Learn to Trade - RULES OF ENGAGEMENT (for the long haul)
InvestorEducation / Elliott Wave Theory Apr 01, 2007 - 11:01 AMBy: Joseph_Russo
In this, our last article in the public series, we will focus our attention on long-term broad market strategies for self-directed index investors. The Traders' Series is in development, and will be available on our website soon.
In addition to inviting index investors' to realize the power and convenience of Elliott Wave Technology's Interim Monthly Forecast , this article will present:
- The premise and composition for three types of long-term investment strategies
- Simple guidelines to which one must adhere in effectively deploying each • Pitfalls and risks if strategy disciplines are not implemented
- Long-Term Charts of the Japanese Nikkei and the NASDAQ Composite Index from 1982 through present
- An opening graphical summary of charts illustrating the results of Elliott Wave Technology's Pro-Active Long-Term Investment Strategy for the NASDAQ 100 from 1994 to present
- The easiest and most effective way for self-directed index investors to monitor, and automatically track EWT's ongoing Pro-Active investment strategies
ELLIOTT WAVE TECHNOLOGY'S, PRO-ACTIVE / LONG TERM INVESTMENT RESULTS:
This series began with a Grand Strategy overview of the NASDAQ 100, as such; we shall conclude with it. Although the NASDAQ 100 is not a large broad based market, it will serve as a prime example in illustrating the profit capturing strategy of Elliott Wave Technology's long-haul investment discipline.
Below is a performance summary illustrating the difference between practicing a modest level of strategic control, a purely passive (always long) strategy, and adhering to Elliott Wave Technology's “easy to follow” Pro-Active Strategy.
In the table above, the Modestly Controlled, or (mostly passive strategy) has banked $212,771 dollars in realized profit , and is positioned long the market with open profits of 7.14% from its last 90 share purchase, re-entering a full position back in September of 2006.
In contrast, a Purely Passive (always long) Strategy has booked zero in profits , and remains long the original 90 shares purchased at 397.90 back in August of 1994. The purely passive strategy has unrealized open paper profits of $123,701 per the market close on March 30, 2007 - $89,070 dollars less than the Modestly Controlled Strategy has already taken to the bank!
Elliott Wave Technology's Pro-Active Strategy has banked $271,835 dollars in realized profit , and is positioned long the market with open profits of 34.06% from its current 60-share exposure as of September of 2006.
In contrast, a Purely Passive (always long) Strategy has booked zero in profits , and remains long the original 90 shares purchased at 397.90 back in August of 1994. The purely passive strategy has unrealized open paper profits of $123,701 per the market close on March 30, 2007 - $148,134 dollars less than the Pro-Active Strategy has already taken to the bank!
In further contrast, our Pro-Active Strategy has outperformed the Modestly Controlled Strategy by $59,063 dollars or 27%, has less current market exposure, and open profit of 34% vs 7% on shares held.
Below are the charts that drive Elliott Wave Technology's long-term approach:
Typical Broad Market / Long-Term Investment Analysis Included with EWT's Interim Monthly Forecast
Chart Highlights:
• Here we see all three strategies long the market in August of 1994
• Note the long six-year span prior to any actionable signals
• We also keep tabs on currency values, inflation, and the gold price in the upper panel
• The indicators in the lower panel of our chart track early warning signals and monitors the integrity of the Primary trend in force
• We define Wave Labels identifying the maturity of trend as price action evolves
Typical Broad Market / Long-Term Investment Analysis Included with EWT's Interim Monthly Forecast
Chart highlights:
• Note how our Pro-Active Strategy begins taking profits at higher price levels
• The Modestly Controlled Strategy waits for a FULL EXIT ALERT to go to cash
• After more than six-years without a signal, how many investors maintained the discipline, and patience in monitoring such events, and actually went to a full cash position in November of 2000?
• Note how our Pro-Active Strategy begins fishing for a bottom in October of 2002
• Properly interpreting Elliott Wave structures, in combination with directional and early alert indicators, sets our Pro-Active long-term Investment Strategy far ahead of all other methods in managing exposure to broad based market indices
Typical Broad Market Long-Term Investment Analysis Included with EWT's Interim Monthly Forecast
Chart highlights:
• Note how wave structure evolution is governed by our Grand Strategy view of the market under study
• Of added note is the increase in signal and caution frequency vs the goldilocks runaway bull from 1994 -2000
• Note how our strategy stands pat amid the seven-month 16.5 % correction from late 2003 through the summer of 2004.
Let's talk Strategy:
We shall limit our strategy discussions to the three most common categories of self-directed index investors.
Three general types of long-term investment strategies are:
• Purely Passive Strategy
• Mostly Passive Strategy
• Pro-Active Strategy
The basic objective:
To let profits run, and remain exposed to long-term cyclical trends amid a diversified mix of broad market indices.
The general exit strategy:
To cash out when the invested funds are needed to serve a specific purpose at a designated time in the future.
Purely Passive strategy:
The Purely Passive Investment Strategy is a rather simple one. Its simplicity and brilliance is most compelling, and has broad universal appeal.
This strategy involves no effort at all. Its singular objective is to cash out when the funds invested are required for their intended purpose at a predetermined future date i.e. retirement, college, home purchase, etc.
Caveat:
In order to adhere to this simple strategy, one must be totally immune from emotional, or knee-jerk reaction to market crashes, recessions, depressions, wars, hyperinflation, deflation, acts of terror, natural disasters, currency crisis', and all other imaginable market shaking events.
The Strategy:
Stay fully invested under all market conditions. Dollar cost average, or invest regular amounts of capital into the markets overtime, and one should come out on top when one needs the funds for their intended purpose.
The only aspect of this strategy that needs management is to define ones' timeline for exit.
The premise of this strategy is that markets always rise over the long run. The appeal lies in its simplicity and effectiveness amid long trending bull markets.
Is this a valid premise?
In numerous instances, history has shown the answer is yes. Large Stock Exchanges must “go up” to attract investment. That is precisely why they exist.
Unbelievably, this seemingly “asleep at the wheel” strategy has worked (in nominal terms) for decades in select broad market indices. Unless the current paradigm shifts, purely passive investment strategy should selectively continue to perform.
Tactical Considerations:
It is essential that one diversify when employing a purely passive investment strategy.
One must ask and answer the following questions:
• Within what specific time horizon does one generally expect to “cash out?”
• What are the anticipated annual returns vs risk-free alternatives?
• What mix of broad markets will most likely achieve this objective?
General:
When we refer to “nominal terms”, we are referring to the returns calculated from the broad index itself. Nominal returns do not take into account fluctuations in the underlying purchasing power of the currency from which the broad market index is derived.
Another way to describe the enduring success of purely passive investment is to say that in select indices, paper claims on future corporate earnings (stocks) have been a good hedge against the eroding purchasing power of fiat currencies for quite some time.
A large part of this strategy's on going success hinges upon governments continually increasing supplies of money, thus eroding the value of currencies relative to their respective equity indices. Simply put, this strategy relies heavily on continued inflation.
By themselves, inflation, and deflation (a strengthening currency - less money and credit in circulation) are relatively benign and quite natural supply/demand responses to prevailing free market conditions.
However, the financial sphere is in large part, a tangent manifestation of the political process. The natural ebb and flow of free markets are often intervened upon by governments' central control over the supply of money and credit.
Right or wrong, by decree, governments or quasi agents thereof, have control of managing sovereign fiscal affairs and imposing a desired rate of inflation or deflation to accommodate the prevailing mandate of the times.
Risk imbalances and the potential for dislocations escalate when inflation or deflation approach extreme, unsustainable levels for prolonged periods. Risk also surfaces in the short term, should there be a rapid, unanticipated rate of change in the prevailing inflation or deflation expectation.
The deep-rooted paradigm, is that a steady and controlled inflation will persist indefinitely into the future without interruption or consequence. This paradigm provides a powerful incentive, fostering confidence in forever-rising stock prices, real estate prices, and therefore the general cost of living.
Until this long-standing paradigm shifts, purely passive investment strategies will no doubt remain viable in select indices.
Risk:
Given ones' broad market selection, level of diversification, and time horizon for “cashing out,” a purely passive strategy may not always work out as planned.
Do the broad markets always “come back?” The short answer is generally yes; larger broad markets do eventually bounce back, and maintain an inherent upward bias over time.
However, one must recognize that there can be unusually long periods of extended flat, volatile, or downward regress in markets as well.
The possibility of one's long-term time horizon coinciding with an extended flat, volatile, or down cycle , presents the greatest risk to this strategy achieving its intended objective.
The Japanese Nikkei Index is a clear and recent illustration of such timing risk. Had one adhered to a purely passive investment strategy in the Nikkei over the past 20-years, one would more or less be right where one started.
The longer a market continues advancing in an unchecked parabolic fashion, the higher the odds of reaching an inevitable and lasting crest.
Such extremes can lead to longer-term sideways or potentially devastating bear markets, similar to that which the Japanese market struggles with today, 18 years from its peak.
After a 13-year bear market slaughter from 1989 -2002, it has taken the Nikkei 5-years to reclaim only 30% of all the gains lost since 1989.
Tokyo 's Nikkei Stock Market: 1982 - 2007
Typical Broad Market / Long-Term Investment Analysis Included with EWT's Interim Monthly Forecast
Chart Notes:
• From a larger perspective, it is clear that from 1982, that Japans fiscal posture has engendered a long-term deflationary environment
• Real Inflation, as measured by the Yens value relative to that of Gold, has been on the rise since 1999, and continues to accelerate sharply in the 2005-2007 period
The Nasdaq 100 experienced a similar massacre; however, the 80% loss in the NASDAQ took place over a 2-year period. It is interesting to note that similar to the Nikkei, the NASDAQ is also in the midst of struggle to reclaim 30% of its losses, 5-years after bottoming.
The NASDAQ Stock Market: 1982 - 2007
Typical Broad Market / Long-Term Investment Analysis Included with EWT's Interim Monthly Forecast
Chart Notes:
• From a much larger perspective, it is abundantly clear that since the inception of the Federal Reserve System in 1913, that the United States fiscal posture has fostered a long-term inflationary environment
• Real Inflation, as measured by the Dollars value relative to that of Gold, has been in perpetual rise from the turn of our last century, and continues to accelerate sharply from the 2001-2007 period
Those who elect to embrace the purely passive investment strategy should do so knowing that the odds of a sustained long-term down, flat, or volatile sideways market will increase with each passing year amid a maturing secular, or runaway bull market.
Mostly-Passive (modestly controlled) strategy:
This strategy may fair better, or worse than the purely passive approach.
Depending on reactions to various market conditions, such investors may be scared out of the markets right near the bottom of a deep correction, or become overly exuberant when markets are in their latter stages of a topping process.
To acquire just a modest level of control , one must adhere to a disciplined strategic approach.
The Strategy:
This strategy is very similar to the purely passive approach, but contains two essential differences.
• In addition to setting a specific time horizon for exit, this strategy also involves monthly trailing exit stops in order to maintain engagement.
• The strategy also incorporates a monthly trailing re-entry provision in the event an exit level breaches.
Key points:
• Secure a competitive advantage to provide regular checks and balances
• Have discipline to monitor monthly closing price levels
• Maintain consistency in adhering to all aspects of management and execution
• Keep plans as simple as is needed to accomplish each task
• Maintain confidence even in the face of setbacks
Tactical Considerations:
Defining ones' exit and re-entry triggers should be simple, and maintain adequate alignment with ones' long-term objectives.
A monthly moving average that has held numerous closes at key pivotal lows over an extended period is a good indicator with which to monitor the health and integrity of longer-term uptrends.
This strategy will NOT get one out near major tops, nor get them back in near major bottoms.
The strategy's Long-term exit triggers intend to protect the lion's share of amassed profit, and move one out of harms way and into a full cash position.
Likewise, re-entry triggers intend to assure the longer-term trend has returned to a more favorable climate, fostering confident redeployment of funds.
Risk:
In a word, “whipsaw.” Whipsaw is a term describing a choppy or volatile non-trending market that is stuck in a narrow or wide trading range for an extended period. Such conditions may trigger a succession of exit, and re-entries of no apparent value.
Key Point:
• Consider a flexible strategy so one can adapt to changing conditions
elliott wave technology's pro-Active strategy:
The Pro-Active Investor segment is subject to the same pitfalls as the previous. Perhaps more so, in that active investors may be inclined to try to time, or side-step markets more frequently.
To take such a level of proactive control, one must adhere to a much higher level of both patience and discipline.
The Strategy:
This strategy is very similar to the last, but contains two additional parameters.
In addition to dynamic monthly exit and re-entry stops, this strategy intends to:
• Begin reducing exposure near critical market highs
• Begin adding back exposure near critical market lows
Key points:
• Secure competitive advantage for checks and balances
• Discipline to monitor price chart indicators on a regular basis
• Maintain consistency in adhering to all aspects of management and execution
• Keep plans as simple as is needed to accomplish each task
• Maintain confidence even in the face of setbacks
Tactical Considerations:
In monitoring a combination of wave structures and indicators, this strategy intends to reduce exposure by 1/3, taking high-level profits when early warning indicators and maturing wave structures warn in confluence.
Should the market continue down, and breach a full exit warning, this strategy will either disengage and go to a full cash position, or further reduce exposure, maintaining a 1/3 long exposure, contingent upon the cycle maturity of the Elliott Wave structures.
Should the market continue to fall hard for an extended period, this strategy will monitor indicators and wave structure for signs of a lasting bottom. When such elements are in confluence, the strategy intends to begin building back in a 1/3 position size near market lows.
Risk:
“Whipsaw,” once again Whipsaw is a term describing a choppy or volatile non-trending market that is stuck in a narrow or wide trading range for an extended period. Such conditions may trigger a succession of exit, and re-entries of no apparent value.
Key Point:
• Consider a flexible strategy so you can adapt to changing conditions
To summarize, one must identify what type of investor one is, or wishes to become. Once decided, one must then be accountable, and disciplined enough in managing the responsibilities associated with their objectives.
Any strategies more complex than these would fall under the classification of trading vs long-term investing.
coming soon…
“Rules of Engagement: Strategies for Traders ”
• Position Traders
• Swing Traders
• Short-Term Traders
The traders' series will soon be available FREE to all Near Term Outlook clients, or by special purchase at our website.
In closing, it is our hope that this short series has provided prudent and actionable guidance for self-directed index investors.
We trust that with such guidance, many will now be able to navigate the markets more confidently in applying some of the basic rules we have outlined.
For those who prefer the convenience and assurances derived from delegating such duties, Elliott Wave Technology's Interim Monthly Forecast is now covering the following markets:
• The U.S Dollar
• Gold
• 20-Year Treasury Bonds
• The CRB Index
• S&P 500
• Dow Jones Industrial Average
• MSCI Emerging Markets Index
• NYSE Composite Index
In addition to covering the indices above, the Interim Monthly Forecast also weighs in on correlating, or inverse ETF's and funds, relative to each of the specific indices under watch.
Until next time…
Trade Better/Invest Smarter,
By Joseph Russo
Chief Editor and Technical Analyst
Elliott Wave Technology
Copyright © 2007 Elliott Wave Technology. All Rights Reserved.
Joseph Russo, presently the Publisher and Chief Market analyst for Elliott Wave Technology, has been studying Elliott Wave Theory, and the Technical Analysis of Financial Markets since 1991 and currently maintains active member status in the "Market Technicians Association." Joe continues to expand his body of knowledge through the MTA's accredited CMT program.
© 2005-2012 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.
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