From the end of 1999 through the end of 2009, all of the popular Wall Street market performance measurement tools were in the red. The average bloodletting level of the DJIA, the S & P 500, and the NASDAQ was a disturbing-to-some minus nineteen percent.

Most of the investment community is either open-mouthed in shock or strident in blame about the somethings or someones who must be responsible for such horrific performance. Never again they swear to their clients— without ever a hint that they might themselves be the problem.

It won’t be long before the Wizards of Wall Street announce that they have studied the situation, and readied their sales minions to switch the shattered investment public into yet another fail proof (fool-magnet?) portfolio of hedges, gimmicks, signal responders, and panaceas for whatever the new decade brings.

Once again they will attempt to debug the market cycle and create an upward only future for the masses. Try not to be abused again— the markets aren’t broken, just the market shakers. Your portfolio should be up in market value— and not by just a little for the “dismal decade”.

These are the same geniuses that created the dotcom bubble by cramming valueless securities and speculative IPOs down your throats. They are the same charlatans who created the derivative markets and fraudulently hid their gaming devices in innocent looking rolls of tissue paper.

Wall Street thrives on the boom and bust scenario — because it doesn’t really matter to them how many of you win or lose. The evidence is clear; a boring-but-winning approach has been out there (and ignored) for three equally productive decades. The investment gods are outraged!

The past decade was a fabulous decade for old-fashioned value investors, particularly those with a reasonable selling discipline in their methodology!

It was a fabulous decade for those who understood that quality, diversification, and income generation are principles as opposed to media placating buzzwords.

It was a fabulous decade for those investors who were able to see over, beyond, and through artificial time constraints to find the long-term opportunities within every beautiful market cycle undulation. There were plenty of gyrations to gyrate to if you only knew how.

Investing is no longer a passive enterprise; and it never really was. If you can’t manage your portfolio throughout the market cycle, without succumbing either to greed, to panic, or to artificial and complicated hedging strategies, just stop. Right now. Listen and learn something old.

The only market cycle hedges needed are quality, diversification, and income— all classically defined. Throw in some disciplined selection and selling guidelines, a cost-based asset allocation formula, and a non-calendar year perspective and success will follow— cyclically.

You may miss a speculative spike or two (i.e., bubbles), but in the long run, Market Cycle Investment Management (MCIM) is a proven methodology for long run investment success.

You just can’t replace market cycle reality with calendar year gimmickry. Do better. Google investment grade value stock and request the ten-year MCIM numbers.

Change is good.

Steve Selengut

Actually, hindsight and the Investment Grade Value Stock Index (IGVSI) Bargain Level Monitor tell us that it died early in March 2009. More realistically, however, corrections don’t die quite so abruptly. They are supplanted by rallies— and vice versa.

The IGVSI Bargain Stock Monitor tracks the price movements of an elite group of New York Stock Exchange equities. Their “eliteness” is earned by a B+ or higher S & P rating, a history of profitability, and the fact that they pay dividends to their shareholders.

Unfortunately, they are the same companies whose boards of directors allow senior executives to pillage treasuries with obscene salaries and bonuses— and elite does not mean invulnerable to the whims of markets and governments.

But, for Working Capital Model (WCM) equity investments, they are just perfectly less risky (historically) than the others.

An IGVSI equity becomes a bargain stock (or “OK to add to your portfolio if it meets strict WCM diversification and price standards) when it falls at least 20% from its 52-week high. From 15% to 20% down, it is held in a mental “bull pen”, getting ready for the “bigs” after a few more down-tics.

The fewer IGV stocks at bargain prices, the stronger the market, and the more profit taking WCM methodology investors should be experiencing. The most important thing most investors fail to do during rallies is to prepare for their “supplantation” by the next correction.

Fewer equity bargains and higher prices should result in growing “smart cash” levels. Smart cash results from dividends, interest, profit taking, and systematic portfolio contributions.

Why smart cash? Its not reallocated to other classes of securities, it anticipates the next turn in the market cycle, and it patiently waits for new (and pre-defined) opportunities. Uh-uh, smart cash is never market-timing cash.

Here’s what the Bargain Level Monitor has been reporting:

* The 2007 monitor showed a decreasing number of bargains through May, followed by rapidly increasing numbers through year-end when nearly half the population was down 15% or more.

* The trend worsened in 2008, and at the February 2009 month-end bottom, a dartboard stock selection approach would probably have worked fairly well.

* Second Quarter numbers were the best in nearly two years— meaning there were far fewer investment opportunities to choose from. The Third Quarter figures surpassed them by 31%.

* September was the best rally month since early in 2007, with fewer than 8% of the entire IGVSI selection universe qualifying as “bargain stocks” by month end.

Here’s what the Bargain Level Monitor is telling you:

* The seven-month-old “fat lady” is signaling the death knell of the last stock market correction. WCM portfolios should be within striking distance of the all time market value highs achieved 28 months ago.

* We are absolutely in a potent rally, in both equities and closed end income funds. Profit-taking opportunities are staring you in the face, heckling, whispering to hold on for even greater returns.

* The last time we experienced six consecutive months with less than 20% of the IGVSI population down 20% or more from 52-week highs? Yup, the third quarter of a 2007.

So if you have not taken profits (and realized a few not quite as bad as they might have been losses in your major “thank you Mr. Congressman” disasters), one of these things is happening:

* You are being greedy by ignoring the WCM profit taking guidelines.

* You have no profits because you believed “the financial world is coming to an end thesis” and kept your stash in some form of mattress.

* You don’t want the tax burden associated with short-term gains or you think this new rally will actually last forever.

* You are waiting for the experts to pronounce that this upturn has become a new trend and that you may once again feel good about paying more for something than anyone else on the planet has ever paid— ever.

There is no question that we have experienced a powerful rally. The only unknown is its duration. So what do me do in rallies?

About the author:
Steve Selengut
sanserve (at) aol.com

September is fewer than three weeks away. Feeling nervous? Maybe you should be. For investors, the period between Labor Day and Halloween is proving an annual fright show. And no one knows why.

It was, of course, in September last year that Lehman collapsed and everything fell apart. But then it was also September-October 2002 that the last bear market plunged to its lows.

The 1998 financial crisis? It began late August, and rolled on for two months.

The famous crash of 1987 came in October. But most people have forgotten that the market actually started sliding downhill in late August.

That’s almost exactly what happened in 1929 too. The big crash came in October, but the market peaked just after Labor Day. Prices began falling through September, then tumbled further still.

The worst month of the Depression? September, 1931, when the Dow fell about 30 percent. It was also in September, 2000, that the bear market really got going.

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It’s time to overthrow the evil Masters of the Universe and deactivate their weapons of financial destruction. Let’s outlaw the brainwashing that has changed how average investors look at and value their investment portfolios.

It’s time to exorcize the Wall Street demons and return to stocks and bonds— and to QDI, “the Force” for long-term investment portfolio security.

Speculating is complicated, even for financial rocket scientists. What most of us want (or would certainly settle for) is simplicity, stability, and reasonable growth in our productive working capital.

A return to plain vanilla investing strategies with operating procedures that minimize risk and encourage understanding of the financial markets needs to become part of our financial force field.

As bad as things have been since this black hole appeared, investment models true to fundamental concepts, simple strategies, and disciplined operating rules have probably bettered the market numbers in at least six important ways:

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One – Higher lows during market downturns: Equity portfolios managed using basic principles of quality, diversification, and income (the QDI) and disciplined profit taking rules should not fall as much in market value as most mutual funds or poorly diversified portfolios.

Constant cash flow, even if not reinvested, places a floor under market values, and investors feel better when their values fall less than the market averages. In soundly managed programs, buying activity slows as prices rise— increasing “smart cash” for buying at lower levels later.

Two – Moves to cash or other sectors before bubbles burst: Disciplined profit taking automatically moves dollars from overheated sectors to cash or undervalued sectors during rising markets. This process creates capital that can be used to lower the average cost of remaining positions or to take advantage of new opportunities.

Investors feel better when no profits have been left on the table.

Three – Maintenance of planned income streams during financial crises: Most financial plans focus so strongly on growing market values that they lose touch with the need for planning a dependable retirement income. They rely on selling equity fund units or inflated indices for cash flow, instead of generating stable income with less exciting cash producing staples.

Steadily increasing annual income can be placed on “cruise control” through the use of the cost basis asset allocation methods contained in the WCM (Working Capital Model). How many would-be retirees are searching for jobs because of improper income planning?

Four – Faster movement to new all time market value highs: When investors have a reasonable understanding of the various cycles impacting their investment portfolios, they develop valid expectations about the market value “performance” of their portfolios.

They are less likely to initiate knee-jerk or panic driven transactions and more likely to take advantage of the new opportunities that lower security prices always create. Additionally, higher quality securities invariably are in the first group to regain popularity with investors as good news reports begin to dominate.

Five – Steady growth in working capital in all market environments: Working capital is measured in terms of cost basis instead of market price. As a result, all income generated from interest, dividends, and realized gains grow working capital regardless of the direction of market prices.

A treasury bond generates the same income at $85 as at $115. Most closed-end municipal bond funds (CEFs) maintained their 5% to 7% tax-free cash flow throughout the financial crisis— in spite of their reduced market values. Similarly, short-term profits on high quality securities have been growing working capital since the current rally took hold in March.

Six – Annual growth in realized “base income” in standard portfolios: WCM portfolios are income machines by design. No security is ever purchased if it does not produce regular dividend or interest payments; at least 30% of all base income should be reallocated to income-objective securities.

Similarly, every dollar of capital gains income, and net portfolio additions are partially allocated to income producers— and the use of a cost based asset allocation formula insures annual income growth.

Few financial professionals begin their careers with any encouragement to become comfortable with individual equity securities and the surprisingly large variety of individual, relatively uncomplicated, and generally safe(r) income producers available for their clients.

Financial products are far more lucrative for their institutional employers and, as a result, the incentives for brokers and advisors to sell products is pretty much irresistible. Few pros can afford to be one with “The Force”.

The Dark Side of investing beckons like a Siren’s song, luring the majority of professional advisors away from the safety and simplicity of QDI. Institutional propaganda, projections, predictions, and hype have the same affect on unsuspecting boatloads of speculators who most often become shipwrecked on the derivative rocks.

Investors and their professionals need to re-evaluate their product orientation and plot a global escape from the Dark Side of investing.

Contact the “Skywalker” foundation for emotional and financial support while making the transition— and may the force be with you.

About the author:
Steve Selengut has been a Professional Investment Manager since 1979.
Author of: The Brainwashing of the American Investor: The Book that Wall Street Does Not Want YOU to Read, and A Millionaire’s Secret Investment Strategy.

I’m not a professional tennis player. I’m not even a tennis player. The last time I touched a tennis racket was 5 years ago. But I did read about how a professional tennis player aims to hit as many balls to the opponent to make him miss, in order to win. An amateur , on the other hand, aims to try to catch as many balls as possible, aiming not to make any mistakes till his opponent eventually makes a mistake and causes himself to lose. That’s defensive playing.

I’m not a professional stock investor either. I admit neither I have the time nor the patience to go through every financial report, visit the companies I’m interested in buying and whatever else it takes to be really confident enough to put a huge chunk of my hard-earned money into the stock. So I have to invest defensively. I aim to minimise my losses while riding the general upward trend of the stock market, rather than maximising my gains on the individual hot stocks. It may limit my gains a little, but in the event of a crash, I hope to come out relatively intact. I basically expect a crash, even in the longest bull run ever. It’s like having a Plan B even though you hope you never have to use it, or buying insurance though you don’t really want to die or get a critical illness just to make the most of it.

So how do I play my defensive game ? I protect myself the following ways.

1. I stick with what I know. It’s easier to figure out that maybe the market has over-reacted when you are familiar with the industry. For example, I bought Bank Of America at $4 and Citigroup at $1. The prices were crashing as people anticipated a further crash and that didn’t happen. Today they are holding at $13 and $3.5 respectively. Do the exact opposite of what the average investor is doing. I bought Merck when it was being sued for one of its drugs , Vioxx. The price crashed as people anticipated huge lawsuit payouts, which never happened.

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2. I buy stocks when the price is low. It works either when the market is down, or if the individual stock has fallen out of favour. If you buy when the market is down, it can only turn up. Of course, the risk is that you never know when it is going to turn up and you may be stuck with a low price for a long time. It really isn’t easy to time the market, but you can tell for example, if there has been an irrational selling off of stocks. That’s a good time to buy. The stock market has gone on sale. Stock up !

3. I try to buy stocks that are near their underlying values. I’m not very good at analysing companies, but I figure if the company has $X in cash per share, or $Y in assets that can be sold off should the company fold, and the price is within that range, it should be reasonably safe.

4. I like stocks with good dividend yields. That way, even if the stock price falls, eventually, the dividend payout becomes so good, people will start buying it again, so helping to support the stock price. Plus I figure, if the company can afford to give out dividends regularly every year, it can’t be doing too badly.

5. I have some of Warren Buffet’s stock. It doesn’t come cheap. But hey, if he can’t get his investments right, who can ?

The sentiment was so strong in the trading community and the going was so good on the BSE Sensex that it reached the 17.24 per cent gain mark in no time, forcing the authorities to temporarily halt trading, when the circuit breaker* kicked in.

The same story repeated itself on the National Stock Exchange where the trading was also halted with the Nifty up by 17.33 per cent.

Within seconds of trading, the Bombay Stock Exchange’s benchmark Sensex vaulted 2,110.79 points, or 17.3 percent, to 14,284.21, triggering the historic shutdown Monday. Infrastructure, banking and real estate companies led gains. Trade was forced to close for the day, after the Congress Party’s definitive victory in national elections set the scene for long-delayed economic reforms

“The big question – is it a game changer? Can India get back to the high growth, high valuation of recent years? This event probably does open up meaningful possibilities, but there’s a lot to do, and there could be a lot in the way,” she said in a report.

Trading has never before been halted due to an upward swing in stock prices, according to the Bombay Stock Exchange.

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The last time trading circuit breakers, which are designed to temper wild market movements, were triggered was January 22, 2008, when the Sensex plunged on fears of a U.S. recession.

Investors, many of whom had been sitting on cash, welcomed the end to uncertainty’ predicts a long bull run for the market.

“Compared to other emerging markets, we had underperformed by 25 to 30 percent because politics in India were unstable,” he said. “Now that there is no event risk and there is a strong government, we will catch up.”

Despite the high sprits, even within India there are headwinds to change. Congress is unlikely to curtail costly social welfare programs which have added to the budget deficit.

The global financial crisis has already slowed the pace of some reform, as Indian authorities look with fresh skepticism on the wisdom of U.S.-style markets and regulation.

If you look at a long-term chart of the Dow Jones average, you will see that it is currently at some of the 2002-2003 levels. It has dropped dramatically since the financial collapse of 2008-2009, but it is still in familiar territory. It may take another two years or more for a large upswing in the markets, but at least we hope that the Dow will not drop below 7,000 points. That may bring hope and some peace of mind about starting to invest again.

Dollar Cost Averaging

The concept of Dollar Cost Averaging comes to mind in the current market situation. It is the process of buying stocks or similar investments on a regular basis, such as once a month, using a fixed amount of money. When prices are low, you are able to buy more shares. When prices are high, you buy fewer. In this way, you are able to take advantage of temporary low prices. This is especially helpful for long-term investments, such as retirement accounts. It may go against human nature to buy stocks when everything is falling and red but in fact it can lead to a bigger payoff if done correctly.
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Don’t Wait Too Long

As soon as you believe the markets will not drop much more, that is the time to start investing. When an upswing begins, it may happen so fast that you will miss a good portion of it. There are literally billions of dollars of cash on the sidelines, just waiting to go back into the market when the time is right. You can imagine what impact that might have on prices because of a surging demand but limited supply of stocks and mutual funds. Don’t wait too long!

Which Companies to Buy

There are a lot of low-priced stocks right now. Don’t jump into any old stock just because the price is low. There may be good reasons for it, such as the company being dangerously close to bankruptcy. One popular example is GM. Their stock price has dropped incredibly far. Is it a good deal? The government will probably not allow them to go into bankruptcy because that could have catastrophic affects on the country. Even if they survive, though, they may not thrive, and the stock price might hold its value or drop even more. Nobody can predict the future of GM. This is just an example of how difficult it can be to make a trading decision at the present time.

You also need to consider how the company is adapting to the economy. Are they offering low-price items to their customers? Are they reducing expenses significantly, such as layoffs, to stay in business? Do they have access to enough credit to stay operational? These are very important questions to consider before making a trade.

Will the Economy Get Worse?

This is probably the single most important factor that traders are considering right now. Why put your money into investments if they are just going to drop again? The government is trying hard to stabilize the economy, but there are many experts who believe there is more doom and gloom in the future, with more foreclosures, bank failures, and lost jobs on the way. A lot of this depends on how the government handles the situation and how the public perceives their actions.

If the public believes things are stabilized, they will begin to spend and invest again, businesses will have more money and they can hire more people, and the economy can begin to thrive again. When this will happen, nobody knows for sure. Hopefully in 2009 it will, but it may be 2010 or later.

Every correction is different, the result of various economic and/or political circumstances that create the need for adjustments in the financial markets.

While everything is down in price, as it is now, there is actually less to worry about. When the going gets tough, the tough go shopping.

In this case, an overheated real estate market, an overdose of financial bad judgment, and a damn the torpedoes stock market, propelled by demand for speculative derivative securities and Hedge Funds, finally came unglued.

But it is the reality of corrections that is one of the few certainties of the financial world, one that separates the men from the boys, if you will. If you fixate on your portfolio market value during a correction, you will just give yourself a headache, or worse.

Few of the fundamental qualities that made your IGVSI securities sound investments just two years ago have permanently disappeared. We’ll be using credit cards, driving cars and motorcycles, drinking beer, and buying clothes twenty years from now. Very few interest payments have been missed and surprisingly few dividends eliminated.

Only the prices have changed, to preserve the long-term reality of things—and in both of our markets.
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Corrections are beautiful things, but having two of them going on at the same time is like a trip to Fantasy Land. Theoretically, even technically I’m told, corrections adjust prices to their actual value or “support levels”. In reality, it’s much easier than that. Prices go down because of speculator reactions to expectations of news, speculator reactions to actual news, and investor profit taking.

The two “becauses” are more potent than ever because there is more self-directed money than ever. And therein lies the core of correctional beauty. Mutual Fund unit holders rarely take profits but rush to take losses. Additionally, the new breed of unregulated index-fund speculations is capable of producing a constant diet of volatility overload. New investment opportunities are everywhere.

Here’s a list of ten things to think about or to do during corrections:

1. Don’t beat yourself up by looking at your market value. You don’t live in a vacuum and you should expect lower valuations. That is why you should only buy the highest quality securities in the first place and stick with a well-defined asset allocation plan. Look for ways to add to your portfolios.

2. Take a look at the past. There has never been a correction that has not proven to be a buying opportunity, in spite of the media hype that this one is somehow special. When they are broad, long, and deep, the rally that follows is normally broad, long, and steep. Get ready to party.

3. The “Smart Cash” produced by interest and dividends should be placed in new stocks for rapid profitable turnover— don’t be shy when you’re looking at 50% discounts from recent highs. Buying too soon, in the right portfolio percentage, is nearly as important to long-term investment success as selling too soon is during rallies.

4. Take a look at the future. Nope, you can’t tell when the rally will come or how long it will last. If you are buying quality securities now, as you certainly should be, you will be able to love the rally even more than you did the last time— as you take yet another round of profits.

5. Buy more quickly in a prolonged correction, but establish new positions incompletely so that you can add to them safely later. There’s more to “Shop at the Gap” than meets the eye, and you should remain confidently fully-invested at least until the media starts whispering: “rally”.

6. Cash flow is king. Take smaller profits sooner than usual as long as there are abundant buying opportunities. Today, nearly sixty percent of all Investment Grade Value Stocks are down more than 25% from their 52-week highs. As long your cash flow continues unabated, change in market value is just a perceptual issue.

7. Note that your Working Capital is growing, in spite of fallen market prices, and examine your holdings for opportunities to average down and increase your yield on fixed income securities. Examine both fundamentals and price, lean hard on your experience, and don’t force the issue.

8. Identify new buying opportunities using a consistent set of rules, be it rally or correction. That way you will always know which of the two you are dealing with in spite of the Wall Street propaganda. Focus on Investment Grade Value Stocks; it’s easier, less risky, and better for your peace of mind.

9. Examine your portfolio’s performance in terms of market, interest rate, and economic cycles as opposed to calendar time intervals. Apply your asset allocation to your analysis for meaningful-to-you results.

10. So long as everything is down, there is little to worry about long term. Downgraded, or simply lazy, portfolio holdings should not be discarded during general or group specific weakness— unless you don’t have the courage to get rid of them during rallies.

Corrections of all types will vary in depth and duration, and both characteristics are clearly visible only in institutional-grade rear view mirrors. The short and deep ones are most lovable; the long and slow ones are more difficult to deal with.

Most corrections are relatively short and difficult to take advantage of with mutual funds. So if you over-think the environment or over-cook the research, you’ll miss the after-party. Unlike many things in life, Stock Market realities need to be dealt with quickly, decisively, and with zero hindsight.

Amid all of the uncertainty, there is one indisputable fact that reads equally well in either market direction: there has never been a correction-rally that has not succumbed to the next rally-correction.

About the author:
Steve Selengut has been a Professional Investment Manager since 1979.
Author of: The Brainwashing of the American Investor: The Book that Wall Street Does Not Want YOU to Read, and A Millionaire’s Secret Investment Strategy.

One method of controlling risk is by timing purchases so that they occur at or near support. That way, your stop loss can be a very small distance away from your purchase price. If you buy when the stock is 5% above its trendline, for example, it will mean little if the stock declines 5% to reach its trendline. Since stocks often return to support, why would you sell? You would sell only if it broke to the downside through its rising trendline. Therefore, your loss would be calculated by adding the distance the sell point is below the trendline to the distance the purchase price was above the trendline. Buying at the trendline instead of above it would eliminate that unnecessary 5% loss.

However, stocks often make a small temporary penetration through a support line and then resume their climb. When, precisely do you sell? Let us use the suggestions offered in Technical Analysis of Stock Trends by Edwards and Magee as an example. If you are using stops that are based on closing prices, they suggest a trendline penetration of 3% would warrant selling. If your stop loss is placed with a broker, they recommend that the stop be placed 6% below the trendline because of the possibility of inconsequential intra-day spikes. Therefore, if you buy when the stock is 8% above its rising trendline and place the stop loss 3% below the trendline, you will lose 11% before your stop is triggered. On the other hand, if you wait for the stock to return to its trendline before buying, you will lose only 3% if your stop is triggered. It is important to buy right so that you can sell right.
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Risk is also blunted when the downside behavior of stocks is strictly limited to predefined tolerances. For example, a trader might plan his purchases so that the projected profit is about three times the expected loss if the trade goes against him. Thus, in order to try to capture a gain of 6%, the stop loss must be no more than 2% below the purchase price. If he can reasonably expect a gain of 12%, then his stop loss would be no more than about 4% below the purchase price. Long-term investors can use a ratio perhaps as low as two to one because they have a presumptive tolerance for wider price swings and a longer time-horizon. It can take more than one price cycle to reach the targeted profit, and the uncertainty associated with the accomplishment of that is already part of the risk accepted by the long-term investor. Therefore, there is greater tolerance for negative price movement relative to the expected gain. The trader, on the other hand, does not have that luxury. He must put into effect more rigorous profit to loss ratio requirements.

Another approach to blunting the downside behavior of stocks is to reject as a purchase candidate any stock that has a logical stop loss placement greater than a certain amount. Let’s say that our investor or trader finds a stock with a great story and feels he must have it. The stock is climbing rapidly and it looks as though it will never be at the current price level again. If the stock is rising at a steep angle of ascent, an appropriate stop loss may be 16% below support. If his rule is never to risk more than a 1% portfolio loss because of a single position and he has 15 positions, the stock must be rejected. A 15% loss on one position when there are 15 positions would cause the portfolio to lose 1%. A 16% loss would exceed the limit. Though downside behavior would be permitted within the parameters and tolerances of the prevailing growth pattern, the outer limit is set at some specific amount by design. The amount should be determined by the overall risk assumed by the portfolio. For example, limiting the portfolio’s risk to 1% per position would mean that a portfolio of 10 stocks would have to reject any stock that has a logical stop loss more than 10% below the purchase price.

The volatility-adjusted stop loss makes use of probability theory. The idea here is to measure the stock volatility and place the stop loss just beyond the normal price excursion of the stock. The distance of the stop will be determined by the investor’s preference as to the probability that the stop loss will be triggered by the random non-meaningful fluctuations of the stock. Thus, he can set the stop so that it will be triggered once in twenty days, once in 100 days, or once in 200 days because of a random surge. Any probability can be chosen. Let’s assume that our trader wants to minimize the chances that a random spike will trigger the stop. He could set the stop so that a random spike would be likely to trigger the stop no more than once out of 161 days by setting the stop 2.5 standard deviations below the average price. Other probabilities are reported in the twenty-fourth stockdiscipline tutorial. These statistical references may sound complicated, but there is a tool available to traders that makes it possible to do this without any knowledge of statistics. Since random noise in the stock’s behavior would cause a sale only once in 161 days, then the probability is quite high that if the stop loss is triggered, it is because the stock is misbehaving to a significant degree. An unusual decline has occurred, a decline that is well beyond what is probable for that stock. Think about it. Those are precisely the conditions under which an investor would want to sell. The beauty of this approach is that the stock tells on itself. It’s as if the stock were shouting “hey, I’m behaving badly. Sell me before I cause you pain!”

One characteristic that differentiates an expert trader from an amateur, is that all the losses of the expert are small. He has no large losses. The trading pattern of amateurs is strewn with losses and gains of all sizes. Amateurs and experts can both find big winners, but amateurs are likely to lose those gains on subsequent trades. Only experts consistently control their losses so that none of them are large. If you learn to control risk (limit the downside behavior of stocks), accumulated profits should be the consequence. In the market, it is wiser to concentrate on developing a good sell strategy than to concentrate on developing a good way to find winning stocks. Part of controlling risk is buying right. Any stock can be a winner if it is bought right. The bottom line is that it is more a matter of what you can keep than what you can gain. If you want to perform like an expert, develop your stop loss and selling disciplines. Many professional money managers do not have true ownership of this principle. It is imperative that you make loss-control an integral part of your discipline.

The increased volatility of the market caused me to review my data on thousands of different strategies. I saw the elements that all the most profitable strategies had in common. The point was driven home. All these strategies exercised rigorous risk control. Sometimes they even generated more losses than gains, but they were all profitable. There was one characteristic trading pattern all the strategies had in common. They all generated consistently small losses and occasional big gains, but they never had a large gain wiped out by a large loss. There were no large losses.

In this note we comment on the problems facing emerging markets, and some broad thoughts on why capitalism remains a reasonable starting point for economic systems.

What is our market outlook?

The threat of a global financial meltdown has diminished thanks to massive central bank and government intervention, which has addressed the liquidity and solvency issues of many US and European banks. However, corporate earnings estimates for 2009 still look too optimistic in light of the poor economic leading indicators that we are seeing, such as consumer and business confidence levels. Therefore, sandwiched between the possibilityof an immediate short-term relief rally and a positive long-term view that equities are currently cheap, we have a near-term view that markets will remain volatile and are likely to trade sideways while the US, Europe and Japan endure a recession.

Emerging markets: the real threat would be a rise in global protectionism.

If the worst is over regarding the US and European banking crisis, it certainly is not for some emerging markets. Hungary finds itselfwith a massively over borrowed consumer sector, with foreign currencyborrowings in Swiss francs and Japanese yen. As these safe havencurrencies appreciate, the risk of widespread default on mortgages and other bank loans increases. The Ukraine economy is coming down with a bump as foreign lenders are put off by 25% inflation. Other emerging markets are suffering from a mix of problems that can include an overvalued currency, excess consumer borrowing (in local and sometimes foreign currencies), falling prices for commodity exports, domestic politics and a drop in demand for exports as the G7 enters recession.
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With little sign of a pick up in investor risk appetite, the near-term outlook is for continued underperformance for emerging market equities. But as investors pull money out of the asset class, P/E valuations are falling fast and some currencies are now appearing undervalued on a purchasing parity basis. Also, the long-term case for emerging markets remains in place: stronger productivity andGDP growth relative to the G7 economies, resulting in better long-term prospects for corporate earnings growth and share price appreciation. The only thing that will stop this, long term, is a retreat from globalisation by the G7 and/or the emerging markets themselves. Exports will slow down, competition in home markets will weaken as emerging markets raise tariffs on imports in a tit-for-tat measure, leading to weak productivity growth and lower GDP growth.

Fortunately the G7 does not appear likely to repeat the mistakesof the 1930s, when the US responded to the great depression by running a balanced budget, maintaining high real interest rates and imposing import tariffs. Indeed, it is interesting to note thatthe election speeches of both US presidential candidates have less protectionist rhetoric in them today than they did at the start of the year.

Capitalism remains the best method we have forallocating resources, just ask AynRand.

Few would wish to defend a completely unregulated dog-eat-dog version of capitalism, since this form usually destroys itself assuccessful companies become monopolies. But within a regulatedenvironment, with the accent on maintaining competition rather thansafeguarding producer interests, capitalism -through trade -hassucceeded in delivering the fastest increase in living standardsover the last 50 years for more people than we have known in history.The key is in its ability to find the right price for a given resource, whether labour, raw materials, money or time.

For the price to be an effective signal to producers and suppliers ofgoods, it must be ‘real’. By ‘real’ I mean a price that results fromcompeting suppliers and buyers in that market. If prices are instead influenced by government interference, over or under supply willresult, leading to wasted resources. Many governments have triedto ignore market prices, with taxpayers having to foot the bill forthe resulting subsidies and everyone suffering from the low productivitygrowth that occurs when government involvement in a sector prevents competition amongst suppliers. Indeed, the northern European countries that we perhaps most often think of assuccessful socialist countries are arguably prosperous because thestate by and large stays out of business and instead focuses onwelfare benefits.

For anyone who has become disillusioned on this point, and do not wish to wade through economics text books, I recommend as a tonic for your Christmas wish list the classic American novel byAynRand, ‘Atlas Shrugged’.

A word on dividends.

A reduction in corporate earnings may lead to a reduction individends, however history shows that the link is weaker than one might have thought. Dividends tend to fall much less than headline earnings, as companies like to have stable dividend policies where possible to encourage income investors. If necessary, companiesmay continue to pay dividends with very little cover if they believe they have strong enough balance sheets to afford such a policy.Banks and other financials that have recently taken government funds to recapitalise may see the sharpest dividend cuts as acondition of taking taxpayers money. Therefore the best performing income funds over the next year or so may be those that are widelydiversified by sector, invested in companies with strong free cashflow and with low exposure to financial stocks that may be underboth balance sheet and political pressure to slash their dividends.