1. Overall Market Direction
As we said earlier, trends come and go. Our main duty - our number 1 duty - as trend followers is to recognize and react to trends. To get the “big picture” of market trends, we like to use weekly and monthly charts of the S&P 500 as our reference. That index is made up of the top 500 publicly traded stocks in the U.S. and gives us a good overall “feel” for the stock market in general.
Major market trends fluctuate with major economic cycles. Very generally speaking, since 1928 bullish trends of S&P 500 stocks have lasted an average of 18 months to 2 1/2 years while bearish trends have lasted 12 to 14 months.
> During those bullish trends, we want to have our money invested in stocks or mutual funds - according to our asset allocation guidelines (more on that later).
> During those bearish trends, we want to pile our money into our safe investments - cash and bonds or bond funds.
Now, if that sounds like we trade in our portfolio frequently, please re-read the paragraph above: trends last for months, even years. Once we have our portfolio set up with the current trend, we don’t have to touch it for the duration of the trend - months or years!
When we do move money around in our portfolio, we like to do it thirds. That is, the total amount of money we have to put into or take out of stocks, we’ll move a third of that amount at a time. We do that for 2 reasons:
> We can get a “head start” on a change of trend: As prices and moving averages roll over and start to signal a trend change, we move the first third of our money. If the roll over continues, we’ll move the second third. Once the roll over is complete and
the new trend is confirmed, we’ll move the last third.
Some folks wait to move their money all at once after a new trend is confirmed. Some move a fourth of their
money at a time during a transition. Still others move a small percentage first, then larger percentages as the
transition takes place. There is really not a wrong or right way - it all depends on how aggressive or cautious
an investor is and what he or she is comfortable with.
> We reduce some of the risk in the event that we are wrong: As we have said before, there is no investment
strategy out there that is 100% accurate 100% of the time - not even trend following. There will be times we will interpret the
charts wrong; times we will fail to react in a timely manner; times that the market just flat out does a head fake and goes back
the way it came!
By moving our moolah a bit at a time - instead of all at once - we can change our portfolio more easily and with less damage if a trend change doesn’t actually take place:
Let’s say for instance that during a lengthy bull market, we saw the S&P 500’s 50-day moving average dip below the 200-day average along with current S&P prices. Expecting a coming bear market, we might move a third of the money we have in stock funds into our safe cash/bond funds. We look at our charts in a couple of weeks and, uh oh, we see that the S&P has reversed course and shot upward, resuming the bull market! We’ve only lost money on that third we had moved early, instead of the whole amount and we promptly slide that third back into the stock funds we had before. The reverse is true, too: this approach keeps risk at a minimum when we move early from a bear market into an apparent bull market.
All in all, our simple trend following guidelines served us very well - even though they are very conservative guidelines!
> We avoided 44.5% of the 57% drop that crushed most investment accounts in 2008 (we were totally out of stock funds by the second week of January 2008).
> That gave us a tidy sum of moolah to invest at bargain prices when the market went bullish in March 2009 (we were totally back in stock funds by the second week of July 2009 - a bit too cautious probably!).
> Despite getting bumped out by the market “head fake” in 2011, we have captured over 108% of the 155% market rise
(as of 8/2/13) from the March 2009 low of 666.
From a bottom line standpoint since October 2007, that puts our trend following method roughly 38% ahead of a buy-and-hold method to date (1/2/2013). Now, that’s assuming the buy-and-hold-ers used index funds. If they tried to beat the market with some “nifty” mutual fund picks, 80% of them did worse still (we'll explain why later)!!
We don’t care where you’re from: that’s a butt kicking in any neighborhood. The sad part is, this butt kicking represents real money that honest, hard working folks have lost by going along with Wall Street’s “buy-and-hold” investment advice.
As we said, ours is a very conservative method. More experienced and more aggressive investors could have made better returns over this time period. We have made good money and still slept soundly at night! We’re OK with that.
> Note that our method, like all trend following methods, lost a little money as the S&P fell off those October 2007 highs. Our
method also missed the early gains when the market turned in March of 2009. But that is the nature of trend following.
Trend followers don’t try to pick market tops or bottoms - that’s a losing game for sure. We wait for the market to
make the turn and confirm its direction before we make our portfolio moves. The small amount of money we miss
out on at the beginning or end of a trend doesn’t bother us at all because we are looking to get that “fat part” in
Combining our “thirds” buying and selling method with our trend following guidelines gives us more peace of mind,
more flexibility and some very nice returns in our investment accounts.