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The Most Important Questions You Have To Answer

Daily State of the Markets
Monday, December 10, 2012

Good Morning. Ah, the holidays... That special time of year when there seems to be a steady stream of social gatherings of all shapes and sizes on the calendar. When mingling with friends, family, or colleagues - and usually with some sort of festive adult beverage in hand - the question of the stock market seems to follow me around. Especially at this time year, the question I get asked most often is, what is the stock market going to do next year?

The problem is that although I devote nearly every waking hour to the study of the stock market, I really don't have a clue what the market is going to do next. Heck, sometimes I can't tell what the market is going to do in the next hour, let alone, the next day, week, month, quarter, or year. This brings me to my point this morning.

Too many investors don't have a plan of attack for the stock market. Too many investors basically wander through the year looking for the next Apple trade and focus on all the wrong stuff (I blame this on all the "fast money" talk on T.V. and on the internet). Too many investors are distracted by the "shiny objects" (the latest hot trade) in the market. Too many investors don't have a clue about how to manage risk - they don't know what they will do when a correction begins or how to recognize the signs that it is safe to get back into the market when the bears return to hibernation. And too many investors don't have a clear-cut strategy on how they will go about making money next year.

So, the first point on this fine Monday morning is that this is the time of year when you should be thinking about your plan of attack or strategy for next year. And since the stock market appears to be in waiting mode until the two teams in Washington can figure out a way to avoid sending the U.S. economy into recession, I thought it might be a good idea to talk some strategy.

Let's Talk Strategy

The very first question you have to ask yourself is what is your objective with your stock market investing? Are you investing for retirement? Are you trying to produce income? Are you looking for growth or saving for something specific such as college tuition payments?

Next up is the question of risk tolerance. What degree of volatility are you willing to accept in your portfolios? What degree of risk are you willing to take in terms of principal loss? And what type of return are you trying to achieve?

Once you've answered the first two questions, you are ready for the most important question - what is your timeframe? I'm not talking about the length of time you are going to be investing for. No, I'm talking about your strategy toward managing your investments. I'm talking about deciding if you a day-trader, a swing-trader, or a long-term investor. Do you want to or have time to watch your investments on an hourly basis? Will you be able to consistently and unemotionally set price targets up and down on your positions? Or would you prefer to check in every once in a while when you have time?

The reason this question is SO important is there are lots of ways to "beat the market." For example, playing the 50/200-day crossovers on the S&P 500, will allow you to outperform over the long-term and help you avoid those nasty bear market declines. At the other end of the spectrum, a "stop and reverse" strategy on a 30-minute basis will also produce strong results over time. However, if you don't understand what timeframe you are working with, the fluctuations in the market may cause you to lose sight of your goals or strategy.

Understanding the Timeframes

Unless you have a PhD in applied mathematics and access to a supercomputer, as well as a speed-of-light data feed, it is safe to say that we can rule out the "micro term" - a timeframe that involves milliseconds and trading algorithms. While I chide some of these traders (primarily the algos that "data mine" the headlines and then react based on a preprogrammed combination of words) on a very regular basis for causing undue volatility, I also see how trend-following strategies based in milliseconds could be quite successful.

However, since such a strategy isn't available to those without the $100K/month data feed, the other timeframe choices are as follows: The Very Short-Term (1- to 3-days), Short-Term (3 days to 3 weeks), Intermediate-Term (3 weeks to 3 months), Long-Term (3 months to 1 year), and Very Long-Term (more than 1 year).

It is important to make a decision about which timeframe you are playing for one simple reason: You can't have it all in this business. While playing in the short-term timeframe will keep you on the right side of the market most of the time and get you into moves early, such a strategy also creates a large number of "whipsaws" (selling lower than you bought on a long-side trade). And I can tell you with certainty that most investors don't have the internal fortitude to stick with such an approach after about the 4th consecutive losing trade. In addition, a short-term approach (whether it be trend-following or mean reversion oriented) will oftentimes cause you to take profits too early during big, strong uptrends.

If you are playing for the intermediate-term (something as simple as a 50-day ma will work pretty well here), you've got to understand that you are going to be "late" to the party almost all the time. And then if the intermediate-term trend that you thought was developing peters out quickly, you can easily find yourself with a whipsaw on your hands. Do this a couple times and your year can be blown up in a hurry (been there, done that).

If you decide that a longer-term approach is for you (I like a 10/27 week trend-following system or even a 10-month system), you will likely get the really big moves in the market right. However, you need to be willing to sit through painful corrections in the market of 10% or more during the year. And while a long-term strategy will get you "out" of stocks during bear market cycles, it WILL feel like you are selling entirely too late and such a strategy only succeeds when the "big ones" occur such as 2000-2003 and 2008.

So, while all of the timeframes discussed can be uber successful - assuming you stick with them and don't hop from strategy to strategy the second something doesn't work perfectly - it is important to understand the plusses and minuses of each approach. I guess what I'm saying is that it really doesn't matter which way you choose to skin the cat, as long as you (a) go at it purposefully and (b) understand the game you are playing.

My Answer

For me, choosing one time-frame isn't enough. Experience has taught me that there are times you need to focus on the short-term so as to be ready for the next big move (recent example: late-summer/early fall 2011) and then there are times to make the trend your friend and not get faked out by a 2% pullback during a confirmed trend (recent example: December 2011 - April 2012). As such, there are times to focus on the short-term and times to focus on the intermediate-term.

It is for this reason that I utilize a multi-strategy, multi-timeframe approach that employs "triggers" to tell us when the odds favor switching timeframes. While nothing in this game is ever perfect and all systems struggle in certain environments, such an approach allows me to sleep at night knowing that I should be able to get the majority of the big moves right.

One relatively simple strategy for this approach that doesn't require a multitude of models is to use the 10- and 27-week moving averages as your guide. For example, if the 10-week is above the 27-week, we can assume that the market is trending higher and that it might make sense to use an intermediate-term approach (so as to give the bulls some room to work). And then when the 10-week is below the 27-week, it makes sense to utilize a shorter-term strategy (remember, stocks go down something on the order of three times as fast as they go up). While this is not a perfect system, it may help you understand when to flip the switch on your timeframe strategy.

Turning to this morning... The talks on the Fiscal Cliff between Speaker Boehner and President Obama continued over the weekend and the President has reportedly cleared his schedule this week to work on the issue. In addition, the economic data out of China was moderately positive over the weekend. However, the turmoil in Europe is back this morning as Italian Prime Minister Mario Monti announced on Saturday that he would resign after the country's 2013 budget was passed. This is causing losses across the pond and a decline in U.S. futures.

On the Economic front... There are no key economic releases scheduled for this morning.

Thought for the day... It's not the load that breaks you down, it's the way you carry it. -Lou Holtz

Pre-Game Indicators

Here are the Pre-Market indicators we review each morning before the opening bell...

Major Foreign Markets:
- Shanghai: +1.08%
- Hong Kong: +0.35%
- Japan: +0.07%
- France: -0.54%
- Germany: -0.50%
- Italy: -3.57%
- Spain: -1.70%
- London: -0.21%

Crude Oil Futures: +$0.73 to $86.66

Gold: +$9.60 to $1715.10

Dollar: higher against the yen, lower vs. the euro and pound

10-Year Bond Yield: Currently trading at 1.603%

Stock Futures Ahead of Open in U.S. (relative to fair value):
- S&P 500: -3.67
- Dow Jones Industrial Average: -17
- NASDAQ Composite: -7.39

Positions in stocks mentioned: none

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In his latest video presentation, Dave M. walks you through the New "Adaptive" Active Risk Management System for the Stock Market

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