Saturday, April 4, 2020

Dow Theory Update for April 4th: Did Rhea really tell that secondary reactions had to last three weeks?

A study on the proper appraisal of secondary reactions as taught by Rhea

I am re-reading (for 10th, 11th time?) Rhea’s book “The Dow Theory,” and I am unearthing many gems. 

Those gems relate to the thorny issue of appraising secondary reactions. The proper ascertainment of a secondary reaction is vital. The lows of secondary reactions serve as our exit point (stop-loss) when broken down, or as an entry point (stop-buy) when its highs a broken up (always with confirmation). More about secondary reactions as stops here.
Thus, if we are too quick in determining secondary reactions, we may probably end up by having too narrow stops, which may render the Dow Theory less effective (lower profit factor). By the same token, if we are too slow in determining secondary reactions, we may probably end up being always late to the party (late entries and exits due to the excessive amount of time and/or extent required for the existence of the secondary reaction). So we are confronted with a Goldilocks situation: Neither too hot nor too cold. 

Market lore has it that Rhea’s Dow Theory requires at least three weeks of price action against the primary trend and a retracement of the preceding primary bull or bear swing between 1/3 and 2/3.

Jack Schannep, whose rendering of the Dow Theory I label as “Schannep’s Dow Theory,” was considered “heretical” by some self-appointed wardens of the Dow Theory because he dared to do three things. Several names of inquisitors come to my mind, some famous, some wannabes, all of them bad performers compared to Schannep. I’d better forget their names and let the readers guess. These are the three main features of Schannep's Dow Theory:

Firstly, Schannep shortened the time requirement for a secondary reaction (just 8 trading days as the average of 3 indices, and at least 2 calendar weeks on two indices).

Secondly, Schannep disregarded the 1/3 retracement requirement. If the rally/pullback exceeded on a confirmed basis 3%, then the extent requirement was confirmed.

Thirdly, he introduced the S&P 500 as a third index.

I’ll focus on the two alleged “variations” introduced by Schannep. Please mind the word “alleged.” As, in truth, Schannep was more faithful to Rhea than many interpreters of the Dow Theory.

I contend that a careful reading of Rhea’s book proves that Schannep’s is closer to Rhea’s than many mainstream Dow Theorists who wrongly feel they are keeping the Dow Theory deposit of knowledge intact. Readers of this blog should know that Rhea was an excellent trader with a real “bottom line” (as Schannep is). Hence, if we want to be even moderately successful in the markets, we better led Rhea’s wisdom to soak in (and also read at least five times Schannep's book "The Dow Theory for the 21st Century").

Hence, Jack Schannep and his interpretation of the Dow Theory are no “heretical” after all. Rhea, if one reads him carefully, offers many clues as to the proper determining of secondary reactions. Of course, we all would have liked Rhea to lay down his ideas in a more structured way. But good traders, trade, don’t write books. So we have to thank Rhea (and Schannep) who, besides being good traders, have left us books. Luckily enough, my writing this blog until now has not impaired my trading performance, but I must remain alert as there seems to exist a negative correlation between writing and performance. 

In a future post, I will prove two things by quoting Rhea:

  • That a secondary reaction may last less than three weeks.

  • That the famous 1/3 retracement rather than being one requirement for a secondary reaction to exist, is just an observation, once through other means, its existence has been determined. The minimum 1/3 retracement may come in handy in dubious cases. However, Rhea did appraise secondary reactions even when the retracements fell short of 1/3.

Proving that we can be more “flexible” (as Schannep is) when appraising secondary reactions is vital. It is the key to call the turns in the trend accurately. By the way, “flexible” is not tantamount to being “sloppy” or to “cut corners.” Flexible in our Dow Theory context means to be able to be attuned to the changes in trends. “Inflexible” traders (and Dow Theorists) end up calling the turns of the trend when it’s too late. One blatant example (and a good explanation on secondary reactions as per Rhea's Dow Theory) of being too late is given here. More recently (March 2020) you can find another example of being extremely late because of failing to timely pinpoint secondary reactions, as explained here.

More about Rhea, Schannep, and the proper appraisal of secondary reactions in the next post of this new “saga.”

One Dow Theorist

Saturday, March 28, 2020

Dow Theory Update for March 28th: Watch the S&P 500. If it rallied a little bit more a bull market would be signaled

 Trends unchanged for all the markets I cover


Under Schannep’s Dow Theory

The primary trend is bearish since March 9th (penetration of the lows of the current secondary reaction) or even February 25th (alternative exit based on the penetration of the lows of the previously completed secondary reaction), as explained here.

 Of course, the secondary trend is also bearish. However, since on March 9th, 2020 we had capitulation, this means that the time requirement for the appraisal of a secondary reaction gets shortened to just one week. Schannep in his letter to Subscribers of November 1st, 2008 provides a good explanation as to the shortening of the time requirement following capitulation.

Off the 03/23/2020 bottom, the three indices we monitor have rallied for 3 trading days. Hence the time requirement has not been fulfilled, and no talk of secondary reaction.

As to the extent requirement, the three indices have staged powerful rallies with clearly exceed the minimum 3% on at least two indices. The spreadsheet below displays the powerful rally.

By the way, you’ll notice that the Industrials have rallied more than 19% off the hitherto established bear market lows. The S&P 500, though, has failed to do so. Thus, we have not reached the definition of a bull market (a cyclical one, higher order than those appraised under the typical signals). Once the S&P 500 joins the parade and rallies +19% , a bull market definition will be met. More about Schannep’s bull and bear market definitions and the powerful implications of such signals here and here. By “powerful” I mean that the average “bull market” as defined by a confirmed +19% rally has very long legs. The average bull market averaged 109.6% (from top to bottom) and lasted 34.1 months. So this is no small potatoes.

Furthermore, we should recall that the capitulation indicator tends to accurately signal the end of bear markets and predicts powerful rallies. Out of 17 signals since 1962, 16 showed profit 6 months after the day of the signal. Only the one of October 7th, 2008, showed a loss six months after the signal but a gain of +6.6% after one year. The takeaway is clear: Capitulation is a powerful indicator and identifies deeply long term oversold conditions where a strong rebound is likely. Here you have the complete record of the capitulation indicator showing the subsequent gains 6 months, 1 year, 3 years and 5 years after the signal.

Thus, in spite of all the pessimism that surrounds us, if the S&P 500 manages to rally +19% off the 03/23/2020 closing lows, we would have a technically promising picture, as we’d have two simultaneous “up” waves:

a)     A bull market signal which in itself is harbinger of strong and long rallies.

b)    A bull market signal given within the context of severely long term oversold conditions (compressed spring further providing tailwind to the new bull market)

Therefore, the action of the S&P 500 is vital. It is the index to watch.

Under the Rhea/Classical Dow Theory

The primary and secondary trend turned bearish on March 9th (once again: the lows of the last completed secondary reaction violated) as explained here. As a reminder, the classical Dow Theory does not use either “capitulation” or “bull market definition of +19%”. Hence, we have to wait for a change of trend until:

a)     Either a secondary reaction develops, followed by a pullback and subsequent breakup.

b)     Or, if no secondary reaction develops, until the last primary bull market highs are broken up (which would be a horrendous and very unlikely entry).


The primary and secondary trend were signaled as bullish on 02/19/2020, as explained here

Following a sharp decline SLV penetrated its last recorded primary bear market lows on 3/12/2020. GLD declined but on a much more muted basis and did not confirm. Hence, no primary bear market signal. Rhea (page 77 of his book, Fraser Edition 1993) recognized as a valid exist point the closing lows of the last primary bear market (red horizontal lines on the charts below). GLD remains at a safe distance, and hence no primary bear market was signaled. More about the alternative entry and exit signals under the Dow Theory here.

GLD has declined for just 9 trading days. SLV (from last highs to bottom) for 17 trading day. Hence, the decline does not meet the time requirement for a secondary reaction. Since we just have two indices, I’m inclined to go quite “classical” as far as the time requirement is concerned (requiring 3 confirmed weeks). Furthermore, the rules of Schannep’s Dow Theory presuppose the existence of three indices. If I had more time (another project for my pipeline), it’d be interesting so include a third index (let’s say GDX) and apply to them the tenets of Schannep’s Dow Theory (i.e. less days in order to declare a secondary reaction). Would we get better results? I’m inclined to say “yes” provided the third index is correlated enough to the other two. This is another further area of research. From burning my eyes looking at charts using Schannep’s Dow Theory applied to US stock indices, I know that we derive more “signal” by using three than by using two. And this is why, in spite of requiring less time for a secondary reaction (the less time, the more noise and erratic movement) Schannep’s Dow Theory is more efficient (better profit factor) than the “classical” Dow Theory. If the inclusion of a third index wouldn’t add value (“signal”), trading with shorter secondary reactions should result in a worse profit factor. And this is not the case. Hence, I feel that, provided we find the right kind of “triplets” (which is not an easy feat) the tenets of Schannep’s Dow Theory could be in all likelihood successfully applied to other markets. If some futures trader is reading this post, it’d be interesting to see what’d happen if we’d used three different contract months futures and applied to them Schannep’s Dow Theory.

Here you have an updated chart:


The primary trend was signaled as bearish on March 11th, 2020, as explained here.

Following the turmoil which afflicted markets last week, SIL violated on 02/28/2020 the lows of the last completed secondary reaction, which also constitute a valid exit signal (especially under the Classical Dow Theory), unconfirmed by GDX. On March 11th, 2020 GDX confirmed, and, thus, we got a primary bear market signal. 

On 03/13/2020 both ETFs made their hitherto last primary bear market lows. From that date they have rallied (from bottom to last top) for 8 trading years, which falls short from 3 confirmed weeks. So no secondary reaction in sight, yet.

Here you have an updated chart:


Depending on the way one appraises the secondary reaction that led to the setup that resulted in the primary bull market signal, the primary bull market was signalled either on 11/19/2018 or 12/18/2018. Rhea wrote that the definition of secondary reaction is not carved in stone. The signal of 11/19/2018 was obtained by being satisfied with just 14 trading days for TLT and 15 days for IEF. The signal of 12/18/2018 was obtained by being strict and demanding on a confirmed basis at least 15 trading days on both ETFs. It’s up to each investor to decide what to do (i.e. to commit to each signal 50% of one’s equity or go fully invested with just one signal).

On 11/08/2019 as secondary reaction was signaled, as explained here.

On 02/21/2020 TLT bettered its last recorded primary bull market highs of 08/28/2019. On that date IEF equaled (but did not better) its last recorded primary bull market highs of 09/04/2019, and hence there was no confirmation. On 02/24/2020 IEF did better its primary bull market highs and, therefore, we can declare the secondary reaction has ended, and the primary bull market as reconfirmed. From the reconfirmation date of 02/24/2020 TLT and IEF went parabolic reflecting the current chaos which is plaguing all markets. From the 03/09/2020 closing highs both ETFs declined until a bottom was made on 3/18/2020. Hence, there was been just 7 days of decline, and, thus, the time requirement for a secondary reaction against the strongly bullish trend has not been met.

All in all: both the primary and secondary trend remains bullish.

Here you have an updated chart:

One Dow Theorist