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.

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

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

More volatility wiped out a big part of last Monday’s 400 point rally in the Dow. However, the major indexes closed higher on the week.

Our Trend Tracking Index (TTI) for domestic funds/ETFs has now crossed its trend line (red) to the upside by +2.57% (last week +1.52%) keeping the current buy signal intact. The effective date was June 3, 2009.



The international index broke below its long-term trend line by -1.25% (last week -2.69%). A Sell Signal was triggered effective May 7, 2010. We are no longer holding any positions in that arena.



[Click on charts to enlarge]

For more details, and the latest market commentary, as well as the updated No load Fund/ETF StatSheet, please see the above link.

With last week’s market drop and Monday’s rebound still on everyone’s mind, let’s take a look at the big picture via the domestic Trend Tracking Index (TTI), which I have enlarged for better demonstration.

The two big red arrows indicate a gap opening as upside momentum picked up steam after the February pullback.

As I have mentioned in previous posts on this subject, gaps to the upside (called breakaway gaps) on a weekly chart are caused by this week’s high price being lower than next week’s lows price (more buyers than sellers) leaving a gap behind.

Gaps will always be closed meaning that prices eventually will retreat to “cover” them. The big unknown is the timing of it, which could be days, weeks or even years.

For example, take a look at the above chart and notice the large downside gaps (more sellers than buyers) during the meltdown of 2008. They were all closed a year later during the rebound of 2009.

As you can also see, the gap identified by the upper large red arrow was almost reached by last week’s market meltdown.

To me, these gaps are a good sign as to where equities will head sooner or later.

Further weakness could cover these gaps leaving us at an inflection point where the markets could break down further or resume their rally. Given how far we’ve come, the former may be more likely.

Violent market moves in both directions such as we’ve seen over past week are occurring most often during or at the beginning of bear markets. Mish at Global Trends featured some interesting charts on the subject yesterday in “Visualization About Violent Market Drops.” Towards the end he quoted this interesting fact:

The further increase in volatility is bearish. We often see that right at the beginning of major bear markets. You get some single day rallies that really impress everyone. We had one of those after the August 2007 swoon for instance.

Those huge bear market rallies were all taken back and then some.

While we’re not in bear market territory according to my indicators, we did come close last week. Volatility has increased and it behooves you to be on guard and use your sell stops when necessary.

Yes, we may watch the market go higher and realize we’ve been whip-sawed with some of our positions.

Remember, that this is the investment insurance we pay every so often to guard against extreme downside moves. Should the market resume its upward trend, we will then look for a new entry point to re-deploy our idle cash.

Several readers have emailed wanting to know about investing in MLPs via ETFs/ETNs. While I have not used them in my course of business, ETF Trends had this to say in “MLP ETNs: Another Source of Income?”

Income-focused investors have been looking for new sources of dividends and interest, since yields are low, low, low. There is an alternative exchange traded note (ETN) investment that many investors could be overlooking.

However, with an MLP ETN, you do not own the companies in the index, you own a bond issued by the bank whose return is tied to the index.

Let’s take a look at AMJ, which is the JP Morgan Alerian MLP Index ETN. Since it covers energy limited partnerships, I have compared it to XLE, the well known energy ETF:

Interestingly enough, AMJ outperformed XLE by a wide margin. Daily volume is decent with an average of $16 million being traded. The current yield is 4.24%, according to Morningstar, while the bid/ask spread is 2 cents.

Over the past year, this ETN would have given you a nice bang for the buck along with a decent dividend. As you can see from the chart above, volatility can be an issue, although AMJ has held up better than XLE.

Nevertheless, if you consider AMJ as an addition to your portfolio, be sure to use my recommended sell stop discipline.

Disclosure: No holdings in the above funds