A reader pointed to the quarterly letter (PDF file) by Jeremy Grantham titled “The Last Hurrah and Seven Lean Years.”

While the entire report is simply superb, I want to focus on two sections, namely “Seven Lean Years” and “The VL Recovery.” Let’s look at some highlights of the former first:

Probably the single biggest drag on the economy over the next several years will be the massive write-down in perceived wealth that I described briefly last quarter.

Collectively, we will save more, spend less, and waste less. It may not even be a less pleasant world when we get used to it, but for several years it will cause a lot of readjustment problems. Not the least of these will be downward pressure on profit margins that for 20 years had benefited from rising asset prices sneaking through into margins.

Besides the loss of wealth being a life-altering shock for many, it will also postpone any inflationary effects. I am not an economist but, to my way of thinking, the Fed would need to first “replace” this lost wealth of some $20 trillion via the creation of new money before any inflationary effect can work itself through the economy.

The change of lifestyle along with saving more and spending less will also contribute to the current deflationary environment staying with us for some time to come. I believe that those betting on a fast return to growth and inflationary times lurking right around the corner will be sadly mistaken.

Here are some interesting highlights from “The VL Recovery:”

So we’re used to the idea of a preferred V recovery and the dreaded L-shaped recovery that we associate with Japan.

We’re also familiar with a U-shaped recovery, and even a double-dip like 1980 and 1982, the W recovery. Well, what I’m proposing could be known as a VL recovery (or
very long), in which the stimulus causes a fairly quick but superficial recovery, followed by a second decline, followed in turn by a long, drawn-out period of sub-normal growth as the basic underlying economic and financial problems are corrected.

I must admit that I have never heard of a VL type of recovery, but I find myself agreeing with its concept wholeheartedly.

As far as the market is concerned, we may be already in the rising part of the “V” (the superficial recovery), which then should be followed by a second decline. I have in the past referred to the recovery portion as a bear market rally but only time will tell if and when this VL concept comes to pass and if the next down-leg is upon us.

I believe things will play out like this to some degree. Since we are following trends, the type of recovery, nor the length of it, has really no bearing on our investment decisions. When a trend comes to an end, for whatever reason, we get out of our positions, head for the sidelines and wait for the next opportunity.

Unfortunately, those investors simply buying and holding, with no plan to ever exit the markets, will be paying a steep price for ignorance by watching their portfolios get annihilated again.

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

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

Aimless meandering kept the major indexes close to the unchanged line.

Our Trend Tracking Index (TTI) for domestic funds/ETFs remains below its trend line (red) by -1.33% thereby confirming the current bear market trend.



The international index has now broken above its long-term trend line by +4.96%. A Buy signal was triggered effective May 11, 2009. We are holding our positions subject to a trailing stop loss.

Yesterday’s rally out of the starting blocks fizzled slowly, and all 3 major indexes lost moderately.

Causing this retreat was the release of the minutes from a late April Fed meeting showing that the members see signs of stability, but threats remain and any recovery is unlikely to be quick. The economy is now expected to shrink between 1.3% and 2% this year up from a revised range of 0.5% to 1.3%.

Additionally, the committee anticipates that the nation’s unemployment rate will peak at 9.6% this year and that it could take some five years to get joblessness back to below 5%.

To me, these are rosy assumptions and don’t seem to show any immediate recovery lurking on the horizon. I wonder if and when that message gets to Wall Street.

Nevertheless, trends do what they do regardless and our Trend Tracking Indexes (TTIs) gained, and are now positioned as follows in regards to their long-term trend lines:

Domestic TTI: -0.02%
International TTI: +5.03%
Hedge TTI: +2.22%

The domestic TTI has some sensitivity to interest rates, which is why it moved higher while the overall markets declined. We’re again within breathing distance of a domestic Buy signal.

As I mentioned before, I want to see a clear break above the line and also review the effect when the trend line gets recalculated this Friday. By the time you receive Friday’s update, we may a better idea as to where we stand.

It’s far more important to be diligent in following through when a Sell signal occurs, since markets move down a lot faster than they move up. As a consequence, losses can pile up quickly as we saw in 2008.

Being late in participating in a Buy signal merely means potentially losing out on some profits, which most investors can live with. Stay tuned!

In regards to my recent post “More On Risk Control,” one reader had this to say:

With only a cursory review of your market timing/trend following investment approach, I find it to be quite conservative. If I remember correctly, some time early this year, your market timing index was waiting for a 20+% increase before getting back into the market. I took this snippet from the October 8th edition of the New York Times for your and your readers’ consideration. I felt the last sentence in the quotation below was most relevant for market timers.

This fall, Javier Estrada, a professor of finance at IESE Business School in Barcelona, published a similar study in The Journal of Investing that looked at equity markets in 15 nations, including the United States. A portfolio belonging to an investor who missed the 10 best days over several decades across all of those markets would end up, on average, with about half the balance of someone who sat tight throughout.

[My emphasis]

This response is most typical for those deeply entrenched in buy-and-hold investing, which is also the most widely held view on Wall Street. The prime reason is so that the commission hungry armies of salesmen can always justify selling product to unsuspecting investors whether it makes sense in the current economic environment or not.

The most violent rebound rallies occur in bear markets more often than in bull markets. To state that missing the 10 best days will lead to inferior performance is simply not thinking straight.

The past year or so is a prime example, because it proves that you do not need to participate in every sharp rally, whether it happens on one day or over 6 weeks, to be ahead of most investors. By all measures, the recent 30% plus rebound of the March 9 lows qualifies as a dramatic rally in scope, yet we did not participate.

Because we avoided the big market drop last year by selling out on June 23, 2008, we have the luxury to wait until a new major trend develops before making a commitment again.

And if that means that we miss out on one of those best 10 days, it does not really matter. Because the S&P; 500 needs to rally 45% from yesterday’s close just to get back to the same price level it was when we sold on June 23, 2008. That’s a daunting task indeed and represents a figure that you’ll never hear quoted by the buy-and-hold crowd.

Our domestic Trend Tracking Index (TTI) is within striking distance of generating a new buy signal. If it materializes this week, it means that we’ll be buying in at far lower prices than we sold, but at a point that does not simply represent random bottom picking and guessing.

It represents a point in time, where a trend reversal appears to be occurring, which allows us the opportunity to get onboard again while at the same time our clearly defined exit strategy will get us out, in case we’re wrong.

Yes, as trend trackers we actually admit from time that we’re wrong, and that we may have to take a small loss in order to avoid a big one. There should be a lesson in that for the buy-and-hold crowd.

Hope and optimism that the economy may have bottomed were pushed to the front burner again, and all major indexes gained solidly to start the week out on a positive note.

Lowe’s better than expected first quarter results provided the fuel for the rally, which was followed by improved homebuilder confidence as well as an upgrade of the financial sector.

Our Trend Tracking Indexes (TTIs) moved higher as well and, as of yesterday, the domestic TTI has moved again within striking distance of a Buy signal:

Domestic TTI: -0.26%
International TTI: +4.20%
Hedge TTI: +1.97%

To avoid any potential whip-saw signal, I want to see a clear break above the trend line as far as the domestic TTI is concerned, just as I did with the international TTI a week ago.

I will keep you informed via future posts as to effective date of any buy signal that might materialize this week.

Saturday’s post “Buyer Beware of Risk control” elicited a number of reader comments. Here’s one I want to elaborate on:

In your post, “Buyer Beware Of Risk Control,” you highlighted the statement, “It does not really matter how much of a return you make during good times, what matters is how much you keep when the markets turn south.” I feel that is an oversimplification, and you may be inadvertently playing the same game as that of American Century management.

From 1976 to date, the S&P; 500 has provided a buy-and-hold return of 10%/year. If one is satisfied with a 10%/year return, then the (paper) losses associated with bear markets pale into insignificance. And if one compares the bear market negative with the bull market positive returns, then I submit that maybe just the inverse of your statement is more accurate.

First, the buy-and-hold crowd always looks in the rear view mirror and, with the benefit of hindsight, comes up with returns of what the S&P; 500 has done. Just to clarify, for the period from 1/2/1976 to 5/15/2009, the annual compounded rate of return was 7% and not 10% as quoted above.

Second, while that sounds great on the surface, it does not emphasize the pain and agony investors went through, including the 87 crash, to get to these numbers. Bear markets and huge portfolio draw downs along with their emotional impact on an investor’s psyche are not accurately reflected.

Third, the time period of evaluation is critical. For example, the S&P; 500 stood at 1,469 on 12/31/1999. It closed last Friday at 883. That’s a 40% loss over 9-1/2 years for those who simply bought and hold and matched the S&P;’s return. In other words, most investors have made no money during this century and only because they did not apply a sell stop discipline.

Stories like this abound. Recently an investor called and told me that his advisor made him 35% per year for 3 years in a row—before losing 80% in 2008. Put the pencil to these numbers and you realize that, after these tremendous gains, he has lost 50% of his principal. Tell me, where is the value in that? Making great returns is a useless endeavor, unless you can preserve them during market downturns.

Of course, you should strive for good returns during bull markets, but be aware that it is more important, to hang on to a large chunk of your gains when the trend reverses.

Translated into your personal life this means “it’s not how much money you earn, it’s what you keep that matters.”