Reader Ben brought up an excellent question regarding the use of trend lines to determine the direction of the overall market or certain areas of it. Here’s what he said:

I’ve followed your StatSheet, and recently the blog, for a couple of years. I think yours is some of the soundest market advice around.

I’m thinking of a few well-regarded international funds that did well in 2007, but suffered losses like most in Q1 of 2008. Now, they’re well up over their lows and above their 39-week MA, although the index still has a way to go before it catches up. Are the individual funds a “buy” already, or does your disciplined approach caution delay until the index gives a general buy signal?

Using the international Trend Tracking Index (TTI) as a buy signal generator has worked well for me over the past 20 years, but I admit that it is a very conservative approach. Since I use the piercing of the trend lines as a signal with sector and country funds/ETFs, you could do the same with those well-regarded international funds you were referring to.

If you are more aggressive, and you decide to go that route, I suggest that you work with my recommended exit strategy to be sure that you limit your losses should it turn out that you were wrong or simply too early with your decision.

However, I also recommend that you decide on a strategy and then stick to it. I don’t favor using one approach and flopping back and forth to another, because in your mind circumstances have changed. Again, there is nothing wrong with trying to get onboard a little early, as long as you protect yourself from too much downside risk.

My preference is to read business books that offer a fresh perspective or a different view of looking at things. The same applies to books that deal with investments. Most aren’t worth the paper they are printed on because they rehash MPT, Modern Portfolio Theory (which by now is some 60 years old and in dire need of revamping), or focus on why ETFs are better than mutual funds along with the same old Buy & Hold scenario.

All of these are approaches that are based on a bullish environment and, when the bear suddenly appears, those portfolios get slaughtered big time. Of course, heavy bear market losses get swept under the rug in a hurry by the media and by many of the most well-known B & H proponents.

Bear markets can be considered Black Swans, or rare events, as I wrote about last year. In my advisor practice, I like to be prepared as best as I can to deal with those events by being disciplined and always have an exit strategy to fall back on. To me, if a bear market has the power to slice portfolios in half over a fairly short period of time, then one should pay attention and be prepared at all times.

I was reminded of that again when I read Nassim Taleb’s book “Fooled by Randomness,” which further elaborates on the Black Swan concept. Nassim explores how randomness not only affects the markets but also makes inroads into your daily life. It’s a fascinating read and gives some insight in how the author himself, a mathematical trader, is trying to resist being fooled by randomness and how he tricks his emotions in regards to probabilistic outcomes.

He cites examples of high profile traders making hundreds of millions of dollars for their employers only to lose more than that in just one week, because they did not consider the possibility of career ending rare events. I was shocked to learn that only very few of the top traders working for investment banks base their decisions on certain observations (that includes past history) and then make sure that the costs of being wrong are limited. Here’s what Nassim said (page 131):

They know (the traders) before getting involved in the trading strategy which event would prove their conjecture wrong and allow for it. They would then terminate their trade. This is called a stop loss, a predetermined exit point, a protection from the black swan. I find it rarely practiced.

Read that last sentence again! This is only way I know of to protect your portfolio from receiving a serious haircut, yet most investment approaches, especially those based on Buy and Hold, do not allow for it. Whether you call it randomness, a rare event, a black swan or any other name, the outcome will be the same.

I believe that especially in a bubble bursting economic environment with worldwide effects, such as we have been experiencing, not paying attention or simply ignoring the possibility of a bear market, will have dire consequences for those in denial.

If with all my blog posts, I can get only one idea across to you, which is to never ever work without a sell stop, then my efforts will have been successful.

You constantly hear me harping on the essentials of trend tracking, such as keeping your losses small by using a clearly defined exit strategy, accepting whip-saws as a necessary part of investing, letting your profits run and many others.

It appears that I am not the only one using these ideas. The WSJ posted a story titled “If It Feels Bad, It’s Probably A Good Trade,” which features hedge fund manager Lorenzo Di Mattia, and how he handles the emotional ups and downs and the frustrations of the market place.

Here are some snippets:

Emotions are contrarian indicators, says Lorenzo Di Mattia, manager of hedge fund Sibilla Global Fund.

The feelgood option is to ignore the market in the belief that the idea will eventually come good. Kind of like not going to the doctor because those burns will probably heal on their own.

“Taking small losses is the only way to avoid big losses,” Mr. Di Mattia says.

Another painful strategy that he’s found profitable: going right back into the same trade with the burns still fresh on the fingers. As Anthony Burgess’s novel, A Clockwork Orange, memorably demonstrated, learned aversion is a tough instinct to overcome.

“Just because the trade was wrong at that time doesn’t mean you drop it altogether,” says Mr. Di Mattia. “Sometimes you even have to do it at a higher price, and that really hurts. When the trade works, you have to do it.”

Even if the trade goes his way this time, the decisions may be painful. One of the toughest feelings to fight is the urge to take a profit, he says. The further into the green the trade goes, the stronger the inclination to close it. In today’s momentum markets, that can mean leaving the party before it even gets started. For a hedge-fund manager, that’s a real pain.

Even though a hedge fund may have different objectives (more aggressive) and a shorter time frame for its trades as opposed to a long-term investor, the principles mentioned remain the same.

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

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

Decent economic news and lower oil prices helped the markets stage a nice rebound.

Our Trend Tracking Index (TTI) for domestic funds/ETFs has now moved to +1.42% above its long-term trend line (red).



The international index improved as well and now remains -2.06% 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.

Wednesday’s good news in form of a better than expected durable goods report was overshadowed by a rebound in oil prices causing continued worries about the impact on consumers.

Nevertheless, the major indexes managed a decent afternoon rebound, despite the financials being a big drag. This was caused by an analyst’s opinion that AIG’s recent $20 billion raise in capital may not be sufficient and that the insurer’s financial position could worsen.

That’s not surprising to me, since I believe that the fallout from the real estate/credit bubble, and the fact that many investment banks are still stuck with worthless, leveraged holdings, has not fully played out yet.

Be that as it may, yesterday’s activity affected our Trend Tracking Indexes (TTIs) positively, and they improved slightly:

Domestic TTI: +1.20%
International TTI: -3.01%

A fact is that prices tend to decline faster than they rise. If the markets decide to resume the previous upward trend, chances are that it will take a lot longer than the 5-day drubbing the major indexes took last week.

However, since we don’t control those factors, we will focus only on what we can control, which are our sell stop points. Yesterday’s activity had no effect, and we will hold all positions.

Uncertainty was the word of the day on Tuesday as the markets see-sawed (see chart from Marketwatch.com). However, after the drubbing of last week, momentum picked up late in the session supported by a drop in oil prices and an unexpected gain in new home sales.

On the other hand, continued lower consumer confidence figures kept a lid on advances. I suspect that some further sideways action will dictate trading in the near future until some catalyst can propel the major indexes higher again. In the absence of such a catalyst, we may be treading water for a while longer. Here’s how our Trend Tracking Indexes (TTIs) fared yesterday:

Domestic TTI: +1.09%
International TTI: -3.20%

Domestically, we’ve slipped back into the neutral zone and will hold our positions subject to our trailing sell stop points.

With energy prices being on the front burner, despite today’s pullback, I have added a position in that area last week, along with gold, which broke out to the upside but retreated today.