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Capital Preservation – The #1 Rule

Two market meltdowns in the last decade has left a majority of the average investors wary of the stock market. There is an overload of information for the average investor about how or not how to invest. We continue the overload. But attempt to shed a very small light, in a hope to educate investors on possible investment strategies that actually do work and will help to preserve their well earned capital.

At Portfolio Strategy Inc, we advocate several strategies. One strategy is trading with trend by using a trend model. First you must determine the major market trend. The trend is the observation of the direction of the market. Is the market going up, a bull market? A down trend, or Bear market? Or maybe  sideways, where it just can't make it's mind up. The trend of the market normally indicates the direction of most stocks and sectors.70-20-10 rule of thumb – 70% of a stocks movement is due to the averages, 20% to the sector and 10 % to the individual stock.

We us a 5
week ema crossing over 21 week ema on a S&P500 weekly chart. When the shorter time frame goes either above or below the longer ema that signals a corresponding buy or sell signal. Used by itself as the only indicator, since June 5th 2006 till Sept.13 2010 you would of had 5 buys and 5 sells.

Red Arrow  -  Sell Signal  - 5 ema crosses BELOW 21 ema

Green Arrow  -  Buy Signal - 5 ema crosses ABOVE 21 ema


As you can see from the chart you miss a large share of the market downturns. You also miss some of the markets bull run. Late 2007 & early 2008  also gave a couple buy and sell signals fairly close together. Not a perfect model, but nothing is. If you would of been using this in 2008, you would had to of said that it worked great. You could of avoided a large portion of the 2008 market losses, by using this crossover method. An alternative is to use a 17 week ema and 44 week ema chart.

PSTI  -  Portfolio Strategy Trend Indicator

You are not forecasting what will happen. We follow the market trends and do what it tells us to do. We do not try to guess where the market is going. You ANALYZE the current market trends, EVALUATE the results, REACT if needed. This method takes the emotion out of  your investment decisions. Implementing a trend-following crossover strategy – has no guess work, no sophisticated technical analysis, and no judgement.

The above chart used alone can be used as a simple - conservative trading platform. Bull or bear markets can last for months to years. The market will have many fairly large ups and down moves and still be considered a primary bull or bear market. If you miss the initial buy signal, or want to buy and sell within the major trend, you need to know what the medium term and shorter term trends are doing. If you don't do a lot of trades you can just use the PSTI chart. Use the extra information as a heads up FYI.

It's important be be aware of all three trends. Long term trend changes are first detected in the shorter time frames. This trend model is used for a majority of your market decisions. If the long term trend (NASDAQ:PSTI) is up, we can be long or neutral (in cash) according to the medium (weeks to months) term trend. Once the long term trend is identified, wait until the medium term trend is moving in the same direction before opening compatible positions. Information from the short-term (days to weeks) trend used in conjunction with analysis of the particular stock you want to purchase, should help you to get optimum execution on entry and exit positions. Evaluation of the condition of the current market trends is performed and shown with a easy to read Market Condition Indicator (PSMCI).

Trend Model Instructions: Any completely objective trend model, you wait till one of the three trends cross over before you act according to your trading style and portfolio.

  1. Identify the current primary long term market trend.
  2. Recognize the shorter term trends.
  3. Analyze the current trend(s) health condition/strength.
  4. If trend model identifies possible actions are needed per your portfolio, respond accordingly.

Infrequent traders:

  1. At a minimum, check the 3 trends on a weekly basis.
  2. Any investor should be aware of the market's general health for a heads up FYI.

Frequent trader examples in using our market condition indicator:

  1. When planning to buy within a primary bull trend, and the market conditions are pointing to a down trend with a weaker short trend, you would wait to open any new positions. Wait for conditions to strengthen the short trend signal or further deteriorate and the trend completely rolls over to the downside.
  2. When in a strong short term downtrend, the medium trend likely will look to turn down. So instead of any new purchases, you would wait to see if the medium term trend does in fact cross to the down side. If it does, look at a primary turn down and sell signal for a cash hold. The other possible scenario is the medium and shorter trends could reverse to the upside and the primary trend stays intact, negating a sell signal. Long term trend changes are first detected in the shorter time frames.

This is not a recommendation to buy or sell, use for education purposes only. Realize that this is only one important part of a total trading system. A plan is needed in how much to buy, when is the best time is to buy and sell, what to buy, etc……

Seeing how everyone, including us, has an opinion. We like to show supporting articles by other authors. Below are three supporting article excerpts and links. We had been using a 5/20 week model and raised it to 5/21 when we ran into the first article

1.) Forbes

The phrase "market timing" means different things to different people. To some, it means anticipating almost every short-term zig and zag of the market. Others seek to predict only the major moves. The timing model is a bit of the latter, slow to catch the turns, but it has the advantage of giving very few false signals.

The model has two factors.

The first is valuation of the broad stock market. It's bullish if the S&P 500 risk premium, defined as S&P 500 earnings yield minus the yield on the 10-year Treasury note, is greater than 1%. Right now, the risk premium is above 3%, a comfortably bullish level.

The second requirement, the one that has triggered the major signals in the recent past, is that the overall consensus earnings per share estimate for the S&P 500 companies must be trending higher. Specifically, this factor will be considered bullish if the five-week moving average estimate is above the 21-week moving average. Presently, this signal is also bullish. We've had some ominous headlines lately, and a conspicuous correction, but thus far earnings estimates continue to chart the upward course that took hold in mid-2009. Read More

2.) Diversification in Time

The Modern Portfolio Theory tells us not to put all your eggs in one basket. The B/H strategy calls for holding all your eggs in one continuous “basket” of time. That sounds like a risky proposition to me. Market timing is not witchcraft. It reduces risk through temporal diversification. There are times to hold, and there are times to fold.

Active investment management with market timing works not by forecasting the future, but by following major market trends. By way of example, let me illustrate  how the 6-month MAC system described in Part 1 and Part 2 realizes temporal diversification. Figure 4 shows the difference between $1 investments in B/H and in MAC made in January 2000. How have the two systems performed through the 2000 Internet Bubble

From 2000 to 2009

and the 2008 Systemic Meltdown, to June 2009? I’ll let you be the judge. The MAC system doesn’t predict the markets, it follows the trends. It doesn’t sell at peaks or buy at bottoms. But it’s effective in preserving wealth in bear markets and accumulating wealth in good times.

Now you know why the B/H strategy that worked so well in the past has proven so fallible since 2000. The question is whether you believe the secular bull of the past is likely to return after the current recession is over. If you think that the next decades will not match the good fortune of the post-WWII era, you should start looking for an alternative investment approach.

excerpt from Moving Average: Holy Grail or Fairy Tale, Author Theodore Wong. All three parts are also here

3.) Market Timing Works. Even A Simple Moving Average System can Beat Buy & Hold

As part of our ongoing market timing research, we've done an analysis on moving average systems to prove dead wrong the market "experts" who continually claim market timing doesn't work.  The Gleason Report doesn't use moving averages for timing the S&P500 but many investors and advisory services do. Our results confirm that many moving average systems can easily beat buy and hold.  There are, however, significant differences in performance over various time periods. The best moving average system we devised is based on a 40/10 week two average model but we'll discuss the results from other intervals too. The conclusion from our research:

The most important point of our analysis is: A simple, mechanical moving average system beats the Buy & Hold of an index fund over 20 year periods and with 30% less risk.

Moving Average systems will have periods of poor performance but hold up quite well over time.

So, why do so many commentators and so-called experts continually bash market timing when it obviously works?

First, most investors don't have the patience or the confidence to trade the stock market. They panic out of trades when the market moves against them rather than wait for the system's signal. They are probably better off in a mutual fund at least making some money. Second, uninformed investors are the source of profits for mutual funds. It's not the funds job to educate investors about market strategies. Besides, they get a percentage of the assets even if the investor loses money. Many mutual funds have over 100% portfolio turnover each year as they frantically buy and sell stocks. Ironically, they're lousy market timers trading on investor money.

Fact: Most mutual funds underperform index funds in the short term and virtually all mutual funds underperform over any 10 year period. They're held back by trading costs and expenses. The obvious conclusion: Place your assets in an index fund. Optionally, buy some individual stocks or manage a portion of your portfolio with a proven timing strategy.

If you're willing to manage your own money and have self discipline, shouldn't you consider managing the market with some of your money to get much better returns?

excerpt from the Gleason Report