Last week I said to "think of the Color Guard as you would a traffic light. Green means go, it's OK to buy stocks. Yellow means caution, it may or may not be OK to buy stocks. Red means stop, don't buy any stocks."

I also said there's more here than meets the eye and went on to introduce our trend indicators, the Primary Wave and Market Timing Indicator. To make things simple, I also said that it's always OK to buy stocks when the Primary Wave is Up. Having said all that, I thought I would take the Color Guard out for a test drive.

I wanted to see what would happen if I bought stocks when the Primary Wave was Up and deferred purchases when it was Dn. So I created a 10-stock portfolio as of five years ago, 09/19/03, and managed it week-to-week, selling on an "S" Rec. I stayed long 100% of the time and replaced empty positions only when the Primary Wave was Up. The exercise was very instructional.

At the end of the first year, I had a gain of 22.91%, and a gain of 71.17% after two years. Not bad, I thought, but then my portfolio peaked on May 12, 2006, up 123.51%, and got mauled during the summer of '06. It fell to a gain of 61.67% by September 22, 2006, the three year mark. It fought back to a gain of 99.67% on December 08, 2006; then it went down again. Nevertheless, it recovered once again to a gain of 76.47% by September 21, 2007, the fourth year. It peaked at 99.35% on October 26, 2007 and went downhill after that. As of yesterday, September 18, 2008, it had a gain of 22.55%.

You might say that performance is not very good and I certainly would agree with you. It's not very good at all. But you should remember that I didn't take full advantage of all the information the Color Guard provides and the portfolio still survived 10 months of a terrible bear market. So what other information in the Color Guard could I have used?

Perhaps the most important signals it gives: The Confirmed Up and Confirmed Dn signals. These signals are presented in the Trends column as C/Up and C/Dn. These signals should not be ignored. While there's a lot of flexibility as to when you may buy stocks, you're playing with fire if you buy them when the market is falling. Again, you cannot ignore a C/Dn signal. Had I heeded the C/Dn of November 1, 2007 and gone into cash on November 2, 2007, I would be sitting here with a gain of over 99%. Had I gone into cash on November 2, 2007 and gone long during the following C/Up to C/Dn period of April 3, 2008 to June 11, 2008, I'd have a gain of 135.53%. Now that's not bad, but we can still do a lot better.

Simply buying on Primary Wave Up signals and not buying on Dn signals is a good beginning and using the C/Up and C/Dn signals is a must, but there's much more than that, which I will present in the next few weeks, to fully explain Implementing the Color Guard.

The surest way to wreck the economy and bring on a Bear market is to raise interest rates. The Fed has made eleven one-quarter point rate increases since June 2004, (see V V Views 06/10/2004), raising the Federal Funds Rate from 1.00% to 3.75%. It now appears that The Fed will continue on this path for some time to come. So, when will the Bear market arrive?

All subscribers should familiarize themselves with the "Climate" section of these Views in which we track key data relevant to the state of The Investment Climate. Moreover, we identify whether the stock market is in a Bullish or Bearish mode. Currently, the market is in a Case 4, Bull market scenario in which earnings, inflation and interest rates are rising. This scenario is the one in which Bull markets end. (You may learn more about various Bull and Bear market scenarios by reading the VectorVest Views of 03/21/03, 03/28/03, 10/24/03, 04/16/04, 03/11/05 and 04/22/05.) I have repeatedly noted in these essays that Case 4 scenarios can last a long time. This one has been going on since May 7, 2004 or seventeen months. I have also said that the key to knowing when we are in a bona fide Bear market is to identify when corporate earnings start heading down.

So here we are in October, typically a month of major reversals, and earnings reporting season is upon us. Analysts, so far, have been surprised that pre-reporting earnings warnings have been so few. Yes, I said so few. Only about 500 companies have released warnings compared to about 750-900 for recent quarters. But we all know that thousands of companies have been impacted adversely by the devastating hurricanes that ravaged the Gulf Coast. Other companies are beginning to feel the affects of higher raw material and energy prices. So analysts' earnings estimates for the third quarter may be too high. We will keep a watchful eye on these earnings reports and let you know if and when we see earnings starting to go down.

You should also be aware that stock prices will fall sharply before a clear indication of an earnings downturn is evident. Therefore, you want to keep your eye on the Color Guard. It has already informed us that the market is trending downward with a series of yellow and red lights. The MTI has fallen below 1.00 again and we still have the Confirmed Down signal from September 21st. I don't know whether this drawdown is just a temporary blip or the real thing. Nevertheless, it's time to be watchful and prepare yourself for The Next Bear Market.

A LOOSE CANNON.
Mr. Richard W. Fisher became President of the Federal Reserve Bank of Dallas on April 4, 2005. Shortly thereafter, in June as I recall, he appeared on CNBC. I was struck by the flippant manner in which he answered questions. Here was a guy, I thought, that truly loves the limelight. Well, he got it that day. When asked about the Fed's string of interest rate hikes, he said the Fed was in the eighth inning, suggesting that the Fed's interest rate increases were close to ending soon. This comment caused the market to rally and CNBC played the clip over and over all day long.

Last Tuesday, Mr. Fisher helped kill a nice rally and trigger an afternoon sell-off when he said inflation is now near the "upper end" of the Fed's comfort range. This comment suggested that more rate hikes are on the way, just the opposite of what he said just a few months ago. Apparently, he liked the attention and followed up his remarks yesterday when he said The Fed can't "let the inflation virus infect the blood supply and poison the system." Does this guy have a clue of what he's talking about?

Some observers have questioned whether Mr. Fisher has become the unofficial spokesperson of the Federal Reserve Board. I don't think so. After watching Dr. Greenspan, Chairman of the Federal Reserve Board, carefully parse his words and master the art of doublespeak over the last 15 years, I would seriously doubt that he would select Mr. Fisher to be its spokesperson. The last thing we need is someone speaking for The Fed who is A Loose Cannon.

SYNTHETIC LONG STOCK.
The thing I like most about call options is that they give you the opportunity for unlimited profit potential with limited downside risk. They also provide about ten-to-one leverage. This allows you to invest in high priced stocks on a poor man's budget. For example, when Valero Energy, VLO, broke out of its slump last May, I bought 10 January 70 Call option contracts for about $9,000, not counting commissions. It would have cost me $67,840 to buy 1,000 shares of stock. The most I could lose on the 10 option contracts was $9,000. Theoretically, I could have lost the whole $67,840 had I bought the stock.

Being the cheap so and so that I am, however, I didn't even want to lay out the 9,000 bucks for the call options. So I also sold 10 VLO January 70 Put option contracts for about $8,000. My net cost for these positions was about $1,000 or $1.00 per share. That's nice, but to save the $8,000, I increased my risk of loss to $71,000. I didn't mind this because I thought the risk of VLO going to zero was zero and I was going to buy the stock anyway. Fortunately, VLO ran up to $116.12 a share and I had a paper profit of over $36,000. VLO got whacked this week and so I ended up taking about $30,000 profit on the trade. Based upon my net cost, that's a 2,900% gain in less than six months.

There's a lot more to placing and managing long synthetic stock option positions than I've indicated here, but I prefer to make this trade than to buying high-priced stocks. Please see my essay of 12/17/04 for more information on Synthetic Long Stocks.

SPECIAL NOTE: DO NOT TRADE OPTIONS UNLESS YOU KNOW WHAT YOU ARE DOING. YOU MAY RECEIVE A FREE INTRODUCTION TO OPTIONS AT THE VECTORVEST UNIVERSITY, PURCHASE OUR OPTIONS COURSE ON CDs OR ATTEND ONE OF OUR LIVE OPTIONS COURSES.