Euphoria reigned on Wall Street yesterday as a sharp opening rally gave way to a drop and a subsequent recovery, all caused by the government bailout plan of Fannie Mae and Freddie Mac.

Over the next few days, when more details become known, the markets may react to the reality of what really happened. The government bailed out an institution that should have been allowed to fail. This artificial prop-up will do nothing for homeowners, foreclosures, the credit crisis or the recovery of real estate in general. It was simply designed to throw a lifeline to an institution in order to protect the financial system. Nothing more, nothing less.

Of course, the total expense of this venture is the dark horse here, but what’s a few hundred billion dollars among friends? Eventually, we all get to participate in paying for this newly created monster.

The old adage “watch what they do, not what they say,” certainly rang true over the past few weeks leading up to this takeover event. Mish at Global Economics posted a great analogy in case you are not sure what politicians really mean based on what they’re saying. You can read it at “Paulson And Others Translated.”

Be sure to watch the music video referenced at the end of the post with the appropriate title “Take a load of Fannie.” It hits the nail on the head with a classic song, which is funny, sad and true.

In case you’re wondering, this rebound did nothing to change the direction of our Trend Tracking Indexes (TTIs), which are still under water and in bear territory:

Domestic TTI: -2.00%
International TTI: -8.23%

New reader Lloyd had this experience to share:

I invest in mutual funds and ETFs. I was using Fidelity funds and using the 1 mo, 3 months, and 1-year returns to pick the best performing funds.

This seemed to work okay, but recently it had me in all oil and oil related funds and when oil dropped I lost all my profits. I was wondering if your method would do the same or would it get me out with some profit. Also, what do you use for a sell signal for the sector ETFs and sector mutual funds?

I was looking at your M-Index and wondering why you use YTD in your calculations rather than 1 year. It seems to me that if you use YTD, you’re not always using the same number of months to make your calculations. The last month of the year the YTD is 12 months of data whereas the first of the month of the year the YTD is only one month. Does this affect the ranking?

First, using longer term momentum figures as Lloyd suggests can work as well. However, you still need to pay attention to the direction of the trends and follow a strict sell stop discipline. Just because momentum figures are still in positive territory does not mean holding a fund/ETF is advisable.

Once you have established your invested position, you need to set up your trailing stop loss point. For sector and country funds, I use 10% and for domestic and broadly diversified international funds I use 7%. Without it, you are exposing yourself to tremendous risk no matter which investment approach you use.

Second, you are correct in your observation that the value of the M-Index is reduced to a smaller number every January due to the new YTD returns. Since all M-Indexes for all ETFs/Mutual Funds are adjusted at the same time, it really does not really matter since the figure by itself has no meaning. It is only important when compared to others and shows increasing and decreasing momentum.

Again, when working with momentum figures or trends in general, the implementation of a sell stop discipline will save your portfolio from major damage. Unfortunately, many Buy & Hold investors have not figured that out yet and will have to learn the hard way (by losing serious money) that a bear market is not to be taken lightly.

The fallout from the credit crunch has been well documented, because the top names in investment banking had to cumulatively write down so far in excess of some $500 billion dollars with no end in sight. In case you missed it, Merrill Lynch has held the dubious #1 ranking when comparing losses to historical profits.

News reports had this to say (sorry, no link available):

Merrill Lynch’s losses in the past 18 months amount to about a quarter of the profits it has made in its 36 years as a listed company, according to Financial Times research that highlights the extent of the global banking crisis.

UBS, which has lost more than $15 billion during the crisis, had the second-highest ratio.

[Emphasis added]

This describes investment banking in a nutshell, as I have posted about previously. Companies use sophisticated computer models that can make tremendous amounts of profits but rely on computations and assumptions which do not include the rare Black Swan event.

Every so often a blow up occurs, which has the potential to completely wipe out companies, such as happened with LTCM (Long Term Capital Management) in 1998, when a stable of the brainiest investment people along with Nobel laureates placed ill-timed trades without a plan to exit in case their assumptions proved incorrect. I reviewed the book in “When Genius Failed.”

Nassim Taleb writes in “Fooled by Randomness” that this is a frequent occurrence and no one seems to have learned from the past. He states that simple techniques such as using sell stops are rarely used by “professionals.” Hard to believe, isn’t it?

Recent news reports state that Merrill is still having problems unloading some troubled holdings. Undoubtedly, this will continue until every company owning garbage assets has finally cleaned up their balance sheets.

Common sense would dictate that coming clean all at once, spilling your guts and getting it over with would be the fastest way to a new beginning rather than hanging on to continuously deteriorating toxic holdings. Maybe some of the companies would prefer that approach, but can’t.

Why?

Could it be that if they produced a “marked to market” type balance sheet that it might disclose that they are no longer a viable entity?

MarketWatch featured an interesting story titled “Is that deflation we smell?” Let’s listen in:

What do you call it when both stocks and commodities are plunging?

Unless Fed chairman Bernanke can pull more rabbits out of his hat, and soon, we should probably prepare ourselves for more days like Thursday.

I agree with that assessment, because it should not be earthshaking news to anyone that, with the continuing destruction of assets across corporate America, deflation has taken a firm hold. With the continuing unwinding of the credit bubble, the Fed is pretty helpless but to let the current scenario run its course. The question in my mind is just which entity will be big and important enough to get bailed out and which one with be not worthy of that option.

While I personally do not support any kind of bailout (because tax payers will be on the hook), choices will have to be made. Given the enormity of the credit crisis, even the Fed’s balance sheet has limits.

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

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

The bears feasted on a bullish carcass, and the major indexes lost heavily.

Our Trend Tracking Index (TTI) for domestic funds/ETFs remains below its trend line (red) by -2.66% thereby confirming the current bear market trend.



The international index now remains -9.96% 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.

Reader Joao has been watching our Trend Tracking Indexes (TTIs) for some time now and had this to say:

I am observing your TTIs very carefully, and plan to take action when you recommend.

I have a question however on the slope of the TTI: how relevant is this slope (as compared, for instance, to a 200 day moving average)? Looking at the US domestic TTI, the slope is now tending downwards for the first time in several years (since 2003).

Would this signify a down trending (bear) market, and therefore, should one not take “shorts” in tune with the falling market rather than go long when the index line goes above the TTI line? I am saying this on the assumption that you’d concur with the strategy of investing “with the trend” … and if the trend is sloping down, then why go long?

Thanks for your insights; I am trying to get a better understanding of your proprietary TTI system.

Let’s take a look at a blown up portion of the domestic TTI to better understand what Joao is saying:



Since our Sell signal on 6/23/08, the trend line (red) has been in fact sloping down confirming that we are indeed in a bear market. As you can also see, prices (green bars) have been on the rebound and may very well break through the trend line to upside into neutral territory. I define the neutral territory as an area between the long-term trend line (red) and a point, which is 1.5% above it (blue). Once prices pierce the blue line, a new domestic buy signal is generated.

To answer Joao’s question, I have to say that in the past 20 years I have not found that a buy signal generated via the piercing of a falling trend line vs. the piercing of a rising trend line has shown any different results.

Sure, a falling trend line would support a bearish viewpoint; however, you still need to apply caution when entering short positions. Why? Bear market rallies are a powerful counterforce to be reckoned with. If you had any short positions initiated based on our last Sell signal, you most certainly would have been stopped out had you worked with a sell stop (which is a must).

Looking at the big picture, I suggest you review my post “Is Short Selling Worth It,” which makes the argument based on a lot of research that, in the long run, short selling may not add as much to your bottom line profits as you think.