Yesterday’s early morning sell off was met with some bottom fishing, the markets rallied, fell back and ended up just about unchanged.

Bonds continued their upward move, gold (incorrectly quoted above) gained almost 1% while oil dropped again. We’re still in no man’s land as far as domestic equities are concerned, which makes it a moot point to take any new positions here.

The best news of the day was the fact that the markets did not fall apart after a weak opening. Overall economic news included a weaker than expected Japanese GDP, slowing domestic manufacturing orders and low builder sentiment, which simply confirms that there is not a lot of growth potential out there.

The economy is faltering albeit at a slow pace, which means that bulls and bears will still have to battle it out before a winner can be announced. Right now, bond funds/ETFs are the place to be as they seem to display the only clearly definable upward trend.

With the bursting of the credit bubble, and the so far unsuccessful attempts by the Fed to reignite inflation, a deflationary scenario a la Japan seems to be a real possibility.

In any economic environment, there will always be investment areas that will benefit by displaying upward momentum. ETFtrends had some thoughts on the topic in “ETFs to Tame the Deflation Monster:”

Deflation appears to be posing a bigger and bigger risk to markets and investors should know how to deal with this market condition with exchange traded funds (ETFs) if it becomes a reality.

• iShares Barclays 1-3 Year Treasury (NYSEArca: SHY)
• WisdomTree Dividend Top 100 (NYSEArca: DTN)
• ProShares Short S&P; 500 (NYSEArca: SH)
• ProShares Short MSCI EAFE (NYSEArca: EFZ)

While these ETFs may present some good selections for a deflationary environment, they should not be used indiscriminately. First, you have to make sure that their trend is up by verifying that they have broken above their respective trend lines.

Second, while you may be right with your ETF selections long-term, you can always be wrong short-term due to changing market conditions and temporary trend reversals. Consequently, it is important that you employ my recommended sell stop strategy to protect your assets from unforeseen setbacks.

Disclosure: No holdings in above ETFs

Over the past year, much has been written in the mainstream media about the potential for a bond bubble bust. Those who have bet on that scenario by shorting treasuries have suffered big losses as the bond rally, supported by lower interest rates, has actually gathered steam.

The wild card was the fact that, as I posted yesterday, we only had a stimulus induced recovery and not one based on true demand for goods and services. As a consequence, interest rates continued their downward spiral as bond prices rallied and the economy slowed.

The question now is what could bring this bond rally to an end?

The obvious reason would be a real pickup in economic activity, which would cause interest rates to rise over time. While possible, I simply can’t see it happen given the current back drop.

Through my lens, we are far more likely to see further weakening in GDP during the second half of this year as opposed to a recovery. The Fed even has said this much and, while the bond market has caught on, the equity market still has not gotten the message. Once it does, increased downside risk will come into play, and a move back into bear market territory is a distinct possibility. That would translate into low interest rates staying with us for the foreseeable future.

Another factor that eventually could bring this bond rally to an end is the continued tremendous borrowing appetite of the U.S. government to finance its ever rising deficits. With no serious deficit reduction efforts in place at this time, those who buy our bonds may eventually demand higher rates of returns due to increased risk causing bond prices to falter. While this may be years away, it should be a concern nonetheless.

Some have argued that inflation will eventually cause interest rates to go up, but that scenario is very unlikely as the odds are increasing that we will moving into a Japan like deflationary environment.

Then there is always the unknown event that can wreak havoc with any of the above. From a practical investment point of view, and to guard against the unforeseen, I treat our bond holdings just as I do equities. I follow their trends and use a trailing sell stop (5% for bond funds) to be executed should the need arise.

We are living in a very uncertain economic environment with no clear direction recognizable on the horizon. No one can predict the future, so it pays to be cautious by using a sell stop discipline, just in case things turn out opposite of what you had anticipated.

This past week, some reality set in on a global level that especially the U.S. economy is not all it was cracked up to be. Of course, to readers of this blog, this should come as no surprise as I have repeatedly pointed out that the alleged economic recovery has been simply a mirage supported by reckless government stimulus programs.

It defies common sense and logic to assume that artificially created demand can be anything but ephemeral. Short of invoking Stimulus 2.0, we have reached the moment of truth where the real economy needs to stand up and be recognized.

To my way of thinking, this recognition will be in form of utter disappointment during the second half of this year, as GDP numbers are sure to disappoint. When even the #1 cheerleader, Fed chief Bernanke, talks in the most optimistic language that things are “unusually uncertain,” it should serve as a wake-up call that reality may be somewhat different than what was being assumed.

Take a look at what Harry Dent has to say on the subject. His view of the economy matches mine and is spot on. Where I am not as sure is on the numbers he presents as to where the stock market may end up. Hat tip goes to reader Larry for sending in this link to Harry’s July video:

http://www.hsdent.com/july2010update/

If the scenario of a lower stock market comes to pass, bonds/bond funds will continue to be the investment of choice. Eventually, once bear market territory has been entered, and the domestic TTI (Trend Tracking Index) has been broken, some short positions via the major indexes will be a definite possibility.

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

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

Weak economic news handed the bears a victory with the major indexes dropping sharply.

Our Trend Tracking Index (TTI) for domestic funds/ETFs held above its trend line (red) by +2.30% (last week +3.48%) and remains in bullish mode.

The international index has now broken barely below its long-term trend line by -0.17% (last week +3.10%). A new Buy Signal was triggered 7/23/10 with the effective date being 7/26/10. Be sure to use my recommended 7% trailing sell stop discipline, should you decide to participate in this new uptrend. An outright sell signal will be issued once the trend line gets pierced by -1.00%.

Reality about a slowing economy not only hit Wall Street yesterday but also dragged global markets down as no region proved to be a safe haven from the selloff. Bonds were the beneficiary again as interest rates headed lower.

I was not about to wait around to see if that debacle would turn into a 500 point down day, so I sold some of our recently acquired country ETFs. Our international fund, which initially raced higher after we purchased it, headed sharply lower and actually dropped below its own respective long-term trend line. Barring a sharp reversal today, this fund will be sold as well.

While all global markets were affected, the damage was far greater internationally than domestically. This was reflected in the sharp drop of our international Trend Tracking Index (TTI), which moved to within +0.09% of generating a sell signal. Its domestic cousin is still hovering above its own trend line by +2.89%.

Contributing to the market’s sudden demise were continued worries that the global economy will be heading in the wrong direction. Not helping matters was a 19% increase in the June U.S. trade deficit, which will result in a downward revision of the second quarter economic growth figures.

Additionally, after a night of thinking about Tuesday’s Fed move, it became clear that, while they are concerned about a slowdown, their intentions might be too little to right the sinking ship.

It seems like the markets have been moving in a vacuum for most of this year with no sustainable long-term trend in place; either up or down. The result has been whipsaw sideways action where neither the long nor the short side has produced any meaningful results.

Yesterday’s pullback violated some important technical levels. First, the S&P; 500 plunged below its all important 200-day moving average (1,115). Second, it has also moved to within shouting distance of breaking its 50-day moving average (1,081) which, if broken, could invite some serious selling.

The bottom-line is that we’re back to a level within the range where anything is possible. You could see another sharp move up, but given the economic backdrop, it’s questionable whether there will be any staying power.

The reality of globally slowing economies finally seems to have made its way to the stock exchanges of the world. Short of any incredibly good news to the contrary, it’s my opinion that over the next few months the path of least resistance will be to the downside.