We anticipated last week that our market trend signal for the NASDAQ would turn down and that occurred on Friday when the index suffered its second successive distribution day.

Although the major indexes all closed higher for the week, the markets are rattled by doubts that the European bailout will solve the Euro-zone's problems in the long term, multiple investigations by Federal agencies and and NY State of the major Wall Street firms and disappointing forecasts from tech. leader CISCO and graphics chip supplier NVIDIA. While the domestic economic situation continues to improve, with better than expected retail sales and industrial production reports for April, there are real and justified fears that the recovery will continue to be slow and is threatened by the European situation and increasing levels of debt both there and at home.

Two links on Barry Ritholz's blog caught our attention today. If you have time over the weekend, have a look at these links - they will not cheer you up, but they do represent a sanguine view of the challenges facing the US and Europe.

Nassim Taleb on the mini-Crash

Victor Sperandeo on the European Bailout:

click for audio

New Backtest Data shows Importance of Letting Winners Run and Cutting Losses

We know this to be true, but how often do we fail to do it because we lack the discipline to enforce it?

At the request of a subscriber, we have added a 'Target Gain %' to our CwH Strategy Backtest tool and as we shall see, it clearly shows that letting winners run while employing a rigid stop loss strategy pays off handsomely.

Firstly, we recall that we have previously shown (Factors Affecting Performance After Breakout) that the most successful breakouts from a cup-with-handle pattern have these characteristics:

• minimum RS Rank of 92
• CEF2 and CEF3 values of at least 0.6 (these metrics measure recent earnings)
• minimum breakout day volume of three times average volume
• other factors such as industry rank, rank in industry and other fundamentals are of little significance.

We have also found (Newsletter 3/12/10) that the money management technique of selling if the stock falls by 8% from the breakout price and taking profits with a trailing stop of 13%, optimizes returns when backtested over the last 5 years).

Our new parameter allows us to determine the optimum target percentage gain.

Using our previously determined values we ran the backtest for target gains of 10 - 75% with a portfolio size of four stocks. Here are the results:

So we see that the optimum target gain is 25%. If we take profits then we free-up cash to buy our next potential winner. If we hang on for a bigger profit, we are either going to get taken out of the position by our trailing stop for less than our 25% gain, or we are missing an opportunity to make a more profitable trade.

Here are the screen shots for the simulation. You can try it yourself at http://www.breakoutwatch.com/Mike/cwhStrategyTest.php