Yesterday, the markets deteriorated sharply at first with the S&P; 500 finally finding support at its 200-day moving average of 1,101, which turned out to be the low of the day. The support level held for the time being, and we bounced off and ended up closing only 0.51% lower.

It could have been far worse, as major selling would have set in had this level been violated. As it stands right now, this bounce gave us a little breathing room, but there is a good chance that this level will be tested again.

The culprit for the continued selling spree came in form of an announcement from Germany last night as they set in place specific rules to ban naked short selling of stocks of key banks and European Government bonds.

As we’ve seen in 2008, when similar bans were introduced here in the U.S., the downward trend was stopped temporarily, but eventually momentum continued fast and furious to the downside causing heavy losses. We’ll have to wait and see if things will play out the same in euro-land.

With yesterday’s action, our domestic Trend Tracking Index (TTI) moved a little closer to its long-term trend line, but still remains 2.12% above it, which means that technically we’re still in bullish territory.

I would consider the current period neutral and a time of transition. In other words, directional momentum has changed and most of our sell stops, with the exception of some sector funds, have been triggered. This is not the time to be a hero and add new positions hoping for a rebound, since downside risk is simply too great.

Should the 200-day moving average on the S&P; 500 (~1,100) not hold, there is no way of knowing how far south this market can go. As long as the situation in Europe does not show any signs of improvement, or at least better unity in combined efforts, we have to live with the current volatility and the distinct possibility that this bull may turn into a bear.

Reader John had this question regarding the interaction of world markets:

The markets in China, Japan and Europe all trade and close before ours. I’ve often wondered if the trading on our markets is affected by the results in these other markets, like an “early warning system”. I would like your opinion on this, realizing that’s there is no absolute “yes” or “no” answer.

This is one area where I have not found any consistent relationships. Sometimes they react to our previous day’s events, and sometimes they don’t; very rarely are they front runners. Even watching the futures at night is not a guarantee that the markets will open in the direction futures trading indicates.

Last Sunday night was a good example. The Asian markets were down sharply, and the domestic futures pointed to a lower opening with the Dow trading down 120 points. When the markets actually opened, we were bouncing around the unchanged line with no clear direction apparent until later on.

While I have not measured this exactly on a day to day basis, from my general observations, the overnight effect one market has on the others appears to be totally random.

A new type of fund called “target band” fund is supposed to smooth the ride on Wall Street as MarketWatch submits in “Putting a speed limit on risk and return:”

We have target-date funds. We have target-risk funds. We have absolute return funds. And now — just in time for this year’s market volatility — introducing “target band” funds.

The other issue has to do with human behavior. Investors say they would be happy to buy a fund that puts a band around their returns and losses. They’ll soon get a chance to actually do what they say.

[Emphasis added]

Leave it up to Wall Street to come up with a fancy new product. To me, it seems like a bad idea to be limited with upside gains of 12% while having a downside risk of 10%. That’s not a good risk reward ratio.

Here’s how we accomplish the same thing but with unlimited upside potential using trend tracking.

Upon executing the purchase of an investment, we immediately establish a trailing sell stop point of 7%. In other words, as prices rise, the stop loss point rises as well. This essentially fulfills 2 functions:

1. It limits our losses in case the trade goes against us, and

2. It locks in our profits if prices continue to rise until the trend ends when it bends, and we get stopped out.

It couldn’t be any simpler; your downside risk has been clearly defined and your
upside potential is limited only by the duration of the major upward trend.

The NYT reports that “Computer Trades Are Focus in Wall Street Plunge:”

Investigators seeking an explanation for the brief stock market panic last week said Sunday that they were focusing increasingly on how a controlled slowdown in trading on the New York Stock Exchange, meant to bring about stability, instead set off uncontrolled selling on electronic exchanges, Graham Bowley and Edward Wyatt write in The New York Times.

The staff of the Financial Industry Regulatory Authority wrote to the S.E.C. in April that “no single regulator has a full picture of all trading activities in the U.S. equity markets.”

[Emphasis added]

While this is very interesting, it remains to be seen if the S.E.C. will now actually step forward and address this issue to prevent a recurrence in the future. The people who were most hurt in this one day breakdown were those who had placed their sell stops ahead of time and got filled at far away (undesirable) prices.

Why? Remember, you can place a sell stop at a limit price but, once that price has been reached, your order becomes a market order and who knows what price you will get in a fast moving market. I discussed these issues and others in “Front Runners.”

This is one of the reasons why I have been harping on using day-ending prices only to determine whether your sell stops have been triggered or not. If they have, only then should you place the order to sell the next day after the market has opened.

This eliminates front running and getting caught in a huge market downdraft. There are only a few things you have control over when investing; this is one of them, so use it and increase your chances of not falling prey to vagaries of Wall Street.

The recent sharp pullback in the markets caused a few readers to email me with more sell stop questions. Most were discussed in my e-book, but some need clarification. Reader Andy had this to say:

I followed your stop loss strategy and my Trailing Stop Losses were triggered last week while I was out of town (Maui!). This leads me to two questions. I’m sure you have commented on them before, so I’d really appreciate a reference to an archived blog if you have one…

a. What if a stock never reaches that previous high? Do you establish a new (false) “high” after a certain amount of time? Let’s say I followed this strategy in 1999 and had several sells trigger prior to the drop. If these highs from 1999 have not been reached as of now (2010), would you have reassessed what your buy-back price should be? For example, if the high has not been reached for 5 years, would you take the previous X years as a new baseline and use the high during that time as your buy-back point. Hopefully, this question makes sense.

To your points:

1. The idea behind the use of sell stops is to get out of the market before disaster strikes and wreaks havoc with your portfolio. At the same time, the danger of participating in a whip-saw signal always lurks, meaning that a sell can be followed by a buy quickly as the markets turn around and head higher again.

Whenever possible, we like to avoid that situation as discussed in Subjective Reasoning.

For example, if my sell stop got triggered based on last night’s closing price, I prepare myself to enter the order this morning, unless a huge rebound is in the making. If that happens, I will hold off selling until it becomes clear again that my stop levels have been violated. This may take a day or two, but more often than not, a whip-saw will have been avoided.

2. You want to be sure that you don’t get caught in a downdraft twice. This week was a very good example as Monday’s rebound along with Wednesday’s higher close could have gotten you back in based on thinking that happy days are here again. Thursday, the markets retreated sharply and Friday, as I am writing this, we headed for a much lower close, unless a last hour rebound saves the day.

I have found that the more conservative way is to wait with re-entering until the old highs, which served as a basis for calculating your sell stop, have been taken out. This is a case where you’re better off to be a little late than too early, especially, this far into the buy cycle, where we are very likely closer to a top than to a bottom.

a. You totally missed the point here. Re-entering as discussed above refers only to the current sell stop. Say, the markets head further south, and we break below the long term trend line, all old highs no longer matter, and we start all over. That simply means, we re-enter the market and move back into equities when the Domestic and International TTIs (Trend Tracking Indexes) break back above their long-term trend lines.

Trend Tracking attempts as much as possible to let you make unemotional investment decisions. However, at major inflection points, when market direction reverses, you need to step in and make sure your sell stops are executed wisely.

Not having any human interaction at all, can lead to chaos as we saw last week when the Dow dropped almost 1,000 points intra-day, because a bunch of unsupervised computer programs played ping pong with buy and sell orders.