Friday, October 12, 2012

Dow Theory special issue: More on the secondary reaction and its implications. II

Should I buy specific stocks or the indices?

Continued from this post:

I closed yesterday’s post in this Dow Theory blog by asking whether one should just buy an index (i.e. IYT, DIA or SPY) or the existence of a primary bull market warrants the acquisition of specific stocks. This is a tough question.

My answer depends on what are your goals and, more importantly the means to achieve them.

If you are happy with outperforming the SPY by 3-4% a year over long periods (i.e 10 years) while reducing risk (i.e draw downs when the going gets tough like in 2008-2009), then you should stick to buying the indices. If you want to really outperform the market, let’s say by 10% annual, then you must cherry pick your specific stocks. However, this is easier said than done. I am not saying it cannot be done, but here comes the issue of “means” I mentioned in the preceding paragraph. I can confidently say that 99% of the investors lack the “means” or tools or knowledge to select stocks that will outperform the market by 10% a year while keeping losses contained. Such knowledge may be acquired but it times many years of focused effort and deliberate practice.

Furthermore, when buying the individual issues (unless one buys all the components of an index) we don’t know exactly at what level we have to place the particular stops for each stock since normal chart patterns applicable to each stock are much weaker technically than the stops placed under the Dow Theory. Nonetheless, if we buy the IYT, DIA or SPY, we know precisely at what level they underwent the last primary bear market low (concerning the first stop after the inception of a primary bull market) or the lows of subsequent secondary reactions (concerning successive stops as the market advances), and hence we can place the best stops.

Furthermore, it gets more complicated than this. Let’s assume that I am long the SPY and suddenly, the SPY breaks the current stops fixed at the SPY lows of June 4. Should I sell out? No, because such bearish action should be confirmed by at least one index. If the DJIA or the Transports confirm, this is the signal to sell. Absent such confirmation you should hold your breath and wait. This shouldn’t look bizarre to you. After all, in order to buy you demanded the existence of confirmation. By the same token, you need a confirmed violation of previous lows in order to sell out.

This principle of confirmation works well when trading the indices (or their ETFs proxies). However, with individual stocks, one never knows exactly where to place the stops. Should you sell your stock in spite of its going up because the Dow Theory signaled a bear market? Should you keep it and narrow stops? Should you stick with it? When trading individual stocks things get more complicated.

I am not saying that you cannot trade/invest in particular stocks according to the Dow Theory; however, what I say is that you have to be very sophisticated when it comes to placing your stops and choosing your investment candidates. Definitely, this is not a task for beginners and even many professionals fail.

Problems compound because it would be suicidal to just buy 2 or 3 stocks based on a Dow Theory bull market signal. The investor should, at the very least, diversify into 10-15 stocks and make sure that they are not too correlated.

I insist: The only rationale for buying specific stocks instead of the indices is in order to outperform the market. However, by merely following the Dow Theory and buying the indices, the investor knows that long term 3-4% out performance is likely to be achieved while losses will be kept to a minimum. Is this not enough for the average investor? Investors should heed the wisdom of Charles Dow when he said 111 years ago (in 1901):

“If people with either large or small capital would look upon trading in stocks as an attempt to get 12 per cent per annum on their money instead of 50 per cent weekly, they would come out a good deal better in the long run."

Nowadays, we have the possibility (non-existent in recent years) to invest directly in the indices through their ETFs proxies. So, why don’t we heed Dow’s advice?

Of course, and this is the subject for a lengthy post or, better yet, for a new saga, the investor who knows how to couple the Dow theory with particular stocks has a great potential for outperforming the market, but also of losing his shirt in years like 2008 if he is not controlling risk properly. In life, everything comes at a price.

Personally, I wouldn’t allow greed to prevail, and I’d keep it simple (which is not so simple after all if we judge by the permanent strife between Dow Theorists and other technical analysts, I included, who don’t seem to agree on whether we are in a bull or bear market). If one can  keep it masterfully simple, one can expect to outperform the market by ca. 3 or even 4% annual while avoiding the worst drawdowns (i.e. 2008) that the market always has in store for us. If the average investor (and many professionals) can achieve this long term, I can tell you is a remarkable feat.

Or put it another way: First, become proficient in applying the Dow Theory to indices. Once you have proven yourself that you are very good at it by making money (the only valid piece of evidence) consistently (some years), then you may start to dabble with specific stocks. Until then, you have to exert patience.

Well now this lengthy post is ready. Those serious about its implications should carefully read it (and the links pertaining thereto) as well as my disclaimer at the end of this post. I am just writing my thoughts, and I hope to make you think. That’s all.


The Dow Theorist.

Disclaimer: Dow Theory Investment and its author is not a financial adviser. Dow Theory Investment and its author does not offer recommendations or personal investment advice to any specific person for any particular purpose. Please consult your own investment adviser and do your own due diligence before making any investment decisions. Please read the full disclaimer at the bottom of the footer of this blog.

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