Yesterday’s post about a different type of sell stop generated some reader feedback. As always, I appreciate the commentary; although I don’t necessarily agree with all opinions.

Here’s one comment that I feel needs clarification:

Something that you definitely are missing when talking about trailing stops is the Market trend.

If the Market indicators are Bullish, one really should think twice about selling an ETF/Mutual fund on a 7 percent down turn. Had I not used common sense and not sold my ETFs/Mutual funds on a 7 percent down turn, I would have missed out on the 50 percent bull Market run over the last 7 months. I believe you have also advocated using common sense/intuition before selling mutual funds/ETFs.

The reason to use trend tracking along with trailing sell stops in the first place is to have a clear cut plan in place in order to avoid emotional decision making and to control downside risk.

If what you are describing works for you, fine, but it may not work for others. Introducing another subjective variable, such as the identification of the market trend (however you want to define it), causes additional decision making and confusion.

To be clear, when a trend for an ETF/Mutual fund ends, reverses and triggers my trailing sell stop, we get out. At that moment, however, we have a plan in place as to what will have to happen in the market in order for us to re-enter. If you don’t have such a plan, yes, then you will miss out on the potential upside.

2008 was a perfect example in that by most measures the market was still in an uptrend when we moved to the sidelines on 6/23/08. My preference is to act immediately when the signal gets triggered and ask questions later.

As I have often commented, being disciplined and exact with the execution will lead to whip-saws from time to time. That’s the price we simply pay to be sure we avoid the big drops in the market whenever they happen.

Since you apparently use a sell stop along with an analysis of the market trend, I’d be curious to know when you got out last year and when you re-entered this year.

My philosophy over the past 20 years has been to keep things consistent, effective and simple without any attempt of curve fitting my approach to current market conditions.

Discussing the sell stop strategy has been the hot topic over the past few weeks and for good reasons. It’s one of the most important aspects of keeping your portfolio intact when the trend reverses.

There is not just one way to use sell stops as reader SS commented:

I disagree to an extent. If you have a diversified equity mutual fund portfolio, there is no reason why you can’t just have a trailing stop on the entire portfolio.

You can use the S&P; as you gauge if you’d like. The S&P; high is 1072 ytd…if you use 10% of that high, or whatever becomes the high, as your trigger to exit…. you know at what point there are probably some fundamental issues in the economy and you should likely get out. The caution is be careful about setting a trigger too low. The market could drop off 6-7% and still be fundamentally sound. And you don’t want to be in and out of the market needlessly. The best thing is this alternative is much less labor intensive than tracking every fund.. for both clients and advisors:)

To each his own. Using the S&P; as a gauge for setting sell stops can be a dangerous game. Why? For the simple reason that it may drop at a slower pace than your portfolio, which, as a consequence, may lose more than your intended percentage.

Again, there are many ways to work with sell stops. You need to find the one approach that you are most comfortable with. Looking at the big picture, any type of sell stop will be better for your financial health than none at all.

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.