With almost daily news about banks having taken, or are about to, tens of billions of dollars in write-downs due to the real estate/credit bubble, you may be wondering how this whole mess got started.

Sure, you’ve been catching news pieces here and there, but what caused this dilemma in the first place? How can Subprime mortgage investments have spread like a virus with such force and intensity that institutions around the world have become infected?

While I have been posting on that subject for about a year, 24/7 Wall Street featured an article titled “Quants gone wild – The Subprime crisis.” It’s a bit lengthy but a worthwhile read if you need a refresher in what has happened and who messed up.

Here is the conclusion:

So where are we today? Well, regulatory accounting requirements mandate that publicly owned investment banks write down assets of questionable valuable. CMOs/CDOs/SIVs do come to mind. Massive write-downs have wiped out huge chunks of capital and crippled investment banks’ ability to act as financing institutions—and there is more carnage to come. This is important as there is real risk that if the flow of credit from the impacted financial houses tightens further—those that supply vital credit to both consumers and companies—the downturn we’re moving into will be deep and long.

A couple closing thoughts: don’t run with the lemmings; don’t be overly impressed with things you don’t understand; drink some green tea and take time to write a Haiku as we witness a staggering capital meltdown from the consequences of uncontrolled financial engineering in derivatives currently estimated at US$500 trillion globally.

The big unknown time bomb remains the derivative problem, since there is no way to ascertain who is involved to what extend. Just the mere fact that this is a $500 trillion global entanglement has turned this investment arena into a casino with no limit.

Finally, I found a few paragraphs in the media that made some sense. MarketWatch featured a piece titled “Avoidable trillion-dollar tragedies.” While the story addresses several important issues, I want to focus on the portion about the misguided mutual fund management mess. Here is an excerpt along with my comments:

If the next few years are as devastating as the 2000-2002 bear market, traditional mutual funds families risk losing as much as $10.6 trillion of retirement savings balances, including $2.4 trillion of deferred income taxes. In the last bear market investors lost $7.8 trillion simply by “staying the course.”

My comment: The markets have currently moved back into the upper trading range, so investors are in a bullish mood. While it’s too early to tell which way a possible breakout will occur, you not only need to be aware that a bear market can return at anytime, you also must have a plan in place to avoid going down with the crowd.

If fund managers are so smart, why won’t they protect shareholders’ money from bear markets? Read your prospectus; they promised they wouldn’t sell short or “go to cash” in bear markets. When markets decline, you lose money.

My comment: Because the only protection against a bear market is to be in cash on the sidelines or actually invested in bear market funds. And don’t let any of these index proponents tell you any different—when the markets head south, index funds with will join the crowd.

As for tax-deferred programs, they have made their managers more money from inflated balances. Yet so far in this decade, the benchmark Standard & Poor’s 500 Index adjusted for inflation, has lost 23%. The wonder of compounding has been working against you. Many 401(k) plans are employee benefits that have not benefited employees.

Either find an experienced independent adviser who uses low-cost exchange-traded funds, or demand that regulators allow actively managed clones of the buy-and-hold-only funds. Let the investors decide; it’s their money and their choice. In bear markets, shareholders are paying for management that’s likely to lose them money.

My comment: Low cost index funds are fine during bull markets just like mutual funds. In a bear market, however, your portfolio will head down the same, but you may save a few pennies due to lower annual cost. That’s a small consolation when, at the end of a bear market, you’re index portfolio may “only” be down -40% vs. -45% in mutual funds. My point is that a bear market does not discriminate, because any kind of bull market asset will be devoured.

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

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

A strong move to the upside supported the bullish cause and brought us closer to a Buy signal for domestic equities.

Our Trend Tracking Index (TTI) for domestic funds/ETFs has moved now +1.34% above its long-term trend line (red), which means we are honing in on the +1.50% buy level.



The international index improved to -3.21% below its own trend line, keeping us in a sell mode for that arena as well.

For the first time, Fed Chairman Bernanke acknowledged that a possible recession can’t be ruled out. Although he did not back off his viewpoint that there would be some sort of second half recovery, he seems to have come around to what the rest of us have been thinking.

His view put a stop on any continuation of Tuesday’s rally, at least for the time being. He’ll be doing a 2-day testimony, and I would expect Wall Street to hang on and dissect his every word. Interesting to me were his comments regarding the Bear Stearns assist. He said that the damage caused by a failure would have rippled across the entire U.S. economy.

MSN Money reported his statements as follows:

When Bear Stearns told the Fed on March 13 that it was going to have to file for bankruptcy, Bernanke said, the Fed believed that the issues posed by the collapse of the investment bank were bigger than the company itself.

“Our financial system is extremely complex and interconnected,” Bernanke said, “And Bear Stearns participated extensively in a range of critical markets. With financial conditions fragile, the sudden failure of Bear Stearns likely would have led to a chaotic unwinding of positions in those markets and could have severely shaken confidence.”

That’s what I thought as well. The looming question in my mind is if this will be a continued pattern. What if the next Bear Stearns runs into the same problem? And then another one? Or may 2 firms at the same time?

To me it’s not a question of “if” but simply “when,” because I fail to see how banks, having leveraged investments in illiquid or downright garbage assets, can get rid of them. Since all big players are involved in pretty much the same scheme and locked into each other via complex derivatives, which one will be the white knight?

I don’t have any answers to these questions, but I think about them. They affect me only in that my investment stance and approach remain conservative, and I need to see a clear resumption in trend before I make any commitments to the domestic or international market. Right now, our Trend Tracking Indexes are still neutral in those two areas, as I pointed out yesterday.

However, things can change in a hurry, and I am prepared to act if an opportunity presents itself.

Yesterday, the markets staged a major rebound with Dow gaining almost 400 points in very similar fashion to a few weeks ago. The big question remains now if this was just an April Fools’ joke or the real recovery many have been hoping for.

We’ve seen these head fakes not too long ago on both, the upside and the downside. The moves were usually just large enough to bring in enough participants eagerly hoping that the train will continue in the direction it started. So far, every attempt has been a disappointment, however, sooner or later a real trend will materialize, as I posted about yesterday.

For some assistance, let’s look again how our Trend Tracking Indexes (TTIs) closed out the monster day:

Domestic TTI: +0.60%
International TTI: -3.96%

While these numbers represent a great improvement from yesterday, the moment to make a new commitment has not arrived yet. Again, as we’ve seen, when the TTI momentarily broke to the downside by -1.64% a few weeks ago (for one day only), some eager investors jumped in with short positions, which are now not looking so good. The same can happen to the upside.

I found over the years that, in order to limit those whipsaws, it’s best to be a little late entering the market by making sure a directional breakout has really occurred. How can you do that? Let’s take a look at the top portion of the domestic TTI chart:

Click to enlarge

Note that for most of 2008, we have been trading in a large sideways pattern (between the red lines) and therefore have been stuck in what I call a neutral zone. Once we break out either below or above, the odds are greatly enhanced that a new trend with legs has started.

To put more concrete numbers on these lines, I have marked this neutral zone as an area defined by an upper range of +1.5% above its trend line and a lower range of -1.5% below its trend line. Once either is pierced and the price holds, I will take that as an opportunity to enter the domestic market again either on the long or the short side.

However, keep in mind that this is not an exact science but simply my experience of what has worked for me in past to minimize frustrating whipsaws.

As it turned out, this past quarter was one that many investors, traders and advisors are glad to put behind them. The major markets, as the above table shows, were mired deep in red and many sector trends came to an end in January causing several whipsaws. It was the steepest decline in 5 years.

This is not to say that there weren’t any winners. According to my data base, the year-to-date honors go to the U.S. Natural Gas fund (UNG: +34.01%), followed by the iShares Silver Trust (SLV: +16.40%) and PowerShares Base Metals (DBB: +15.11%).

We did not have any positions in these top 3; I missed the beginning of the trend and extreme high volatility did not allow for a safe entry point later on. We stayed with our more conservative allocations in gold and Swiss Francs, but the small position size only had a limited positive effect on our portfolio.

Our Trend Tracking Indexes (TTIs) closed out the quarter being positioned relative to their long-term trend lines as follows:

Domestic TTI: -0.44%
International TTI: -6.76%

I can’t be sure, but I would expect a trend, either up or down, to be set in motion at some point during this coming quarter. History has shown that the longer a sideways pattern lasts, the stronger the subsequent breakout.