The month of November definitely took an emotional toll on all investors including the professionals. Although we use a methodical approach via our trend lines and trailing sell stops, volatile markets at an inflection point can shake anybody’s confidence and/or conviction. An anonymous reader responded to last Saturday’s post as follows:

“It seems that it is always something unexpected that derails even the most powerful moves/bull in the market. They are always so obvious after the event happens. The subprime issues are like an octopus with 8 legs and no brain. Who knows what the other legs will be from the subprime head.

Nassim Taleb has written a very good book “Fooled by Randomness” which really tells us that we will not know until it is over. Your work allows investors to be out during these tough times, and I am personally out of all but 1 domestic fund due to the fact that the others have violated 7% stops. The tough days are the last few when you are itching to get in emotionally, but statistically you must not.

Thanks for the work you do.”

This reader gets it. He has the emotional make-up to deal with market adversity, and he realizes that good times, such as we had during September and October, will undoubtedly followed by bad times. He is also aware that the markets currently are at a crossroads where a resumption of the existing up trend or a reversal towards bear market territory could be at even odds.

Reading books such as Nassim Taleb’s “Fooled by Randomness,” or “The Black Swan,” which I reviewed before, can help you get away from looking at markets with too much emotion but in a more factual way by accepting that tops and bottoms can’t be determined until after they have happened. That’s why sell stops fulfill the critical function of either locking in profits or limiting losses.

As of right now, it appears that October 31st was the high in the market. If you are reviewing your portfolio now, you might see a 5% or so drop off the highs, which should not upset you if you realize that one, you did well during the prior 2 months and two you enabled a protection mechanism that will prevent your portfolio from sliding into oblivion.

The overly eager actions by Treasury secretary Paulson, and the mortgage/banking industry as a whole, to hammer out an agreement by next Wednesday to freeze planned Subprime mortgage increases tells you that there is great urgency to stem the tide of foreclosures. At the same time, as I elaborated in Saturday’s post, banks and lending institutions are in dire straits because of their leveraged positions and shrinking balance sheets.

Again, the markets are at a crucial point. It’s imperative that you protect your portfolio from too much downside risk which means giving up some of your unrealized profits via your sell stops in order to avoid bigger losses. A bear market has become a distinct possibility although we won’t know it until we’re in the middle of it.

Last week, I finished reading a fascinating book called “When Genius Failed” by Roger Lowenstein. It captures the roller-coaster ride of Long-Term Capital Management (LTCM) from 1993 to 1998.

Back then, LTCP was hailed as the most impressive hedge fund in history. Led by the notoriously successful bond arbitrageur John Meriwether, the firm boasted a partnership that included two Nobel-Price-winning economists and a cadre of Wall Street’s and academia’s elite traders.

However, after four years, in which the firm dazzled Wall Street as a $100 billion moneymaking juggernaut, it suddenly suffered catastrophic losses that jeopardized not only the biggest banks on Wall Street but the stability of the financial system itself.

From being a viable entity to no longer being able to operate took only 6 weeks. The biggest problem LTCM had faced was its absolute massive leverage coupled with one-sided trades that, due to external circumstances (Russia and developing countries defaulting), could not be closed out.

As LTCM was sliding into oblivion, their equity dwindled to $1 billion; however, they still controlled $100 billion in assets. That’s 100 to 1 leverage! It would take only a 1% move against their positions to render them bankrupt.

I found it fascinating to read inside story but, at the same time, I had an eerie feeling that this was nothing new because we are currently seeing a very similar scenario with the Subprime/credit crisis. The pig may be wearing a different lipstick, but the underlying facts are the same: Overleveraged institutions holding undervalued assets, which can only be liquidated at a loss.

If you like to read about financial tales of our time, you will enjoy this high drama of fast money and vivid (still living) characters. I couldn’t wait to finish it.

Sure, leave it up to the government to come up with a questionable plan to solve part of the Subprime crisis by proposing a temporary freeze on scheduled interest rate increases for certain home owners.

Michael Shedlock’s article “Temporary Mortgage Freeze Is Doomed” sheds some light on the plan and its implications. Affected will be certain borrowers who had chosen to take out a ridiculously low introductory rate and are now facing a reality check via a rate adjustment. Keep in mind that many of these borrowers had no business to get a loan in the first place, since most ‘qualified’ only via the “fog up the mirror approach.”

Now they need to be bailed out? I have to agree with Mike that the true reason behind this proposal is the fear that many banks are not in a position to take back any more undervalued real estate. It might bring down the very institutions that created this Subprime problem in the first place with their lax lending standards. I am not an economist, but it seems to me that freezing borrower’s payments for a number of years will not solve the problem, it will merely postpone it.

First, government bailouts have never worked in the past. Second, someone is holding these securitized mortgages at a value far less then what was paid for because of the questionable valuations of the underlying security. I am certain that part of the value was determined by the fact that these mortgages would adjust at a certain point in time. If this scheduled increase gets postponed, it would seem that their value would be even less than it currently is. Who will be taking those losses?

Well, most likely it will be banks, hedge funds and other institutional investors. You’d think that this would be a real problem, but as long as they don’t have to mark their assets to market, at least on paper it appears that they are still viable institutions. But, sooner or later, somebody has to pull his head out of the sand and face reality.

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

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

Despite a sluggish start, the bulls took over and pulled the major indexes out of their doldrums.

Our Trend Tracking Index (TTI) for domestic funds/ETFs has moved to +5.40% above its long-term trend line (red) as the chart below shows:

The international index slipped -0.07% below its own trend line, keeping us in a sell mode for that arena.

Yesterday’s follow through rally brought the question back to front burner as to whether the recent down trend has run its course, and happy days are here again.

From my vantage point, it’s too early to tell. Fundamentally, nothing has changed in the past couple of days, other than that Fed talk was interpreted as a confirmation of an easing of interest rates when the Fed meets next month. The same old Subprime/credit and real estate problems still exist, but today Wall Street in its infinite wisdom focused on a “maybe” event.

Technically, we did not miss out on anything since most sector and country ETFs have now just about regained everything that they lost since our sell stops were triggered earlier in the month. Of course, if you were the adventurous type of investor and had thrown your entire portfolio at the market during last Monday’s drubbing, you would have had a nice short-term gain.

If last Monday was in fact the bottom, we will need to have a little more confirmation that this rally indeed has legs and staying power. More follow through buying is needed to confirm that the up trend has been resumed.

Remember, when following trends, we will never buy exactly at the bottom, because that point is unknown at the time and can only be determined after the market comes out of a bottom formation.

In that sense, we will always be late to the party, but it will help avoid a potential whip-saw signal here and there. The objective is to buy somewhere within 10% of the bottom, and sell somewhere within 10% of the top. Since we can’t forecast either point, both conditions have to occur first before we can take any action on either side.

Yesterday’s market rebound was a welcome reprieve from Monday’s drubbing. Actually, only one event caused the financials to come back from abyss and that was Citibank’s announcement that it had received an outside capital infusion of $7.5 billion. After much negative news from the Subprime/credit crisis over the past few weeks, this was all the markets needed to stage a rally. Whether this is sustainable or simply another dead cat bounce remains to be seen.

Our Trend Tracking Indexes (TTIs) followed market direction, and we continue to have a split picture. The domestic TTI remains above its long-term trend line by +3.93% while the international TTI remains below its long-term trend line by -2.25% and thereby in Sell mode. That puts us in no man’s land, and we simply have to wait and see which way the market breaks, before making further adjustments to our portfolios.

Here is the link to the most recent ETF Master list, which has been updated with yesterday’s closing prices. This will enable you to work with more recent data. Again, the road ahead is extremely uncertain and it pays to be on guard against any sudden changes in the long-term trend via the execution of sell stops.