In my
previous post, I made some observations concerning the unrealized gains made by
those following the primary bull market signal in the stock market.
I finished my
observations by mentioning two tools to help the investor avoid
devastating losses (or to lock in profits) if the trend suddenly reverses.
One of this “tools”
is what I label the “Dow Theory’s trailing stop”, of which I wrote here, which you can visualize in the following chart (red horizontal lines):
 |
| Red horizontal lines shows were the Dow Theory stoploss currently stands |
This is the
most commonly occurring “stop”, as it is based upon the existence of a
secondary reaction. The essence of it is as follows: In a primary bull market,
once a secondary reaction has been established, and a rally follows after it,
if the lows of the secondary reaction are jointly
violated a primary bear market (sell signal) is signaled. As a primary bull
market progresses, new secondary reactions develop with higher lows and,
accordingly, the “Dow Theory trailing stop” moves higher locking in more
profits (or reducing the amount of likely losses). For a deeper explanation,
please read this post.
However,
there is a “catch” with the “Dow Theory trailing stop”: it requires the
development of a secondary reaction. And, alas, within the current primary bull market such secondary reaction has not
developed yet.
Since the
bull market started in mid November 2012 and the primary bull market signal was
flashed on January 2, 2013, no secondary reaction has occurred. Accordingly, we
don’t have a “Dow Theory trailing stop” in place. Thus, our stop lays at the
Mid November 2012 lows, which entails a worst-case loss close to 7.63%
(percentage loss from the entry point at 146.02, and the bear market lows at
135.7). In other words, the lack of a secondary reaction has us exposed to a
killing loss (all the unrealized profit now standing at 14.30% wiped out plus
the ca. 7.63% loss) in case the stock market starts falling with no intervening
secondary reaction. While it is unlikely a decline exceeding 21% (14.30+7.63) not
being preceded by a secondary reaction, it might happen.
However, if
we follow Dow Theorist Schannep, there is an alternative way to cut losses short
(or to realize profits) if the market reverses, which is especially apt in
cases (as ours) when the market goes higher and higher and no secondary
reaction occurs and, thus, we are prevented from raising our “Dow Theory
trailing stop”. Schannep has observed that when both the S&P and the
Industrials decline 16% from their highs, there was a further average loss of
12% until the finals lows were made (“Dow Theory for the 21st
Century", Pages 63-64, Table 6.1). You can buy Schannep’s book, which, in my
opinion, ranks among the best Dow Theory books, here.
Therefore, if
we were to place a 16% stop below the current closing high at 166.94 for the
SPY, our stop loss would be at 140.23,
which is significantly higher than the current stop loss placed at the Mid
November 2012 primary bear market lows at 135.7.
If we accept
such new “Schannep’s” stop at 16% below the highest highs recently made, then
our maximum potential loss would stand at:
Entry point
(bull market signaled) = 146.06
Exit point
(-16% stop loss from highest closing high) =140.23
Maximum potential loss: -3.99%
I am not
advocating for discarding the current stop loss established by a strict
application of the Dow Theory (last recorded bear market lows) in favor of the “Schannep’s”
-16% stoploss from the last recorded highs. Each investor must cogitate and
decide which stop to follow. This Dow Theory blog is no substitute for matured and
independent thought. One thing is clear, though. Schannep’s observations are
well rooted in empirical evidence, and 16% is an ample stop when investing
along stock indices like the SPY or the Industrials. Moreover, in many
instances (when secondary reaction lows are made and not subsequently broken)
the “Dow Theory trailing stop” tends to be tighter. Thus, finding protection at
-16% from the highs is not an absurd idea. Russell himself, very often,
recommends a stop loss of only 10%.
Since now we
have two alternative “exit” scenarios, which will change with subsequent price
action, I have modified the spreadsheet which I usually display at the end of
my posts. From now on (until market conditions change and make the Schannep's stop redundant), I will display the two alternative exit points. The one
derived by the strict application of the Dow Theory and Schannep’s.
| Data for May 17, 2013 | |||
| DOW THEORY PRIMARY TREND MONITOR SPY | |||
| SPY | |||
| Bull market started | 11/15/2012 | 135.7 | |
| Bull market signaled | 01/02/2013 | 146.06 | |
| Last close | 05/17/2013 | 166.94 | |
| Current stop level: Bear mkt low | 135.7 | ||
| Unrlzd gain % | Tot advance since start bull mkt | Max Pot Loss % | |
| 14.30% | 23.02% | 7.63% | |
| Alternative Schannep's stoploss: | |||
| Highest closing high | 05/17/2014 | 166.94 | |
| 16% stoploss from highest closing high | 140.23 | ||
| Max Pot Loss % | |||
| -3.99% | |||
Have a
wonderful weekend.
Sincerely,
The Dow
Theorist
