Reader Ray had some interesting observations about the market, very similar to what many others have voiced. Here’s what he had to say:

I feel I am like most investors and most of us are very conflicted in a bear market, as I, most of us feel it will end without being properly positioned for the next up move. (LOOK OUT– EMOTIONS AT HAND) Most of us (like most humans) are positive, optimistic long only investors, and this bear market is difficult to be patient with.

With that said, it has also been demonstrated that you can have some very violent moves to the upside in a bear that appear to leave you in neutral as the market advances only to suck you in at the end of the move with another leg to the downside (financials from Jan 12 to end of the quarter– THEN SMASHED).

Even your last buy was met with a whipsaw, but to your credit, out again before the major damage was done. The hardest thing to do is take a loss for me and therefore mutual funds have offered the best risk adjusted vehicle. I have learned this after some devastating losses in individual stocks– tech heavy in 2000, fooled by dividends i.e. financials or any other excuse to stay in a loser.

My lament is that I was not able to recognize this bear earlier and position myself in those sectors that were deteriorating and take advantage of this wonderful opportunity to add another risk adjusted strategy—-short.

As you can tell by my comment that I am not short, but I am majority cash. Is it too late? My feeling is that a DOW 14,265 now 11,000 it probably is. The real question is how did I miss the opportunity to take advantage of that 3000 point move to the downside that seems so obvious (in hindsight) in retail, finance, homebuilders etc.

I also agree with your point that this bear could be much longer and much more severe because of such a strong move from the beginning of 2003. I state that because I am still wondering if it is too late to position a short?

Great work to get us in cash so soon after that last up signal.

My view is that I’d rather be a little late to the party than too early. I have received some reader email who admitted having shorted the markets heavily a couple of months ago, only to be caught on the wrong side during the rebound rally.

When the domestic Trend Tracking Index (TTI) breaks below its trend line into bear market territory, it’s a buy signal similar to the TTI breaking above it. The only difference is that you’re buying inverse funds/ETFs which gain as the markets fall.

You still need to apply the same discipline by allocating an amount to short funds that you are comfortable with. That could mean 10 – 20% of portfolio value, or more, if you have a higher risk tolerance. But most importantly, you still need to apply the same stop loss discipline that you use on the long side.

So, is it too late to initiate new short positions now? Looking at the big long-term picture, I see a lot more downside potential. However, that does not mean that there won’t be dead cat bounces, which can stop you out quickly.

As always, your emotional makeup should determine whether shorting the market is for you. As I noted recently in “Is Short Selling Worth It?” long-term the effects of short-selling on your portfolio may not be what you would expect.

Reader Jim had this to say about my various recent posts and updates:

OK – I buy everything your saying.

3. Any specific recommendations?

It’s amazing to me how many investors have the urge to get back in the market or feel the need to do some something even if being on the sidelines is the wisest course of action.

I think this need stems from the overwhelming desire to pick a bottom and hoping to ride a market rebound all the way to the top. Fat chance! While your odds of this “buying on dips” may work from time to time in a bull market, it can be financially deadly if you apply this idea in a bear market.

The best you can hope for, when following trends, is that you re-enter the market somewhere within 10% after a bottom has been formed. Remember, a bottom can’t be identified until it has actually occurred and prices are heading back up. Looking in the rearview mirror, you can then observe the turn around. That is exactly what happened at the end of 2002 and into 2003, before bullish tendencies continued.

Trying to pick an interim bottom because the Dow dropped a few thousand points is just nothing but a wild guess.

For me, to get back in on the long side of the market requires the domestic Trend Tracking Index (TTI) to cross back above its long-trend line. Currently the TTI is 2.95% away from that point.

Once that point is reached, we can subsequently identify, via our StatSheet, those domestic mutual funds and ETFs that are showing good upward momentum. We can then allocate accordingly. Trying to make that assessment now, while in the midst of a bear market, is simply an exercise in futility. That’s like someone asking you now what you will have for dinner next Christmas eve.

Try to control your itch wanting you to jump in on the long side of the market and instead let the trends be your guide. While you will have an occasional whip-saw to deal with, following them systematically keeps you at least from doing something you might regret later on.

Some readers seem to be preparing themselves for a turnaround in the market place. Given current conditions, it would seem that we are far away from any lasting bullish scenario. Be that as it may, one reader had this question:

I am one of your regular readers. Thanks for helping many of us. Would you please elaborate more on how you decide on the mix of ETFs and mutual funds? How do you decide what fraction of money is to be invested in US, what fraction to be invested in emerging, single country etc. I understand your TTI system. But how you choose different countries and sectors is still unclear to me. Would benefit from your insights.

There is no hard and fast answer and the selection process is simply a matter of preference along with risk tolerance. If the domestic TTI signals a buy, as it did on 5/15/08, I look at the momentum table in the StatSheet and review the rankings for domestic mutual funds and ETFs. Since we’ve broken above the long-term trend line, many funds/ETFs will show good upward momentum.

Not only do I look at those numbers, I also want to make sure that the mutual fund/ETF under consideration has broken above its own individual long-trend line as you can see in the column titled %M/A. At that point, I am aware that the top ranked performers are also the ones that will correct the fastest. So I may drop down a few points in the M-Index ranking and select a mix of funds/ETFs with different orientations.

I don’t have a particular allocation of mutual funds vs. ETFs. If the momentum figures are equal, then it’s simply a matter of preference. I will also look at recent history to see how much DrawDown any of the funds have had. You won’t have access to that figure, since it’s not published.

At the beginning of such a domestic Buy cycle, I will allocate only 1/3 of portfolio value to be sure the market continues in the intended direction. If it does, I will increase my exposure.

If the international Trend Tracking Index (TTI) signals a buy as well, I will follow the same guidelines.

In regards to sector and country funds, they dance to a beat of their own drummer. You need to follow their momentum figures and consider a position when they cross their individual trend lines to the upside. Since those areas are notoriously volatile, I would only allocate 5% to 10% to any one holding.

No matter what you invest in, you always have to be prepared for the inevitable fact that trends will reverse. That’s why it’s imperative that you never fail to work with trailing stop loss points such as I advocate. Taking small losses is part of investing whether you like it or not. Staying away from the big ones is the goal that should be foremost on your mind.

Over the past few days, I have received some emails from long-time readers asking about how they should invest their money now, which mutual funds to buy and how to diversify into which country ETFs.

Huh? It appears that these investors are reading my weekly updates and daily blog posts, but are missing the message entirely. At this time, we are in a bear market. I don’t know how to be any clearer about it, but this is not the time to enter the market on the long side; you should be in money market on the sidelines or, if your risk tolerance allows, have some selected short positions.

This bear market has the potential to be far worse than the last one of 2000 – 2002, during which many investors lost some 50% of portfolio value. How do I know? Many people called or emailed and told me so. The main reasons for their losses were simply ignorance as well as bad advice.

Let’s look at the unfortunate realities of what happens to your portfolio and, on a bigger scale, your life, if your investments receive a 50% haircut. You are now put in the unenviable if not impossible position of having to make a 100% return on the balance just to get back to a break even point.

How long will that take? In my view, if you have some cooperating markets (meaning a bull market rally) it could take some 7 years, if you’re lucky. If you were one of those unlucky investors, who lost 50% back by 2002, please write me and tell me if you have gotten back to the even point in the past 6 years. Chances are you didn’t quite make it.

Not only have you lost 50% of your portfolio by being ignorant, or having received bad advice by you-know-who, there is another aspect that is even worse. You have wasted 7 years of your financial life that could have been used to grow your assets rather than you chasing your tail trying to make up losses.

Presumably, you work somewhere from age 20 to age 65, which gives you some 45 years to accumulate your nest egg, which is supposed to carry you through your retirement years. Wasting 7 years of it amounts to surrendering about 15% of the efforts of your financial life. That’s a tragedy!

Come to accept the fact that most investment advice that is being showered on you is simply useless. Sure, the Lazy gone fishing portfolio sounds great, because it appeals to the laziness in all of us. But, it is just as stupid as buy and hold, bullish asset allocation/diversification/re-balancing in a bear market.

I said it before but it’s worth repeating. If an event, such as a bear market, has the potential to wipe out your portfolio, or cut the value down in half, then you should be paying attention to such a possibility. At that point it is absolutely useless, as the last bear market has shown, to be diversified or engage in silly arguments as to whether ETFs are better at weathering the storm than mutual funds.

Many years of capital growth and investing efforts can be wiped out in a hurry leaving you holding the short end of the stick. Wall Street, and its army of commissioned and transaction driven salesmen, will not protect your from nasty downside slides. Their motivation goes beyond your best interest, because their bottom line has priority over yours.

When all is said and done, it is your responsibility to make the right choices. I feel it is mine to try to make sure that the financial sadness and pain of the last bear market won’t affect as many investors as it did in 2000 to 2002.

With the markets having retreated into bear territory, I have received many reader questions regarding shorting the market. Nowadays, you have many more choices than compared to the last bear market of 2000-2002.

With the proliferation of ETFs, you are no longer limited to a few bear market mutual funds, you can now buy with great ease inverse ETFs like SH or SDS, that perform opposite to the S&P; 500 or, in the case of SDS, 200% of that value. Of course, if you go that route, be sure to use my recommended sell stop discipline, because bear market rallies are always lurking around the corner.

However, if you take a longer term view, say 15 years, how much will short selling really contribute to your bottom line?

To get some kind of answer, I went back to the previously reviewed book “Trend Following” by Michael Covel.

Michael has researched the investment results of many of the well known CTAs (Commodity Trading Advisors) and detailed some his findings of various trend following systems in his excellent book (p. 270). As you may know, CTAs are probably the most aggressive investors when a short selling opportunity presents itself.

One example, which I found very typical covers a period of 15 years (1990 – 2005) and shows the following annualized gains:

Long + Short: +19.59% (515 trades)
Long Only: +18.86% (368 trades)
Short Only: 5.64% (147 trades)

As you can see, long-term, the short positions have not contributed much to the overall return.

Before you get all excited about this approach, keep in mind that these are leveraged investments and the downside as always is the Draw Down, meaning how much the portfolios have fluctuated:

Long + Short: -46.96%
Long Only: -75.77%
Short Only: -60.36%

For most investors, this is not an easy pill to swallow to see portfolios drop by these numbers. I know, because many people are having difficulties with the fact that the current bear market has shaved off a very modest 10% off the value off their holdings.

This is just one example of how much short selling contributes to the bottom line. If you happen to be a conservative investor you can see that, based on the above numbers, you do not need to be actively shorting the market just because your friends are. If staying on the sidelines is more fitting to your risk profile then by all means do so.

These numbers simply point out that, long-term, short selling for the individual investor may not have the impact on returns as you thought it might.

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

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

Despite various rally attempts, the bulls succumbed to the bears again this week.

Our Trend Tracking Index (TTI) for domestic funds/ETFs remains decisively below its trend line (red) by -2.95% thereby confirming the current bear market trend.



The international index dropped as well and now remains -12.22% below its own trend line, keeping us on the sidelines.

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