Reader Jim posed an interesting question:

Just read this article on Morningstar about the likelihood of a sideways market over the next 5+ years. Basically, the author, a senior vice-president at Legg Mason (fancy title for being a “chief salesman”) think we’ll likely be in a sideways stock market where momentum investing won’t work very well and value stock picking will.

Isn’t your system basically a momentum style of investing? In a sideways market wouldn’t your system keep invested in instruments that didn’t go up (due to sideways market) and didn’t go down more than the 7% sell point as opposed to looking for investment managers who were value stock pickers?

My view is somewhat different. While I agree that we’ll be in some sort of a sideways market, my definition is not as narrow as yours. As I have posted before, I think the market pattern will be more “w” like as we move into and out of recessions once the stimulus programs exhaust themselves.

I believe that the sideways pattern will be much wider than bouncing around the unchanged line by a few percentage points. I think it is far more likely that we will see sharp rebound rallies followed by mind numbing drops; but when all is said and done, the buy and holder will end up very likely with not much to show for.

And that includes value investors as well. After all, value investing is nothing more than an attempt to buy stocks at lower levels and hope for a rally. If the bear strikes, value investors will get clobbered just as anyone else with market exposure. Remember 2008? Only cash was king.

However, if the sideways pattern turns out to be as narrow as you suggest, that will offer a great opportunity to invest in income producing funds/ETFs, because the lack of volatility will keep your principal intact. Personally, I’d like that scenario as well, because I could invest in a high yielding fund like JNK and simply collect the 12% dividend without much downside risk.

Chances are that we will end up with a scenario that is in between. However, I am convinced that somewhere within the next few years (maybe even in 2010) another heavy hit to the downside will occur. That’s the moment where it pays to have insurance via a trend tracking safety net along with a strict exit strategy.

Disclosure: We currently have positions in the funds discussed above.

Some readers were still having trouble about the proper implementation of the sell stop discipline during the recent market pullback:

In my government thrift fund, I can chose from S&P; 500, small cap, international, bond and treasuries. The international fund dropped to just over 7% of its 1/14 high today but your international fund trend line is still in positive territory.

This is where I get frozen in a decision. It has broken the 7% line but it really is not a mutual fund but a broad index which should be closer to your international trend tracker. Shall I wait for you to ignite a sell on the international tracker or trade based on the 7% rule?

Here’s another one:

Has there been a sell stop triggered for international mutual funds? I see in your Friday blog that the international index trend line is still +2.97%. Would appreciate the clarification. Thanks!

Execution of the trailing sell stop takes precedent in the event that either of the Trend Tracking Indexes (TTIs) are still positioned above their long term trend lines.

The TTIs are slow moving indicators. Depending on when a market pullback occurs, waiting all the way for the trend line to be broken to the downside can wipe out your profits or increase your losses to an unacceptable level.

In the case of the international TTI, whether you’re using indexes or mutual funds, the sell stop has priority. If you got stopped out, and now are watching the market resume its upward trend, you have experienced a whip-saw as discussed in the past and need to look for a new entry point.

I mentioned in last Friday’s update that a couple of our holdings triggered their sell stop points and were scheduled to be sold yesterday. As I have talked about numerous times, I do look at market activity first; just to be sure a rebound is not in the making before pulling the trigger.

As it turned out, a rebound was indeed in the making, and I held off liquidating my positions. One retreated back above its sell point while the other one still hovers slightly below it.

I pointed out in Subjective Reasoning, once sell stops are executed, the danger of a whipsaw exists and it pays to watch market activity the following day before entering the sell order. If the markets head higher from here, we’ll be glad we stayed in; if it drops off again, we will have another opportunity to get out. This is one more reason why I use end-of-day pricing only when establishing my exit strategy.

If you set up your sell order on an intra-day basis, which some readers seem to prefer, you will not have the flexibility to sidestep a potential whipsaw. While we accept whipsaws as a necessary evil to avoid going down during adverse market moves, avoiding one will alleviate having to hunt for a new entry point should the markets head further north.

Saturday’s video featuring Bob Prechter supported the view that a potential top similar to 2007 has been formed. For an opposing view, take a look at “Bulls still fit to fight:”

Stephen L. McKee, editor of the No-Load Mutual Fund Selection & Timing Newsletter, says that while investors may be worried about a market correction, they should be looking for bargains.

“Even though the market has come a long way,” McKee said, “we’re still only at the beginning of its move. If it continues, compared to previous markets, we should go another year or year and a half and go up another 50% … based on other bull-market moves.”

There you have it; a totally bullish opinion. Only time will tell who will be right. Personally, I would lean more towards Prechter’s viewpoint. However, in regards to investing any forecast is meaningless, and my preference is to look at the actual trends, since only they represent the reality of the market place.

Right now, we are still in bullish territory, have our trailing sell stops established and will continue to hold on until the market tells us otherwise. In my book, that beats forecasting anytime.

I will be traveling this weekend and will not have an opportunity to write the usual Sunday Musings. Regular posting will resume on Monday. Stay tuned.

Bob Prechter appeared on CNBC a few days ago and discussed seeing a market top similar to the one in 2007. Take a look at the video:

While I believe that the Elliott Wave Theory has merit, it is not a very good timing indicator. Some of Bob’s previous forecasts based on his E-wave analysis have been correct, but were made way early. Given what has happened in the market in 2008, an early exit certainly was better than a late one or none at all.

With the S&P; now having retraced recent gains back to the November level, a trend reversal is a distinct possibility. So far, only sell stops in Asian, Chinese and international ETFs/mutual funds have been triggered, but many more will follow if the markets give back another 2%.

Don’t make any emotional decisions; simply let the market tell you when it’s time to get out.