likely consequences, even though we may be entering un-chartered territory.

I believe the market at current levels has more limited upside potential, but poses tremendous downside risks. Again, as trend followers, we don’t predict or worry about which way the trend will turn.

If continued government stimulus occurs, we will most likely run with the bulls. If not, and the trend reverses favoring the bears, we will let our trailing sell stops guide us as to when to exit.

While I am singing the same old tune, I believe it’s crucial to have a plan in place so you don’t end up like the buy-and-hold crowd, because they’re doomed to repeat the mistakes of 2008 again.

How High Can We Go?

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If you look at the chart of the domestic Trend Tracking Index (TTI), it’s obvious that the market has rallied since March without regards to the laws of gravity—so far.

The million dollar question is “how high can we go?” Every investor expects a serious pullback, but so far it has not happened. Maybe the chart of the TTI can give us some clue as to where a (temporary) top may occur.

When the markets headed south last year, and entered freefall mode, 2 gaps were created on the domestic TTI (see red arrows) price chart. Since they occurred to the downside, they are called exhaustion gaps, meaning that selling activity far outpaced buying activity.

Chart technicians will tell you that gaps will always be closed. In this case, that would translate to prices moving to a point that is higher than the beginning of the gap opening. The lower gap (lower red arrow) has been closed already, and we’re now half way (44.00 price level) through closing the upper gap. This process would be completed at around 44.50.

Having looked at thousands of charts over the past 20 years, this pattern occurs with regularity, the big unknown is always the timing of it. Just because the exhaustion gaps occurred last year does not mean they will be closed this year. However, we seem to be on track with the TTI only having to move up another 1.14% from the 44.00 level.

Here’s the rub. Once the closing of the gap occurs, odds are high that the trend will reverse. However, as anything that has to do with investment concepts, nothing is 100%.

This is not a prediction on my part; it’s simply a pattern that I look at from time to time to try to get some sense as to how high we could go. So, let’s watch out for the 44.50 level.

If this nugget of wisdom does not play out, there is a good chance that still higher prices are ahead.