Maybe I have an advantage. Years ago, when financial futures first came on the scene, it was my job to travel the country and train financial institutions on how they might be able to use the new futures contracts to hedge their risk. So I know first hand how the “smart money” uses the futures markets.

Take the S&P futures contract for example. Commercial traders have different motivations for using that contract. Some are implementing short hedges to hedge a portfolio of stocks. Some are using long hedges to lock in prices for stocks they expect to buy in the future. Some are arbitraging between futures and cash. Others are simply trading.

But no matter the motivation, in one way or another all are expressing an opinion about whether stock prices are relatively overvalued or undervalued. And it’s important to know what commercial traders think because they dominate the market. So just by virtue of their sheer size they have an important influence on market direction.

We have a wonderful recent example. As of the report of May 16, commercial traders were net short the S&P futures contract by 69,414 contracts. It was their largest net short position in almost four years. The S&P index was at 1292 at the time. We first called attention to it in the Smart Money Report that week.

The next week the commercials increased their net short position to 78,476 contracts. Last week they increased it to 79,209 contracts. It has been since the early spring of 2002 that we’ve seen such a build up in commercial shorts. It was significant then and it’s significant now.

Yesterday the S&P closed at 1258 and market pundits are scratching their heads trying to figure out what has caused the recent sharp decline. The Fed signaling that interest rate hikes are likely to continue got the blame. But the COT report has been making bearish noise for weeks. When the big guys talk, I suggest you listen.

You will be asked about your present income. You know the answer to that one. You will be asked about your expenses. That one will be tough. Everyone underestimates their expenses because most of us have no idea what we’re really spending and what we’re spending it on.

You will be asked about your assets — what you own. You know what you own, but it will be tough to put a market value on some of it. You will be asked about your liabilities — what you owe. For most people, facing the reality of their debts is rather daunting.

You will be asked when you want to retire. I would say the average age most people give is 55 years old. I don’t know why that is, but 55 seems to be a popular number. Then the financial planner will tell you that you will need to accumulate enough money to live another 40 or 45 years after retirement. After all, if you live to 90 or 95 you don’t want to run out of money, do you?

You will also be asked about your risk tolerance so that the planner can determine what kind of annual rate of return to factor in for your investments. If you say you have a low risk tolerance, the planner will consider so-called low-risk investments that will give you a lower rate of return. If you say you have a high risk tolerance, investments that could provide a higher rate of return will be considered. You can’t have it both ways. If you don’t take risks, you can’t get a very high rate of return on your investments.

Then all that information will be dumped into a financial planning software program. The software will print out a plan that will say you need to accumulate several million dollars by the time you’re 55 years old. Oh, and it will be exact to the penny — something like $5,387,234.23.

You will look at the plan and you will think, “My gosh, there is no way I can do this!” You may get started doing a few things that the planner recommends. But it won’t last very long and you’ll go right back to doing things the way you’ve always done them.

So what’s wrong with the traditional financial planning process? Plenty. First of all, it’s ridiculous to try to look decades in the future to predict what’s going to be happening in your life. I don’t know about you, but I don’t know what’s going to happen tomorrow, much less decades from now. Also, traditional financial planning doesn’t take into account what financial freedom actually is. You’re financially free when your passive income (money you don’t have to work for) equals your expenses.

So if you have no passive income right now and your expenses are $50,000 a year, and you can get a 10% return on your investments, you need to accumulate $500,000 to become financially free. If you can get a higher return on your money, you can reduce the amount that must be accumulated. If you settle for a lesser return because you’re risk averse, you will need to accumulate more. You should also consider inflation. Of course, if you invest for inflation, it will already be factored into your investments.

Understanding financial freedom as the point where your passive income equals your expenses is a much more realistic way to look at it. Most people who are committed to being financially free can achieve their goal in a matter of a few years, not decades.

Larry Holmes

When as a young and unknown man I started to be successful I was referred to as a gambler. My operations increased in scope and volume. Then I was known as a speculator. The sphere of my activities continued to expand and I am presently known as a banker. Actually I have been doing the same thing all the time.

And…

That observation is particularly worth pondering… J.P. Morgan would gag at the word ‘gamble’ when I used it. Still, the truth is that there is no investment which does not involve some risk and is not something of a gamble… In our own age when Henry Ford started to make the first Model T, he was embarking on one of the most gigantic speculations of all time. We would be foolish to try to stamp out this willingness in man to buck seemingly hopeless odds. What we can try to do perhaps is to come to a better understanding of how to reduce the element of risk in whatever we undertake.

That’s it. It’s foolish to try to avoid risk beacause risk is an essential element of living. The best we can do is manage it.

For example, during the secular bear market of the early 1930’s, five of the six bear market rallies gained more than 20%. In fact, from a low of 199 in November of 1929, the Dow rallied 48% to a high of 294 in April of 1930 only to be followed by a decline of 86% before reaching an ultimate bottom of 41 in 1932. Defining those rallies as bull markets would have caused long-term investors some serious financial set backs.

So those rallies were obviously not the beginning of secular bull markets and I don’t think today’s stock market is a secular bull market either. In fact, you can include me in the circle of the minority of market observers — a minority that seems to include some of the most experienced investors — who believe that the rally that has taken place since 2003 is nothing more than a very strong and long bear market rally that will result in the resumption of the secular bear trend.

I think the secular bull market — the most powerful bull market in history — that began in 1982 ended in early 2000. It also signaled the beginning of a secular bear market that hasn’t didn’t come close to ending when stock prices bottomed in 2002. And you need to look no further than price/earnings ratios for proof.

*The P/E ratio is based on the S&P 500 as developed and presented by Robert Shiller in Irrational Exuberance.
** The returns reflect the Dow Jones Industrial Average at year-end.
Source: Crestmont Research

There are two things you should learn from the data. The first is that since 1900, investing in the stock market during periods of high price/earnings ratios has resulted in inferior investment returns. The other thing is that, without exception, new secular bull markets don’t begin until p/e ratios get to single digits.

And there’s a logical reason for that kind of market behavior. Bull markets tend to go a lot higher and last a lot longer than anyone expects. Conversely, bear markets tend to go a lot lower and last a lot longer than anyone expects.

This phenomenon occurs because the final stages of secular bull markets are always fueled by excessive speculation, whereas the final stages of bear markets result in investors deciding that they can’t stand any more pain, the market is never going to come back again, so they just want out at any price. And when that occurs the news will be terrible and stocks will be dirt cheap. And yet nobody will want to touch them. That’s how bear markets end.

So where are we now? Not even close to a market bottom. In fact, we’re much closer to a historical market top than to any kind of bottom. Right now the p/e ratio for the S&P 500 index is about 18, still relatively high. So the current bear market has a long, long way to go before a new secular bull market can begin.

The market can get to low p/e ratios in one of two ways. Either the S&P gets so low that the p/e ratio for the index drops below 10. That happened during the bear markets of 1929-1932 and 1937-1941. Or the S&P could go through a very long period of sideways action while earnings catch up to price. That happened during the bear markets of 1921-1920 and 1966-1981.

I went through the last half of the one from 1966-1981 and I can tell you that even though the market ended that period about where it began, there were very powerful up and down moves during those years. However, the end result was that it was not a good time for long-term stock market investments.

Finally, I think that the current stock market is on the verge of a steep decline. All of the reasons for that are beyond the scope of this article but I’ll give you one that I consider quite telling. According to the Commitments of Traders report (COT), the net short position of commercial traders for the S&P futures contract is one of the largest in COT history. Ever since the secular bear market began, such a bearish position on the part of the “smart money” has signaled a steep market sell off within the next few months.

We shall see what transpires.

Larry Holmes

• The best bull markets are ones that attract the fewest believers as possible. When the long side of a bull market gets too crowded, the market will sell off to chase off some weak holders. After that, the market can resume its upward climb.

• Bear markets occur when investors refuse to believe that the previous bull market could be over and so they hold tight on any sell off. On the other hand, corrections in bull markets occur when investors want to sell when the market pulls back.

• During the recent sell off in gold, market timers were eager to bail out of their long positions. So gold market timers are out of the market right now.

• In 1980, when gold hit $875 an ounce gold market timers viewed the ensuing sell off as a great buying opportunity. $875 proved to be the peak of the gold market at the time and the beginning of a 20+ year primary bear market.

• The contrast between the current gold market and the one in 1980 couldn’t greater. The odds are overwhelming that the current weakness in gold is a correction within the framework of a primary bull market, and not the beginning of a bear market.

That’s as good an explanation as you will find for what’s going on in the gold market right now.

What are exchange traded funds? ETFs are similar to index mutual funds. Essentially, an ETF is a portfolio of securities that is intended to provide investment results that, before fees and expenses, generally correspond to the price and yield performance of the underlying benchmark index. ETFs trade on the stock exchanges. As such, they offer features of a mutual fund in a stock-like instrument.

There are at least six important advantages that exchange traded funds have over mutual funds:

1. ETFs, instead of pricing once a day after the market closes (like mutual funds), are traded throughout the day as if they were regular stocks.

2. Since an ETF trades like a stock, it can be bought and sold (and shorted) at any time during market hours.

3. Investors can calculate the value of an ETF during the day because the composition of the underlying portfolio – normally a published index – doesn’t change. For example, the value of the SPDR ETF (SPY) that tracks the S&P 500 index is calculated continuously throughout the day.

4. An ETF can be exchanged for the underlying assets it represents with the issuing institution for a small fee. It means that ETFs will not trade at significant discounts or premiums to the value of the underlying assets of the fund. This is not true with closed-end mutual funds.

5. Because they are not actively managed and have very little portfolio turnover, ETFs carry some nice tax advantages over mutual funds because they distribute relatively few capital gains.

6. Most ETFs have very low management fees, especially compared to mutual funds. And the lower the expenses, the more money goes into the investor’s pocket.

So exchange traded funds offer most of the advantages of mutual funds — instant diversification and many to choose from — without the major disadvantages.

The primary disadvantage of an ETF is that if you are making small transactions on a regular basis, you will pay a commission on each transaction — just like you would by buying and selling a stock.

But, all in all, the advantages of an exchange traded fund far outweigh any disadvantages. I suggest that you use ETFs as an important part of your investment strategy.

Larry Holmes

Number 1: Identify Major Investment Themes

In early 2003, we identified our favorable and unfavorable major investment themes for the next 10, 15, 20 years or so:

Favorable investment themes:

Gold and silver
Oil
Other commodities
Emerging markets

Unfavorable investment themes:

U.S. stocks (with certain exceptions)
U.S. bonds
U.S. real estate

Our favorable investment themes are the ones that were in primary bear trends for many years. As a result, they are the markets that are the most undervalued. On the other hand, our unfavorable investment themes are the ones that were in primary bull trends for years. They are the markets that are relatively overvalued.

Markets tend to go from relatively undervalued to relatively overvalued and vice versa. The process can take many years to complete. Concentrating on the big picture of our investment themes allows us to stay focused and not get distracted by counter-trend market corrections and noise emanating from Wall Street and the financial media.

Number 2: Asset Allocation

We allocate assets to emphasize favorable themes and de-emphasize unfavorable themes. For example, 10% of our overall portfolio is allocated to the ownership of gold and silver. We view that part of our portfolio as an insurance policy on a weakening U.S. dollar. We don’t expect that to change for at least several years.

The other 90% is allocated to profit when one of our favorable investment themes rise in price or when one of our unfavorable investment themes decline in price. As a result, we often have additional investments in gold and silver stocks and Exchange Traded Funds (ETFs) over and above our permanent 10% portfolio allocation.

Number 3: Let Profits Run And Cut Losses Short

A substantial percentage of our overall portfolio is allocated for the purchase of shares of stocks and ETFs. With this part of our portfolio we use trailing stop loss orders to allow our profits to run and to cut our losses short.

A trailing stop loss order is one in which the stop loss price is set below the market price. The trailing stop loss price moves incrementally with market price. This technique allows an investor to set a limit on the maximum loss without setting a limit on the maximum gain, and without requiring paying attention to the investment on an ongoing basis.

The stock selection in our portfolio are shares of companies that are either earning a high return on invested capital and are priced at a high earnings yield or shares of companies and ETFs representing one of our major investment themes.

Number 4: Position Sizing

We are firm believers in the fundamental truth that if you keep losses at a minimum, profits will take care of themselves. Therefore, we size our positions so that we rarely risk more than 2-3% of the equity in our stock portfolio on any one stock or ETF position.

The question that the average investor asks before making an investment is how much can I gain? That’s the wrong question. The right question is how much can I lose? We try to never forget asking the right question.

Number 5: Discipline

The typical investor is always searching for the “Holy Grail” investment strategy. There is no Holy Grail except for the discipline of the individual investor.

The best investment strategy in the world will have long periods of underperformance. Therefore, we realize that we must stay disciplined by staying the course when we are going through one of those periods.

Let me quote a passage from chapter 8 of Joel Greenblatt’s amazing book, “The Little Book That Beats The Market“:

Let’s take a look at the experience of a good friend of mine who happens to be the “smartest money manager I know.” Though he doesn’t automatically buy stocks that his computer-based formula spits out, he does follow a disciplined strategy of choosing companies to buy only from the list of companies his formula ranks the highest.

He used this strategy for 10 years at his previous investment firm, and nine years ago he set out to form his own money management firm using the same basic principles. Business wasn’t too good for the first three or four years, as the same strategy that had been so successful in the past drastically underperformed the returns of competing money management firms and the major market averages. Nevertheless, the “smartest money manager I know” strongly believed that his strategy still made tremendous sense in the long run and that he should continue following the same course as always. Unfortunately, his clients disagreed. The vast majority of them ran for the exits, pulling their money away in large numbers, most likely to give it to a manager who, unlike my friend, “knew what he was doing.”

As you guessed, they should have stuck around. The last five or six years have been so good for my friend and his strategy that now the investment record of his firm since its inception (once again, including those tough first few years) has trounced the returns of the major market averages over the comparable time frame. Today it stands among the top of only a small handful of firms with extraordinary investment records out of the thousands of investment firms on Wall Street. To prove that sometimes good things do come to those who wait, my friend’s firm now manages over $10 billion for hundreds of clients. Too bad that, in the face of several years of underperformance, most chose not to wait. Only four original clients remain [Joel Greenblatt is one of them].

The point of the story is that if a winning investment strategy always worked, everybody would follow it. And if everybody followed it, it would stop working. The reason that most people lose is that they lack the discipline to stay with a winning strategy while it goes through an inevitable period of underperformance. So, above all, we focus on being disciplined.

Larry Holmes

How To Read The COT Report

Here’s what happens — the government, specifically the Commodity Futures Trading Commission (CFTC), requires all those who hold a number of futures contracts above a specified limit to report their positions. For example, the threshold limit for S&P futures is currently 1,000 contracts. So only the really big players have to report. But they hold 70% to 90% of all outstanding futures contracts. You may view the reports for the various markets at the Commodity Futures Trading Commission Web site.

The report is released on Fridays (except for holidays) based on data as of the previous Tuesday. So the information is released three days after the fact. That’s OK, because it’s timely enough to be valuable.

The column headings at the top of the report will be labeled NON-COMMERCIAL, COMMERCIAL, and NONREPORTABLE POSITIONS.

When an account is reported to the CFTC as holding positions above the specified reporting level number of contracts, the CFTC determines if the account is a commercial hedger or a large speculator.

Commercial- The CFTC classifies a futures account that meets the reporting level as a “commercial” when that account holder files a statement with the Commission that states it is commercially engaged in business activities hedged by the use of the futures markets. They’re the ones that we’re most interested in. For example, the commercial traders of S&P futures are the largest institutional players like banks, pension funds, mutual funds, hedge funds and the trading arms of Wall Street firms.

Non-commercial – Those classified as non-commercial are “large speculators.” They don’t deal with stocks as a part of doing business. An example of a large speculative account might be a large commodity pool (a fund) that trades futures for speculative profit. Managed futures accounts have grown into the billions of dollars and if they meet the reporting levels, their positions would be reported to the CFTC for monitoring.

Nonreportable positions – All traders, speculative and commercial, that have smaller positions than the reporting level are considered the “small speculators.” In other words, they’re everybody else who participates in the futures markets — the proverbial “little guys.”

The Three Players

To know how to use the COT data, it’s important to take a closer look at the three types of players that are the report’s focus — the commercial trader, the large speculator, and the small speculator. We want to know what makes each of them tick.

Commercial traders dominate the market. That fact really shouldn’t be a surprise to anyone given the nature of who the commercials are. For example, in the S&P futures market they are banks, pension funds, mutual funds, Wall Street brokerage houses and the like. They have vast research departments and have inside information that simply is not available to the average investor in a timely manner.

They also dominate because of their sheer size. They are so large that they actually become the market. So the commercial traders are the ones that we’re most interested in. We want to try to determine what they’re doing and tag along. History has shown that the commercial traders in most futures markets for that matter are right a great deal of the time. And when they’re wrong, they are rarely wrong for very long. They will eventually end up on the right side of the market, whether it be on the upside or downside.

The large speculators tend to be trend followers. After the market has established a trend up or down, they will go the direction of the trend. It’s interesting to know what they’re doing in the market, but it shouldn’t be critical to your decision making process.

The small speculators are usually on the wrong side of the market. In fact, it has been estimated that as many as 90% of small traders lose money in the futures markets. They tend to serve as “cannon fodder” for the big commercial traders. After all, the “smart money” has to have someone to take the opposite side of their trades. The small speculator is usually willing to accept that roll. Think of the Harlem Globetrotters vs. the Washington Generals. The commercials are the Globetrotters. The small speculators are the Generals — the patsies who are bound to lose.

The commercial traders are the ones to follow. They’re the smart money. When they have an extreme long or short position in relation to their positions in the past — or in the case of S&P futures, even when they are net long or short — it is a very useful indicator to help determine market direction.

Larry Holmes

GDX has approximately 43 mining stocks in the index. And it is very well diversified among a wide variety of mining companies. Here are the components as of 4/30/05. It not only has the big guys — Newmont, Barrick, Goldcorp — in the index, it has some small caps as well. It even has a few silver stocks.

And it has the volatility needed for big potential profits:

Over the last five years, the index has gone up 285% while the price of gold has gone up 137%, more than doubling the profit of owning gold over that period of time. I welcome this new addition to the ever-growing list of very useful exchange traded funds.

The I-Shares emerging market ETF (EEM) is off 16% in less than three weeks. In fact, it’s getting very close to its upward trending 40-week moving average. If it holds the moving average, consolidates, and moves up enough to trigger a Parabolic SAR buy signal, there could be a real opportunity there. In other words, the emerging markets are still primary bull markets and the current sell off should be viewed as a potential buying opportunity rather than the beginning of a new bearish trend.