Reader Mel has invested $1.1 million with 45% allocated to the domestic market, 30% to the international arena and 15% to bonds and other small holdings.

Here’s a portion of his comment:

As the market heats up, I worry we may be in for a big correction. I am 70 years old and plan to retire in 3-4 years. Can you provide any advice? If you only do this for a cost, I’d like to know more about that. I manage all my Fidelity holdings. Thanks.

The important point here is not to belabor as to whether his allocations are correct for his particular circumstances, most of which are not known at this point.

Markets are so intertwined and correlated these days that many (if not all) allocation models are pretty useless anyway once the trend heads south again. Most did not learn this lesson last year, or in 2001 for that matter, so the same mistakes will be repeated.

The most important thing that Mel can do is to set up his trailing sell stops for all of his holdings so that his portfolio stays intact for the most part when the next correction materializes. With the current economic backdrop, I do not see this alleged recovery continuing forever, so a meaningful correction will be a virtual guarantee—the timing of it is the big unknown.

Anyone with any type of portfolio needs to protect himself against too much downside risk. The best way I know of is via the use of trailing sells stops. I still remember the phone calls from investors like Mel in 2001, who were desperately trying to figure out what to do “after” their $1 million portfolio was slashed in half thereby changing their retirement plans forever.

In that sense, Mel is ahead of the crowd; he realizes the tremendous downside risk and intends to take action “before” serious portfolio damage occurs. I commend him for that and hope that you are doing the same thing.

One of the most frequently asked questions recently has been whether it’s too late to deploy new money now given the run-up we’ve had over the past 6 months.

Here’s what reader SS had to say:

Your Domestic TTI now is +9.36 and Int’l TTI now is +11.96. You’ve talked a lot about the exit and entering strategies.

However, since both the domestic and international TTI is extended too high, is it still good to commit the fresh cash into the both of the markets at this juncture or is it too late?

Reader Don had similar concerns:

Is this a good time to put new money in the market as long as I use a stop loss or is the market too risky at this level to put in money now?

Thanks for your guidance.

Of course, if I had the exact answer, I would be competing with Gates and Buffett for the top spot on Forbe’s list of richest men.

Since I don’t, and no one can predict whether next week will be the start of a market downturn or not, I have to use a different approach.

New money flows into my advisory business almost on a weekly basis. To determine whether it should be deployed or not, I review with a client his risk tolerance along with the possibility of using my incremental buying procedure and sell stop strategy.

For example, let’s assume that a client is just about fully invested but has another $100k he is considering deploying in the market for long-term growth.

My main question to him would be if, after the investment has been made, the market drops and we get stopped out with a 7% loss, will that be acceptable?

If he’s aggressive, he’ll say “yes,” and we proceed accordingly.

If he’s conservative, he’ll say “no,” and I suggest using the incremental buying procedure. In that case, I would initially deploy only 1/3 of his $100k, or $33k. If the market corrects thereafter, and he gets stopped out with a 7% loss, that only represents a 2.3% loss of his total intended investment of $100k.

If that’s acceptable to him, we’ll proceed accordingly.

If it’s not, he should not invest any other funds in the market at this time.

This is a simple, quick and easy process you can use to identify what type of investor you are and whether adding more money to the market goes along with your emotional make up.

Better yet, if you at all have a pit in your stomach trying to make that decision, simply don’t and stay on the sidelines. Your comfort level is what matters most, which is contrary to what many commissioned brokers want you to do.

Things are so much easier to evaluate with the benefit of hindsight. I was reminded of that when reader Jon sent in this comment:

If the TTI is so accurate, why don’t you short the market when it indicates a major downturn? Why stay on the sidelines when there is money to be made shorting the market, especially now that there are so many inverse ETFs?

It’s not the accuracy of the TTI that will solve all problems for you when intending to short the market; it’s the accompanying volatility that causes frustrations.

Take a look at the blown up chart of the Domestic Trend Tracking Index (TTI) reflecting on market behavior last year:



2008 started with a sell signal on January 18. If you had sold short at that time, you would have been stopped out fairly quickly as the trend reversed and generated another Buy on May 15, which lasted barely 5 weeks until the Sell on June 23.

Shorting again at that time, would have produced another whip-saw, as a rally (upper purple arrow) would have triggered your sell stop again. Sure, the ensuing free wall would have been very profitable but with a sell stop in place, you had no chance to participate.

After the bottom was hit (lower purple arrow), any aggressive shorting during those volatile times would have produced a series of discouraging whip-saws. I know some of clients who attempted such heroics with their “play” accounts, without much success.

The point is, just because many more tools are now available for shorting the market does not mean it’s wise to do so. Personally, I am content with the fact that the TTI gave us a signal to move to the safety of the sidelines, which millions of investors wish they had participated in.

Even after this year’s tremendous rebound, those that followed signal of the TTI are still ahead, since the S&P; 500 will need to gain another +17.5% from Friday’s close just to reach the level of our sell signal on 6/23/08.

As the last 20 years have shown, the TTI is a great tool to use when trying to identify changes in market direction. However, when we are entering bear market territory, volatility usually increases dramatically and may make shorting, along with the use sell stops, an endeavor only suitable for the most aggressive of investors.

My latest No Load Fund/ETF Tracker has been posted at:

http://www.successful-investment.com/newsletter-archive.php

Dow 10,000 was the highlight of the week, and the major indexes closed higher.

Our Trend Tracking Index (TTI) for domestic funds/ETFs has now crossed its trend line (red) to the upside by +9.23% keeping the current buy signal intact. The effective date was June 3, 2009.



The international index has now broken above its long-term trend line by +16.51%. A Buy signal was triggered effective May 11, 2009. We are holding our positions subject to a trailing stop loss.

Ever since the FED “expanded its balance sheet,” investors have increasing become worried about the prospect of inflation. They have pored billions of dollars into TIPS and other funds in the hope that their portfolios will not succumb to the ravages of inflation—whenever it becomes a problem.

I am not so sure whether all of the alleged inflation hedges will actually perform as assumed and/or advertised. The WSJ questioned them as well in “Inflation Protection—No Guarantees:”

The threat of inflation is drifting through the collective consciousness of investors these days. But will the inflation-protection investments so many are turning to work as advertised?
…

Of greater concern is what happens to TIPS if the market or the Fed is particularly aggressive in pushing up interest rates.

If this topic is of interest to you, I suggest you read the entire article, which covers gold and commodity funds as well.

Inflation is not a concern right now, while we are still entrenched in a deflationary environment with a sluggish economy, but eventually it will be. You can better prepare yourself by not just blindly hoping that your chosen anti-inflation investments will perform as assumed, but to also follow the trends.

For example, if TIP all of a sudden starts to reverse direction sharply and heads south, use your trailing sell stop to exit. Afterwards, you can try to assess the reasons, but don’t become complacent thinking that you are prepared just because you hold an investment that allegedly protects you from inflationary forces.

I believe that we are entering un-chartered territory and no one can, with any certainty, tell you what you should be invested in. Use the long-term trends as your guide (via my weekly StatSheet) and let them tell you what areas you should deploy some of your portfolio dollars in.

You can further eliminate guess work and emotional decision making by establishing clearly defined entry and exit points, so you will be working from a blueprint ahead of time and not making decisions by the seat of your pants and/or when the (market) heat is on.

Disclosure: We currently have positions in TIP

A couple of readers already own or are considering purchases in GNMA funds. Here’s what Bob had to say:

I am not currently in any stock mutual funds. I missed the move up and I think we are close to a top. Of course, I could be wrong.

My retirement funds are currently with T. Rowe Price. What do you think about their GNMA fund (PRGMX) for someone with my conservative (and negative) outlook?

Dave had this comment:

I am 54 yrs old and am about 7 yrs away from retirement. I currently have a small portion of my retirement investments in two funds (VFIIX and VBMFX) both of which have a large portion of their assets in GNMA govt bonds. I know that GNMA bonds have a gov’t guarantee; however with the current problems with the FHA is there a great deal of risk with these two funds?

Personally, I don’t think much of any of the GSEs (Government Sponsored Enterprises) that have to rely on taxpayer money to operate. Be that as it may, we, unfortunately, have no way to look under the hood to see where the real problems lie and when they might surface.

Since all of the funds mentioned above are interest rate sensitive, they pretty much move in tandem as the chart below shows:



VFIIX held up the best during last year’s debacle and has advanced the most in this year’s economic environment.

My take is that if GNMA runs into trouble, it will be a well-known event that will not come as a surprise. Given that, there should be enough time to exit if you are implementing a trailing sell stop, as you should with all of your investments.

It will help you to identify the end of the trend, no matter what the underlying fundamental reasons, and exit safely before serious damage to your portfolio occurs. Since the masses of investors have no exit strategy, you should have no problems to liquidate when market conditions tell you to do so.

No matter what your outlook on the market, buying an investment and using sell stops is an easy way to limit any damage should your decision prove to be mistimed. There is nothing wrong with taking a small loss, but there is everything wrong with you letting a small loss turn into a big one.

Disclosure: I am not holding any positions in the funds discussed above.