An ETF Trend-Following Plan for All Seasons

March 2nd at 7:27am by Tom Lydon

It’s hard to believe that the S&P 500 Index has been flat as a pancake since the start of the new millennium – in fact, we are still below the S&P’s starting price of 1,470 at the beginning of 2000. The Index had its ups and downs, but when you connect the dots, it didn’t make any headway.

It’s even harder for index investors who relied on this large-cap benchmark to grow their retirement savings. To think, a portfolio with $100,000 allocated to the S&P 500 hardly budged at all. That’s a lot of wasted time and missed opportunities.

That’s why we advocate following trends and actively managing our portfolios using exchange traded funds. Whether the broad market travels sideways or falls, a trend is always in the making. [What is an ETF?]

Actually, the term “sideways market” is somewhat misleading. There’s plenty of market activity, but it’s in the form of a sharp downward move, and then a slow recovery period back to its original price level. Only the best and luckiest of timers can get in at the lows and exit at the highs. Otherwise, it can be a very frustrating experience, even for seasoned vets.

Surviving the Dry Season

A quick review of history shows that there have been dry spells in the market lasting 10 years or more. For example, an investment in stocks making up the S&P 500 Index during the periods from 1929 through 1942 (13 years) and 1966 through 1982 (16 years) would have amounted to no more than a break-even investment.

In this most recent sideways move, the S&P 500 has fallen off its high of about 1560 prior to the precipitous drop in 2008 after the financial crisis brought the broader index down below 700, or more than a 50% plunge. On the flipside, the S&P 500 has powered through the past couple of years and is now trading around 1350, more than a 90% surge in gains off the low during the financial crisis.

Many financial advisors focus on your timeframe for growth, but it doesn’t matter if you have five years or 25 years left until retirement. You can’t afford to let your investments sit idle for extended periods. For instance, over the last 10 year period, the S&P 500 has only gained around 2.9% on an annualized basis. Worse yet, an idle investment does not take advantage of the beauty of compounded growth. [Using ETFs to Build a Diversified Portfolio]

No matter what the cause, the market’s recent lost decade underscores the inherent danger of the buy-and-hold strategy. Sure, the markets will likely rebound eventually, but that will be of little consolation to investors who need their money now for retirement or to those who may have bailed out of the markets at or near the bottom.

The volatile jerks during a sideways market often make investors believe that a market rally has taken hold during highs, only to experience disappointment when yet another sharp downturn occurs. Some who can’t stand the fluctuations get out of the market and sit on the sidelines, often without any plan for how to get back into the market later on.

Countering Volatility with ETFs

So what can an investor do? Well, an ETF investor who follows the trends and sticks to a sell discipline has a whole bunch of options.

We take advantage of trends that have developed in asset classes, sectors and global regions, increasing allocation to the areas that work well as long as the trend remains intact.

With the growing list of available ETFs and ever-changing trends, we are convinced more than ever that a disciplined investment strategy is required to enhance portfolio returns, diversify and reduce downside risk.

Your strategy, like ours, should be to stick to a plan and not let your emotions take over. Once you start thinking with your heart or gut, it can be hard to kick-start your logic. Even neutralizing emotions will serve the trader well.

Specifically, you need to know what to buy, when to buy and, as importantly, when to sell.

Three Main Rules

Here are three rules that should help keep most ETF investors out of trouble:

  1. Maintain an 8% stop-loss on your ETFs.
  2. Keep an eye on the trend. If your ETF declines below its 50-day average, that’s not a good sign. If the same ETF declines below its 200-day average, sell.
  3. Don’t chase markets that are too hot. The last time many world markets and industry groups collectively hit new highs was in 2000 and again at the end of 2007. You know what happened then – the boom went bust. Keep your emotions in check.

The Business of Buying and Selling

The first and perhaps most important screening process for ETFs is knowing the 200-day moving average of each candidate—and where it stands in relation to it. Trend lines are so key that you should only invest in ETFs trading above their 200-day moving averages. You can find this information by checking any ETF’s information page on our ETF Résumé page

We look for uptrends, and then examine those trends using fundamental analysis. Once a position is entered, we stay in the investment until the trend turns sour or declines below its trend line. [Five Things You Need to Know About Trading ETFs]

In some cases, where trends have moved steeply to the upside, the corresponding ETF may be more than 10% above its moving average. In those cases, we impose an 8% stop-loss. If you buy an ETF trading 15% above its 200-day moving average, it’s best to sell if it drops 8% from a recent high. That way, you take control of when you are leaving position and preserve as much profit as you can.

You must remember that over time, the stock market and individual securities follow general trends and these trends are identifiable. The idea is that you want to be fully invested in stocks when the market is above its long-term trend line, or 200-day moving average. And you want to be safely positioned when the market is trending downward.

For example, below is a chart of the SPDR S&P 500 (NYSEArca: SPY) with its 200-day moving average. You may notice that the fund traded above the trend line between 1995 to mid-2000, at which point the tech bubble was collapsing and the bear market replaced the bull market. The S&P 500 stayed below its 200-day moving average and kept us out of the market from mid-2000 to mid-2003, then climbed back above trend from mid-2003 to late-2008. More recently, the trend following strategy is coming into play, once again, as the broader market has been steadily shifting above the trend line since the start of 2012, following the tumultuous and volatile 2011 market year.

How often we pull the trigger on building or unwinding a position all depends on the ETF and where that ETF lies in relationship to its own moving average and its performance off the high. By following a sell discipline, one can provide protection through locking in the upside performance while avoiding greater losses.

Resolve To Protect and Profit

Momentum can certainly turn on a dime. Just look at the health care sector in 1991 as an example. It was up 50% for that year, but the following year it was down 19%.

Whatever trend you’re following, just be sure to take a disciplined approach and remember to follow through with your strategy.

  • Resolve to stick to your discipline. We know the past year has been rocky, and it is hard not to get emotional. We can’t predict the future, so we don’t know what’s in store for the rest of 2012. One way to avoid pulling every last hair out of your head in frustration over the uncertainty is to have a plan and adhere to it no matter what.
  • Resolve to pay attention to the news. Political upheaval, major weather events and leadership changes are among the things that can indirectly affect your holdings. Don’t just isolate yourself to the business section.
  • Resolve to pay attention to your investments. Are you coming up on a major life change, such as having children or entering the homestretch before retirement? Look at your portfolio and make sure it’s still working for you and the time horizon you have in mind.
  • Resolve not to invest in something simply because it’s “hot.” That’s the best way to get burned. Invest because it fits your needs, interests and your portfolio.

Exiting an ETF… Safely and Profitably

If an ETF falls below its 200-day moving average, or if it drops 8% off its high without going below its 200-day average, sell it. It’s a rigorous discipline and is applied to all asset classes, sectors and global regions where there is ETF representation. It’s clear-cut, and you know exactly what your risk is.

However, if you don’t have an exit strategy, then your risk tolerance may not be as well-defined. It takes a high tolerance and lots of patience to suffer 20% or more in losses that some sectors and regions have experienced a few times over the last several years.

While we are clear proponents of having an exit strategy, we understand that there can be some confusion when certain ETFs drop quickly and then climb sharply. There’s a chance you might have sold a position that declined further after you sold it but then rebounded.

In this case, don’t beat yourself up over lost opportunity. Just stick to your plan, have no regrets, never look back and keep moving forward.

When this happens, remember that you can treat the cash you’ve acquired from previously selling an ETF as a “free agent.” This means that there’s no rule that says you must buy back the same ETF you sold if it’s performing well now. Shop around and see where new trends are developing. There might be a different ETF that’s an even better fit for your portfolio now.

Sharp market movements and subsequent ETF declines can unsettle many investors. However, with an exit strategy and specific stop-loss points, the drops can be less stressful for you as it prevents small losses from turning into there-goes-my-house losses.

There have always been and will always be bubbles, and the only sure way you can protect yourself is to have an exit strategy quickly on hand.

If an ETF you’re holding – whether it’s commodities, equities or something else – drops below its trend line or falls 8% off its high, let it go, no questions asked.

A lesser stop-loss, such as 5%, could be too low since markets often have a 3% to 5% correction before they move on and hit new highs. If your stop loss is too low, for example, at 3%, you’re going to be buying and selling more frequently, racking up commission fees in the process.

Ultimately, that eats up your returns. You also won’t be able to fully take advantage of the trends. Instead, you’ll be dealing with constant short-lived whipsaws. Sometimes there are volatile days in the middle of an overall uptrend, and it’s in your best interest to ride those out.

On the other hand, having a sell point that’s too high can also hurt you. Setting your sell point at 30% could mean that you lose a significant portion of money before you’re out. It also has you sitting in areas that might not be performing so well and missing out on up-and-coming areas that are beginning to trend.

What If You Missed The Safety Boat?

What should you do if you missed the 8% drop, and you’re down much further than that? Missing the sell point creates the conundrum above. That’s when I recommend the following:

  • Sell 1/3 of your equity holdings and focus on the most aggressive positions—those that might be down 20-30% and trading 10-15% below their 200-day moving averages.
  • If those holdings decline by another 5-7%, consider selling another third.
  • Keep an eye on the 200-day average of these positions. As the trend lines continue to decline, there will be an excellent buying opportunity in the future when the markets eventually rebound.

Letting Go of a Winner Can Be Hard

It can be difficult to let go of a mover and shaker you’ve always had a soft spot for, but if you want to protect your money, you must. It’s like your parents always said when they were grounding you every other week: “This hurts me more than it hurts you.” But sometimes it has to be done for everyone’s good.

There are no guarantees that when you let a fund go, it’s not going to turn around and deliver the numbers again. But that doesn’t mean it won’t, either. It’s exactly why you have to remain as stoic as possible and stick to the plan and rationalize nothing.

What if you follow your exit strategy, and the ETFs you sell end up rebounding? Try this:

  • Treat the newly available cash as “free agent” funds. Just because you sold an ETF doesn’t mean you’re obligated to buy it back when it rebounds.
  • Look for ETFs that are above or rising above their trend lines.
  • Look for ETFs with positive, relative strength. When markets rebound off a low, it’s usually those with the greatest momentum that enjoy sustained uptrends.

As you manage your own portfolio, you might feel a need to always have a set amount of money designated to a certain investment (i.e. small-cap, China or commodity). If this is the case, then the cash can be held until that certain investment goes above its 200-day moving average or gains 5% from its recent low.

With the recent volatility in the markets, we have seen some price swings in ETFs. One shouldn’t worry about the daily ETF price movement; having an investment plan is the priority. When there is a discipline in place, it can help guide investors through the volatile times.

If you’ve got nervous hands as your ETFs swing up one day and down the next, the best thing you could do is to just sit on them. However, if market swings become too unbearable, as witnessed in 2011, it might be safer to switch to cash positions and wait for the markets to settle down before becoming too invested.

Removing the emotions from your investing is one of the smartest things you can do.
And, as we’ve said, having a strategy and removing your feelings from your money is especially timely, considering the ups and downs can make you feel sick.

The Anatomy of a Bursting Bubble—Here and Abroad

Investors and economists often use history as gauge for what might happen today and in the future. Could we have studied the onset of a 14-year bear market in Japan to predict the dot-com crash and subsequent bear in the U.S.? And, what do both events say about today’s economy and markets?

Let’s take a look back.

In the 1980s, outsiders perceived Japan as a utopia because its people had the highest quality of life and longest life expectancy. In addition, Japan was the world’s largest creditor and had the highest GDP per capita. Many Americans feared that Japanese-made robots would eliminate their jobs. With the economy booming and the stock market climbing, skyscrapers filled the Tokyo and Osaka skies, causing real estate prices to skyrocket as well.

Between 1986 and 1988, the price of commercial land in greater Tokyo doubled. Real estate prices soared so much that Tokyo alone was worth more than the United States. Between 1955 and 1990, land prices in Japan appreciated by 70 times and stocks increased 100 times over. Large-scale stock speculation led to worldwide mania. Investors all over the world clamored for Japanese shares. These euphoric investors believed in a perpetual bull market. Luxury goods were purchased in large numbers by the newly wealthy.

Unfortunately, all excessively good things must end. To cool the inflated economy, the Japanese government raised rates. Within months, the Nikkei stock index crashed by more than 30,000 points. The Nikkei crashed this far because its value was inflated on false hopes and hype, not solid financials. Japanese housing prices plummeted for 14 straight years. At its height, the Nikkei stood at 40,000. The Nikkei sank to below 8,000 in 2003 and again in 2009.

Dot-com Déjà vu

Back at home, we experienced a similar crash, but one not nearly as lengthy or devastating as that of Japan’s: the dot-com crash, which began on March 11, 2000 and lasted until Oct. 9, 2002. From peak to valley, the Nasdaq lost 78% of its value as it fell from 5046.86 to 1114.11.

The U.S. military created the Internet decades before “dot-com” became a household word. Vastly underestimating how much people would want to be online, it began to catch on in 1995 with an estimated 18 million users. Soon, speculators were barely able to control their excitement over this new economy.

The first holes in this bubble came from the companies themselves: Many reported huge losses and some folded outright within months of their offering. In 1999, there were 457 IPOs, most of which were Internet- and technology-related. Of those 457 IPOs, 117 doubled in price on the first day of trading. In 2001, the number of IPOs shrank to 76, and none of them doubled on the first day of trading.

Many argue that the dot-com boom and bust was a case of too much too fast. Companies unable to decide on their corporate creed were given millions of dollars and told to grow to Microsoft size by tomorrow.

Unfortunately, economic and “unanticipated” risks will always be there. Investors hate uncertainty, and since we can’t always identify them in advance or eliminate them, there will be times when they affect the investment markets negatively.

If you follow a buy-and-hold strategy, you leave your portfolio vulnerable to any number of unknowns: oil spikes to $200/barrel, the Middle East erupts into war, The Fed makes a drastic move with interest rates. With an exit strategy, you’re prepared to cut losses or pocket profits when events send the markets lower.

Risks without Reward

During the 1990s, many investors believed that the stock markets would produce returns of 20% (or more) per year indefinitely, which was a part of the herd mentality back then. Same goes for the late 1970s and early ’80s, when investors thought bank certificates of deposit and fixed annuities would always have double-digit yields—two assumptions that were clearly wrong.

If your expectations for portfolio returns are too high, there is a very good chance your financial goals will not be met. And more importantly, this can lead to saving too little money to meet your retirement goals. Unfortunately, this can also lead to investing in securities and strategies that are far too risky in order to try to “turbo-charge” the returns.

On the flip side, there are investors who invest too conservatively and risk losing purchasing power to inflation. Investing too conservatively can also raise the odds of not meeting investment goals, as well as the risk of outliving your assets.

So, we find ourselves at another crossroads in the markets. Real estate exuberance, based on inflated prices, has gone sour along with values; financial institutions have turned from princes to frogs in a matter of months; consumer debt is at all-time highs, and investors grow increasingly frustrated with the lack of opportunities the current stock markets offer.

But investors who combine the flexibility, diversity and ease-of-use of ETFs with a disciplined buy-and-sell plan don’t have to fret about all the outside influences on the markets. You can turn a deaf ear to financial hype and keep emotions out of the investing equation.

That’s because the simple, technical indicator—the 200-day moving average—tells us precisely when to buy and when to sell. Even when it seems like the entire market is down, you can count on there being a trend-bucking ETF ripe for the picking. [Simple and Exponential Moving Averages]

What the Opportunities Look Like

The major U.S. equities Indices, the Dow Jones Industrial Average, Nasdaq Composite and the S&P 500, are all trading above their 200-day moving averages. Furthermore, their 50-day moving averages have crossed over their 200-day moving averages, forming a very bullish technical indicator known as the “Golden Cross.”

Meanwhile, commodities, sectors and most other asset classes are trading above their 200-day moving averages. This is a good time to start putting money back into the market as the trend is holding. But investors should keep their stop-loss on hand, in case the current bullish rally does turn sour.

Max Chen contributed to this article.

Full disclosure: Tom Lydon’s clients own SPY.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.

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