Dow Theory special issue: Introducing Schannep's stoploss for the stock market

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 21^st 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