The recent bout of market volatility has caused our Daily Decision system to incur several "whipsaw" trades. In fact, of the 6 moves made in the Hybrid Model since the beginning of December, 5 have resulted in losses. And while the losses have been small, this type of period can be hard on one's nerves.

The first and perhaps most important point to make is whipsaw trades are part of the game the Daily Decision plays. Remember, if one attempts to (1) avoid painful declines during severe corrections, (2) make money in bear markets, and (3) outperform the S&P 500 during bull markets, there is a "price" to be paid for such ambitions. The bottom line is that whipsaw trades and occasional periods of underperformance should be viewed as the "price" demanded of investors.

As I have mentioned time and again, there is no such thing as a perfect system. Too many investors (professional and individual alike) look only at the positive returns a system has produced in the past and ignores the "price" the market extracts in order to achieve those returns. And it is for this reason that so many investors wind up "strategy hopping" and/or "chasing the hot dot" in an effort to avoid periods in which a strategy underperforms or struggles.

But remember, even Warren Buffett, considered by most as the greatest investor of a generation, has struggled with performance at times - sometimes dramatically so. However, Mr. Buffett didn't deviate from his approach when he missed the technology boom. He didn't change his stripes when the S&P beat him in a given year. He didn't chase what worked last year. He simply soldiered on employing his approach to the markets. And over time, he has been rewarded handsomely for sticking to his discipline.

If I had to identify one key to long-term success in the stock market it would be discipline. But unfortunately, very few investors are able to implement a disciplined approach over the long-term because their emotions get in the way - usually at the most inopportune times!

However, human emotions ARE INDEED part of the investing game. So, while my personal reaction to a period of whipsaw trades is to ignore them, stick to the plan, and just "keep on keepin' on," I completely understand how emotions can impact one's ability to "stick with it" during challenging markets.

Ways to Deal with Challenging Markets

One way to deal with volatile environments and attempt to limit the impact of whipsaws during challenging times is to adjust exposure on an incremental basis. Instead of using a buy/sell, all-in/all-out approach, the idea is to use a graduated exposure approach, where a series of indicators each controls a portion of the portfolio's overall exposure.

The primary goal of this type of approach is to "smooth out the ride" as it affords investors the opportunity to "stay in tune with the overall risk/reward environment" on a daily basis.

When a big move occurs, a graduated approach will be "mostly" on the right side. To be sure, this approach will never "nail" a top or bottom, but it will keep investors largely in line with what is happening in the market.

A Bonus Portfolio For the Daily Decision

In an effort to make The Daily Decision the premier risk management subscription service available today, we have decided to add a "Daily Exposure Portfolio" to the Daily Decision service. The goal is to provide subscribers with an additional/alternative disciplined approach to employ in their portfolios.

The idea is that there are times when an all-in/all-out approach like the DD uses can be hard on the nerves, making it difficult to continue to stick with the discipline and/or pull the trigger after a string of losing trades. But by adjusting exposure to the market on a gradual basis, investors can avoid potential whipsaws and stay in tune with the overriding environment.

Another positive to an exposure-based approach is strategy diversification. You see, there are multiple indicators at work at all times. Thus, if a particular indicator struggles, the impact to the overall portfolio is limited.

And here's the best part: The cost of the additional portfolio strategy for subscribers is: $0.

The Exposure Approach Explained

The Exposure System employs as many as 12 different indicators (indicators are turned on and off by "triggers" built into the system), each controlling a portion of the portfolio's overall exposure.

Here's how it works: If one indicator gives a sell signal, the portion of the portfolio the indicator controls is moved to cash (or a short position).

For example, let's assume the portfolio is 100% invested. Then an indicator that controls 12.5% of the portfolio flashes a sell signal. The result is the overall exposure in the portfolio would be changed to 87.5%.

The Exposure System may create a net short position at times and can use leverage. And it is important to note that the maximum leverage used in this portfolio is 200%. As such, this system most resembles the Daily Decision Hybrid Model (which, by the way, was designed for my investing personality) in terms of its leverage potential.

We have utilized versions of this type of approach for Heritage clients for many years. However, the exact "mix" of indicators for this system is new. So, below is a table of the historical backtest returns for this specific approach.

Backtest Results for the Daily Exposure System

Please see important disclosures about the inherent limitations of backtesting below.

It is worth nothing that while the returns of this Exposure System are strong, they are not as high as the Daily Decision system. The simple reason for this is an exposure system won't catch turning points the way an all-in/all-out approach can. But it will also avoid many whipsaws and the problem of having no exposure when the market puts in a V-Bottom after a pullback.

If you'd like to compare how the historical test results fare versus the Daily Decision system currently being employed, here is a link to the DD return table.

As you will see, the overall results are not as high as the DD's. However, the "ride" during difficult years such as 2005-06 and 2011 would have been smoother, and volatile periods such as we've seen over the last few months - as well all the V-Bottoms seen in the last 2 years - would have been easier to live with.

How to Use the Exposure System

There are any number of uses for the type of Exposure System. But here are three ideas to consider:

• Diversify your portfolio by using both the Daily Decision and the Daily Exposure Systems
• Utilize the Exposure System when our Market Environment Model is Neutral
• Employ the Exposure System in place of the Daily Decision System
• Use the Exposure System when emotions run high

IMPORTANT: The Daily Decision System Will NOT Change

To clarify, how you employ the Daily Exposure system is up to you as it is not part of the Daily Decision system.

In addition, the Exposure System is an ADD-ON service provided to subscribers and WILL NOT REPLACE any aspect of the Daily Decision system.

Our goal is to offer an additional system for subscribers to possibly utilize if whipsaw trades make it difficult to stick with the type of all-in/all-out approach employed by the DD system.

What Will Change

Starting Monday, January 26, the Daily Decision morning report will include the Exposure Level of this system. Use it or ignore it; it's up to you. However, we continue to strive to make the Daily Decision service the best risk management subscription available to individual investors.

It is my sincere hope that this additional system will help you stay disciplined and "stay the course" during difficult market environments.

Not Yet a Subscriber? Check out The Daily Decision service today.

Wishing you all the best in your investing endeavors,

David D. Moenning
Founder, StateoftheMarkets.com
President, Heritage Capital Research

The opinions and forecasts expressed herein are those of Mr. David Moenning and may not actually come to pass. Mr. Moenning’s opinions and viewpoints regarding the future of the markets should not be construed as recommendations. The analysis and information in this report is for informational purposes only. No part of the material presented in this report is intended as an investment recommendation or investment advice. Neither the information nor any opinion expressed nor any Portfolio constitutes a solicitation to purchase or sell securities or any investment program.

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The analysis provided is based on both technical and fundamental research and is provided “as is” without warranty of any kind, either expressed or implied. Although the information contained is derived from sources which are believed to be reliable, they cannot be guaranteed.

Hypothetical performance records do not represent the results of an actual managed account, but are achieved by means of the retroactive application that was designed and prepared with the benefit of hindsight. No representation is being made that any account will or is likely to achieve profits or have losses similar to those shown. In fact, there may be frequent sharp differences between the hypothetical performance record and actual results.

Hypothetical trading does not involve risk and may not reflect the impact that any material market or economic factor may have on decision making. Since no trades are actually executed, the performance record may have under or over compensated for the impact, if any, of certain market factors (e.g. lack of liquidity, trading costs, etc.). The conditions, objectives or investment strategies may have changed materially during the time period, or after the time period, portrayed in this performance record, and the affect of such change is not portrayed in the performance record.

There is no guarantee that future portfolio management strategies or asset selection decisions will mirror the assumptions used in the creation of this performance record. The investment strategies followed may only partially relate to the type of services offered. The assets utilized in this performance record may be different from the assets utilized when trading actual client accounts (e.g. the performance record may include some assets that are no longer available).

The performance of different assets varies widely. As a result, actual results may vary widely from those shown in this performance record. There are numerous other factors related to the markets in general or to the implementation of any specific strategy which cannot be fully account for in the preparation of this hypothetical performance record, all of which can adversely affect results when actually managing client assets. The performance results reflect the withdrawal of advisory fees, but do not reflect the payment of trading commissions, nor the impact of taxes for the strategy.

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