Dow Theory special issue: Is the primary trend for stocks about to change?

As I promised in my previous post on this Dow Theory blog, let’s analyze the current juncture of the stock market, since, as per my interpretation of the Dow Theory, we have the perfect set up for a primary bear market signal. There is only one last shoe left to drop; namely, the Transports breaking its 09/28/2012 lows.

 

I think it is best to show a chart and comment on it. Below you can see a chart comprising 09/14/2012 (blue arrows on the left) and Friday’s Nov 9 close. Almost two months of price action.

The entrails of a Dow Theory primary bear market signal setup under Dow Theory

 

Let’s review what happened during this period.

On 09/14/2012 the SPY and the Industrials recorded jointly higher highs. For the SPY and Industrials such highs were the highest highs since June 4, when the primary bull market got started. This is what we can label as a primary bull market swing.

From 09/14/2012 to 09/26/2012 the SPY and the Industrials retraced some of its previous advance. However, such pullback was irrelevant under Dow Theory since it didn’t reach 3%.

On 10/24/2012 both the SPY and the Industrials made new lows in a new pullback. Such new pullback exceeded 3% in both indices. Thus, a secondary reaction was officially established. Actually, it would have been only necessary than either the SPY or the Industrials underwent a pullback exceeding 3% since the Transports had already had their own >3% pullback on 09/28/2012. However, to validate further the existence of a secondary reaction, all indices agreed as to having a pullback from their highs exceeding 3%.

On the other hand, the Transports did undergo a pullback exceeding 3%. Since the bull market was signaled (June 29^th) the latest recorded highs of the Transports were made on 07/05/201 at 5249.12. Their lows were made 09/28/2012 at 4892.62 the Transports retraced 6.79%. This is a meaningful movement under Dow Theory. Such Transports lows were later confirmed (10/24/2012)

According to the Dow Theory, the setup for a primary bear market signal requires that a rally exceeding 3% follows the pullback.

The Transports underwent such a +3% rally until 11/07/2012 when they reached 5203.64. The Industrials and the SPY didn’t rally by more than 3% after 10/24/2012 lows.

The setup for a bear market signal was thus completed.

Inquisitive minds should ask: What about the principle of confirmation for the rally that follows the pullback? Isn’t it necessary to have at least in two indices such +3% rally? Since only the Transports underwent such a +3% rally no valid setup exists since confirmation is lacking?

My answer is: You are not misguided, and I wouldn’t brand you as inaccurate if you demanded confirmation (at least two rallies exceeding 3%). Furthermore, when using three indices most of the times one sees two rallies exceeding 3%.

However, Rhea wrote that the principle of confirmation becomes more important the longer the time frame. In other words, a primary bull market signal is meaningless without confirmation. The same basically applies to secondary reactions. However, when it comes to rallies (or small pullbacks in bear markets) which I would label “tertiary movement," some Dow Theorists are lukewarm with the principle of confirmation.

Here are two quotes from Hamilton (contained in Rhea’s master book “The Dow Theory”) which are illustrative:

“…Dow’s theory….stipulates for a confirmation of one average by the other. This constantly occurs at the inceptions of a primary movement, but is anything but consistently present when the market turns for a secondary swing”

“This illustration serves to emphasize the fact that while the two averages may vary in strength they will not materially vary in direction, especially in a major movement. Throughout all the years in which both averages have been kept this rule has proved entirely dependable. It is not only true of the major swings of the market but it is approximately true of the secondary reactions and rallies. It would not be true of the daily fluctuation (…)”

So from the two quotes we can deduct that a rally may be considered in itself without requiring confirmation. While this is not carved in stone and confirmation is always welcome, when we talk of a tertiary movement, we can be a little less demanding with the principle of confirmation. Please mind that one of the quotes even questions the inflexible application of the principle of confirmation to secondary reactions. As far as I know contemporary Dow Theorists like Russell, and Schannep have not gone that far and require confirmation for secondary reactions. So do I.

However, Schannep has done away with the requirement of confirmation when it comes to the rally that follows the secondary reaction in a bull market (same reversed in a bear market). Bearing in mind the preceding quotes, I don’t find anything irregular in it. However, those followers of the Dow Theory that also demand confirmation even for such rallies are not wrong either. Both interpretations may be fully reconciled with the Dow Theory.

Personally, I tend to follow Schannep quite closely and hence, I feel satisfied with just one rally after a secondary reaction has been established (which requires at least two indices going down by more than 3%).

The only aspect where I part ways with Schannep and make my own “Dow Theory” flavor is when it comes to the indices necessary to break the last secondary reaction lows. Schannep does not require the index that underwent the rally to see their secondary reaction lows violated. In other words, in our current situation, a primary bear market signal has been already flashed according to Schannep because the 10/24/2012 lows of the SPY, and the Industrials were broken on 11/07/2012 in spite of the lack of a +3% rally in the SPY and Industrials. The rally underwent by the Transports served to “set up” the primary bear market signal and the price action of the SPY and Industrials alone sufficed to declare a new bear market.

However, my personal interpretation of the Dow Theory is that I require that one of the lows to be broken must belong to the index that underwent the previous rally. This is, in my opinion, the rationale for demanding a +3% rally in the first place.  In our present case, I require the Transports to violate their lowest reaction lows (09/28/2012). Until such lows are not broken, I am reluctant to declare a primary bear market even though the Industrials and SPY have broken their 10/24/2012 secondary reaction lows.

I express the same idea otherwise. Accepting a third index is a variation of the basic Dow Theory with which I agree. More on this in my post “Do the Transports still matter under Dow Theory?” which you can find here.

However, I am keenly aware that accepting a third index (and especially a third one like the SPY that shows a strong correlation with the Industrials) will result in a Dow Theory flavor more prone to flashing signals. I can live with that provided each index completes by itself all the necessary requirements for a signal to be given. In other words, if currently the Transports are the only index that experienced a +3% rally off the secondary reaction lows, the pattern of violating the last secondary reaction lows should be fulfilled by the same Transports, not by the SPY and/or Industrials, even if they confirmed each other (as they did on Nov 7), because, neither the SPY nor the Transports underwent such a +3% rally.

Furthermore, if it is not demanded that the secondary lows to be violated have been, at least in the one index, preceded by a minimum 3% rally, we run the risk of being clouded by noise. This is exactly what happened to the SPY and Industrials which, after their 10/24/2012 lows didn’t even manage to stage a 1.5% rally. Of course, it was easy to penetrate such lows.

What I feel reluctant to accept, and I feel might be a bit of overstretch of the Dow Theory is to simultaneously:

1.      Do away with the principle of confirmation for rallies following secondary reaction lows.

2.      Accept three indices (which increases the odds of a signal as we have just seen on Nov 7).

3.      Accept that the violation of lows be made by an index other than the one that underwent the rally.

I can live with points 1 and 2 (and even welcome them because it makes the Dow Theory more responsive). However, accepting point 3 (together with points 1 and 2) is too much for me.

The truth is that Dow Theory is not math. I don’t like to make the pretense that I know everything. It is good to see how I/we react to the market in real time without the benefit of hindsight.

Thus, I still believe we are in a primary bull market. However, I am keenly aware that we are approaching the “danger zone." Go back to the chart and look at the red horizontal line on the Transports’’ chart (in the middle, blue colored chart). If the red line (secondary reaction lows) is broken, then without any doubt and in spite of only one qualifying rally, I’ll proclaim that a new primary bear market has been signaled. No appeals. No questions asked.

Moreover, I’d like to make the following considerations. While these considerations do not qualify what I have previously written, namely that, in my opinion, no primary bear market signal has been flashed yet, they are important in helping us assess the odds of the demise of the primary bull market.

1.      The primary bull market is not old yet. It has been going on for ca. 5 months (since June 4). I would equate such a market with a 40 years-old  man. While he may die, the odds don’t favor it. This is a plus.

2.      The secondary reaction has been going on for almost 2 months. Since the previous primary bull swing lasted ca. 3 months and 2 weeks (from June 4 to September 14), the secondary reaction is getting old in terms of time. It either is the first primary leg of a new bear market or if just a secondary reaction, it is getting old and should finish soon.

3.      The secondary reaction has retraced ca. 48% of the previous primary bull swing. This is an “average” secondary reaction. Neither too small nor too big. 

4.      Nonetheless, the SPY has traded for two consecutive days below its 200 days simple moving average. This is a clear minus. 

5.      Another clear minus: As I wrote in this Dow Theory blog on Nov 8 (here you have the link) the Gold /Industrials ratio has turned bullish in favor of gold. While not necessarily bearish for stocks (they may go up but less than gold), it certainly suggests that the place to be overweight is precious metals and not stocks.

6.      Even if the worst happens, I feel it is likely for the investor to escape almost unscathed. In spite of the declines witnessed, until now (which are fully “average”), a position in the SPY would show an unrealized gain of 1.51%. The Transports setup for a primary bear market signal makes it likely that, even if the worst happens, losses will be minimal.

Well, now you have food for thought.

Have a wonderful weekend.

Sincerely,

The Dow Theorist.