Reader Frank had this comment regarding the need to set up stop losses:

I have been reading your column and understand the need for the trailing stops; however, the cost to transact at brokerage houses or the redemption time period at mutual fund firms are additional costs that must be considered and could become prohibitive in some cases.

Do you have a favorite place to transact so that these additional fees will not excessively burden the transaction?

Sure, all brokerage firms have some type of transaction costs when it comes to ETFs and early redemption fees with respect to mutual funds. However, that is totally unimportant when it comes to implementing a sell stop strategy because the risk of staying in the market at crucial turning points as opposed to getting out can be very costly as the last year has shown.

Trading costs have become very inexpensive but vary depending on where you keep your account. I use Schwab and selling an ETF typically costs 12.95 (but can be as low as 9.95) while the early redemption fee for buying and selling a mutual fund within 90 days is $49.95. Some custodians like E-Trade may have even lower fees.

Again, I need to stress that nowadays the costs of getting out of a position are not prohibitive in scale; what is prohibitive is staying in the market when trends turn south again and watching your portfolio values evaporate.

Transaction fees are part of life but, when used in conjunction with a sell stop discipline, they fulfill the function of portfolio insurance to assure that you can survive treacherous market conditions.

Monday’s moderate sell off spilled over into Tuesday, until late buying set in—but only the Dow ended up recouping all intraday losses by closing in positive territory.

It was a day that could have ended up really ugly as a menu of negative news ranging from weakness in housing, the selling of financial and technology stocks along with higher oil prices pulled the markets lower before the bungee effect catapulted the averages out of the doldrums. Even the increased probability of GM’s bankruptcy did not break the mid-day recovery.

After yesterday’s close, here’s where Trend Tracking Indexes (TTIs) ended up in respect to their long-term trend lines:

Domestic TTI: -0.69%
International TTI: +2.17%
Hedge TTI: +2.81%

We are maintaining our domestic hedges and have invested in the international arena. Our trailing sell stops are set, and we now need to wait and see if more upward momentum can be generated or if the upcoming dog days of summer are keeping a lid on further advances.

In case you missed, it Reader BD commented on yesterday’s post about “Investment Insurance” as follows:

Today was a good example as to what happens when one buys and sells only on the crossing above or below a moving average line.

I couldn’t live with myself if I allowed myself to be that careless and allowed that to happen to me. I couldn’t sleep at night just thinking about what I had done.

The key to any successful investment approach is the comfort level of the investor and not the method employed. If reader BD’s risk tolerance is such that he needs to wait for further confirmation of an uptrend, then that is what he should do.

However, I caution against finding too many reasons as to why this is not a good time to enter the market in order to simply avoid making a decision. Sooner or later, you need to draw a line in the sand and take a stance.

As long as BD understands that, and it appears he does, then waiting for the circumstances to meet his system’s requirement is the way to go.

Again, I have no idea what tomorrow will bring, and if this international Buy signal has legs or not. That’s why our sell stops have been established, and they will be triggered if market direction goes against us by a certain percentage.

For the record, I have not found that a rising trend line at the time a buy signal is generated via our TTIs has brought improved results over time as opposed to entering the market while the trend line was still descending.

In my last two posts, I talked about investment choices and the importance of using a sell stop discipline.

When you work with a trailing sell stop, you have to accept the fact that an occasional whip-saw signal will become part of your investment life whether you like it or not.

Taxxcpa had this comment:

A whipsaw possibility is like the cost of insurance. The cost of a couple of whipsaw losses is not too big a price to pay and you should recoup those losses when the trend does not end with a whipsaw and keeps moving up.

Even if this is a bear market rally, there is room for profit if the rally continues until the next sell signal is at a higher level than when the buy signal occurred.

That’s exactly my point. In most areas of your life, you have insurance in place to cover catastrophic events. You pay for this peace of mind whether these events occur or not.

The equivalent in investing is the small cost associated with an occasional whip-saw. However, this requires two things on your part:

1. Have a disciplined investment strategy in place with clearly defined entry and exit points.

2. Check your ego at the door by admitting that an investment decision may have been wrong (or too early) and execute your sell strategy before a small loss turns into a big one.

Millions of investors could have avoided portfolio disaster year, if they had acted on these two simple ideas.

History tends to repeat itself. If you did not heed these warnings last year and paid the price for ignorance, make sure that you are better prepared next time the bear makes an appearance.

[Click chart to enlarge]

Hat tip to Doug Short for providing this updated chart (through 5/8/09) showing the “four bad bears.” I added the red arrow to indicate where we are currently at to show how this current market rebound compares historically.

The S&P; 500 closed the week at a new rally high 37.4% above the March 9th low. Are we in a new bull market, or is this a bear market rally?
…
We continue to be fascinated with the saga of the Four Bad Bears. In nominal terms, the latest rally puts the S&P; 500 well above the Dow Crash of 1929 over the equivalent time frame.

As you can see from the chart, the S&P; 500 has rallied 37.4% from its lows on March 9, but is still down 40.6% since the beginning of this bear market. My belief is that this is still a bear market rally, which is about to turn bullish according to my domestic Trend Tracking Index (TTI).

That’s why I keep singing the same old song that, if you participate in this uptrend, you must work with an exit strategy. If you don’t, take a look at the above chart again and watch what happened to the gray line representing the crash of 1929. Despite many up turns, the bear market resumed until all buy and hold investors were wiped out with total losses from top to bottom of -89.2%.

I am not predicting that we may facing the same scenario, I am simply saying that, if you learned anything from last year’s debacle, it should be that the masses of investors along with their advisors will likely be wrong again when the bear returns.

With the international Trend Tracking Index (TTI) having crossed above its long-term trend line by +2.94%, after recalculation yesterday, a Buy signal has been generated effective Monday, May 11, 2009.

The domestic TTI has also moved to within striking distance (-0.49%) of crossing its own long-term trend line to the upside, which may happen next week.

If the domestic Buy signal comes to pass as well, you have a variety of choices as to how to participate:

International Buy Signal

1. If you have a 401k account that is currently sitting in cash, you could allocate a percentage to the international area. Usually, I start with 1/3 of portfolio value and use a 7% trailing stop loss in case this move turns out to be a head fake.

2. If you are not comfortable, you can sit this buy signal out or allocate a smaller percentage. Nobody says that you have to participate.

Potential Domestic Buy Signal

Here you have definitely more choices especially if you followed and set up the SimpleHedge as per my free e-book:

1. Keep your SimpleHedge position as is or increase it to 100% of portfolio value

2. If your hedge is already at 100% of portfolio value, sell the short position and become net long with 50% of your portfolio. If the trend starts to look shaky, you can add the short position back in.

3. If you’ve been out of the market and waiting for this Buy signal, you could allocate 1/3 or more of portfolio value to some of the top ranked funds/ETFs from the most current StatSheet. Remember, the higher the ranking, the higher the volatility; if you’re conservative, drop down a few ranking points on the table.

4. Allocate 1/3 to each the international and domestic arena. Add to those positions if the market moves your way, after you have gained 5% until you eventually become fully invested.

5. Allocate 1/3 each internationally and domestically and fill the balance with small exposure to those sector and country ETFs that are showing strong upward momentum.

6. Use a combination of the above to best suit your risk profile. The goal here is to be onboard those areas with strong upward momentum.

Never ever do any of the above without having an exit strategy in place and actually executing it when the time comes. I personally use a 7% trailing stop domestically and internationally and 10% for sector and country ETFs.

I still believe that the current market rebound is in total disconnect with economic reality. Record unemployment numbers and continuous revisions of job losses do not paint a rosy picture. All this exuberance is simply based on hope that we will be turning the corner in a few months economically speaking and that banks are now on solid footing.

While that is my opinion, it has absolutely nothing to do with my investment decisions. They are based on trends and not on what I think about the fundamentals or the state of the economy.

However, I will use a cautious approach by keeping most of my hedges intact, adding others, but I may use some outright long positions as well.