Thursday, October 11, 2012

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

What do we do with the Transports?


Yesterday this Dow Theory blog announced the inception of secondary reaction. You can read more about it here.

Today, as you know if you read the previous post in this Dow Theory blog, the Industrials closed down for the day, while the SPY closed up. So after the violation of the lows of the “line” the total decline amounts to 2.76% for the SPY and 2.13% for the Industrials.

Had this tiny movement not been preceded by a “line," I would discard it as irrelevant and maintain that the secondary trend remains bullish. As you know, one of the tenets of the Dow Theory is that for a movement to be taken into account it must exceed the 3% threshold. Thus, movements not even attaining this level go undetected under the radar.

However, the only exception to this rule is when two indices have formed a line, and such line has been broken. In such case, the downward rupture of the line denotes a secondary bear movement. This is why, in spite of the meager movement, I reluctantly qualify the current secondary trend as bearish.

Many inquisitive minds are wondering if this “correction” is the enough for latecomers to jump aboard. In my post “What should I do if I missed the Dow Theory bull signals for the SPY and GLD? Dow Theory’s second chance: The first secondary reaction” which you can and should read here, I wrote that:

“We know that secondary reactions are likely to retrace from 1/3 to 2/3 of the previous advance. We know that, until now, both markets have gained more than 12% since the inception of their respective bull markets. So a secondary reaction bringing down the gains to, i.e. 6% wouldn’t be uncommon (this would be a 50% reaction). But, what happens if prices go down by 6%? Then, provided the primary bull market doesn’t end up in a fizzle; you have just found your second sweet entry spot. You would have at your disposal the same entry prices that were available on June 29 (SPY) and August 22 (GLD).”

Bearing the preceding considerations in mind, I feel that a mere 2.76% decline for the SPY and 2.13% for the Industrials is not enough for the latecomer to enter now. And I say this for three reasons:

1.      With such a meager decline, your risk reward is still quite defective. Please re-read the post I linked above to understand well what I mean.

2.      As of today, the stop-loss is still fixed at the June 4 lows, hence your likely loss would be 11.91% (this is the percentage loss from today’s SPY close to the June 4 lows).

3.      There are better alternatives (in risk reward ratio terms) like the Transports.

Consequently, for those interested in buying the DIA or SPY, I’d wait it out a little longer. The study of past secondary reactions shows us that at the very least they tend to correct 4-5% or put it another way, at the very least 20% of the previous primary upswing  movement should be erased. We are far from reaching these levels right now. So patience is required.

This is where the Transports come into play. As you know, yesterday I asked you whether my suggestion to buy the Transports was ill-timed or not. Here you have the answer.

The primary trend continues bullish and there is no indication of change. Hence, the odds favor buying anything since the upside has more likelihood than the downside long term (i.e. one year). Furthermore, if in this instance, the Dow Theory is proven wrong, nothing happens as the stop-loss for the Transports (determined after the Dow Theory) stands very close to current price level. So no catastrophic loss in case of a sudden reversal.

So my suggestion to buy the Transports (IYT) remains fully valid. Furthermore, as I have been writing in several posts in this Dow Theory blog, the Transports are at a sweet juncture, since

1) they are becoming stronger,
2) but they are not overbought yet.
3) they have more upside than the SPY and DIA, since they have just begun to budge.
4) and technically there is a very tight (but technically effective) stop-loss which increases the risk reward of the trade/investment.

Of course, you should read what I wrote in my post “What should I do if I missed the Dow Theory bull signals for the SPY? Dow Theory’s second chance: The Transports” which you can find here before making any commitment.

Given that we are in a secondary reaction, the odds favor a continuation thereof in the coming days (although nothing is carved in stone. I repeat: we are dealing with odds). So for those not already “in," a possible solution to ponder is:

1.      Case number one: The market turns weaker.

You do nothing right now. You wait until at least 5-6% of the primary swing has been corrected. Once this level is attained, then the SPY (or the DIA) becomes again attractive. At that market level, you close your eyes and buy the SPY or even a mix of 50% SPY and 50% IYT (Transports), given that the Transports offer more significant gain potential.

2.      Case number two: The secondary reaction is short lived.

In such case, you can turn your lemon (not being able to buy the SPY) into a lemonade by buying the Transports. As you know, the safest price level under Dow Theory to buy the Transports is when they break above the 09/14/2012 highs at 5215.9. If this correction is short lived, the most likely outcome is for the Transports to better the 09/14/2012 highs. At such level you still have a pretty narrow stop plus the added benefit of having both the primary and secondary trend as tailwind.

The Dow Theory is not stupid because even if you buy at a slightly higher price (the 09/14/2012 Transports highs), the trend is statistically more dependable after the breakout has occurred than before. This is why good traders recommend buying strength. The beauty of the Dow Theory lies in helping us find the technically proper “strength," as not all “strengths” are equal (and hence the whipsaws many breakout traders have to endure). If you compare the average batting rate of 30% of a normal breakout system with ca. 70% correct market calls of the Dow Theory (which essentially is buying breakouts) you will realize the effectiveness of the Dow theory. All these aspects will be further developed in future posts as they are vital to show the intrinsic power of the Dow Theory.

So when you put all the things together, I continue to believe that the Transports are the best play unless the secondary reaction advances further to suggest a 50% or 100% investment in the SPY or DIA.

Now comes the following question:

When I suggest buying the Transports (IYT) or the SPY am I only meaning buying them or am I also meaning buying individual stocks?

The answer: Tomorrow.

Think it over.


The Dow Theorist


  1. yikes, another cliffhanger! And I was all set to buy NSC in the morning!

    So if there's already an uptick in the Transports, are we able to extrapolate an approximate length of time (weeks vs. months) til the Industrials and SPY tick up too? or are their timeframes completely independent of one another?
    also, are there signals that will tell us when the secondary reaction is winding down, and we're resuming a bullish intermediate trend?

    I'd also be curious at some point to see the Dow Theory as applied to 2011--on which dates the signals occurred, etc.

    thanks in advance for answering all of my questions! it's really interesting stuff!

    1. Hi Kolpin,

      One of the tenets of the Dow Theory is that the extent and length of movements (be they “primary” or “secondary”) cannot be predicted in advance.

      We can only deal with odds (i.e. that primary bull market signals tend to be profitable 70% of the time), but we cannot predict their duration, extent or profits resulting therefrom.

      A post will come on secondary reactions. There are some clues (i.e. volume), but again, we are dealing with odds. Furthermore, as investors we shouldn’t get too obsessed with predicting the end of secondary reactions. They are only useful in helping us establish reference points (i.e. stops) when investing along the primary trend. Trading secondary is a losing proposition for most investors. More on this in a future post.

      As to 2011, those following the “Schannep” flavor of the Dow Theory fared quite well in spite of the tremendous volatility. Thus, on August 2, the Dow Theory flashed a sell signal (primary bear market signaled). While the full record is in the subscribers' area, I can tell you that those following the Dow Theory were most of the time (one cannot be “all” of the time by definition) on the right side of the market. However, the Dow Theory is not to be measured in such short time frames. In any given year anything can happen. One has to look at least in five year time horizon and then the big picture begins to emerge: Much lower drawdowns and higher returns,