NEW LOW OBSERVER

The following from Richard Russell’s Dow Theory Letters is what we believe to be one of the most valuable examples of Charles Dow’s 50% Principle in action.   

“I am publishing this arithmetic chart of the D-J Industrials (high and low monthly) from M.C. Honey, Salisbury, Md. 21801. I am using an arithmetic chart because I want to show distance or ground covered by the Dow, not percentages.

“The 50% Principle states the following: After an extended advance, the termination point of the ensuing correction should be watched carefully. If the correction can halt while retaining 50% or more of the previous advance, it is a positive indication, and there is a good chance that movement will rally to test the area of the high again. Conversely, if the correction wipes out more than 50% of the previous extended advance, it is a negative indication, and there is a good chance that the movement will continue down, ultimately testing the area from which the entire advance started.

“It should be remembered that this is a theory, and although it has worked many times in the past there is nothing immutable about this theory (or observation, if you wish to call it that). Second, the 50% Principle should not be applied to short-term movements; it should only be applied to major movements lasting six months to a year or many years.

“There are two important applications of the 50% Principle which may be coming into prominence. First, referring to the chart, note that the Dow has broken the long-term trendline connecting the 1953 and 1962 bottoms. This is obviously a bearish indication, suggesting a reversal of the entire rising trend since 1949. The fact that this occurred within the framework of a primary bear markets makes the penetration of the trendline doubly significant. I do not believe, in other words, that this was a “false” penetration.

“If we measure advance, in the 1962 low of 535.76 on the Dow to the final 1966 peak of 995.15, we note that the movement carried 460 points. The halfway point of the 1962 to 1966 rise was thus 765. This means that during the 1966 and again during the most recent decline the Dow decisively broke the 50% level. The implication under the 50% Principle is that the Dow will probably test the area from which the movement began, or the 1962 area of 535. Whether this will happen remains to be seen, but at any rate that is the implication of the 50% Principle.

“The second important consideration is that the entire primary bull market covered a distance of 834 point; from the 161.60 of 1949 to 995.15 of 1966. The halfway point of the whole bull market rise is thus 578. I feel that if the Dow breaks to lower levels, it will be important to see what happens if and when 578 is approached.

“If a bottom can be formed at or above 578, particularly during a period which shows third phase characteristics, it will be a positive sign. Conversely, if 578 is decisively penetrated, I would take it as a most bearish and tragic sign. If 578 is broken decisively on the downside, my guess is that the final bottom of the bear market will arrive at an area far lower than anyone now thinks possible. (source: Russell, Richard. Dow Theory Letters. May 1, 1970. Page 3. www.dowtheoryletters.com)”

After the May 1, 1970 article by Richard Russell, the Dow Industrials had the following performance:

On December 6, 1974, the Dow Jones Industrial Average closed at 577.60.  After this point, the Dow Industrials never closed lower.  In the January 2, 1975 issue of the Dow Theory Letters, Russell said the following:

“Unless both Averages now break to new lows (Industrials below 577.60, Transports below 125.93) history will record October 3 as the bottom for the bear market (although December 6 will stand as the low day for the D-J Industrial Average alone).”

The 50% Principle is a necessary tool for all investors to gauge how much a decline is expected to run it’s course in the worst case scenario.  A conservative investor should make use of the 50% Principle as a means of determining downside risk.  With this in mind, the expectation is that at some point the stock (or index) will decline by nearly  –50%.  The 50% Principle sets the framework for how to interpret the price action from almost any prior peak.

In a roundabout way, even Charlie Munger, Warren Buffett’s long-time investment partner, considers the prospect of a decline by –50% in the following commentary:

“I think you can argue that if you’re not willing to react with equanimity to a market price decline of 50% two or three times a century you’re not fit to be a common shareholder and you deserve the mediocre result you’re going to get, compared to the people who do have the temperament who can be more philosophical about these market fluctuations.”

The 50% Principle Today

Below is the current 50% Principle for the Dow Jones Industrials Average.

While falling to 11,561.85 isn’t required, it doesn’t hurt to have a sense of the downside risk.  Additionally, as the Dow goes higher, the level for the 50% Principle will increase.  A retest of the ascending trendline should be expected at minimum.