Tuesday, December 4, 2012

Dow Theory special issue: Dissecting the current secondary reaction in the stock market

A secondary reaction within a primary bear market
As I promised in my yesterday’s post in this Dow Theory blog, I will provide you with additional information as to the ongoing secondary reaction.

As a recap, we know that the Dow Theory signaled a primary bear market on Nov 16. You have the details concerning such Dow Theory signal here and here.
The primary bear market lows were made on 11/15/2012 by the SPY and Industrials at 12542.38 and 135.70 respectively. The Transports bottomed next day, 11/16/2012 at 4891.27.

From that point until 11/30/2012 the SPY and the Industrials rallied to 142.15 and 13025.58. This amounts to a 4.75 % rally for the SPY and a 3.85% rally for Industrials. The Transports made their rally highs on 11/29/2012 at 5145.35 for a gain of 5.19%.

As I wrote in a previous post:

"There are three requirements that always must be met in order to qualify a movement contrary to the prevailing primary trend as a secondary correction:

1)     Firstly, it must last at least 10 trading days. This requirement has been met by the three indices I monitor (DJI, DJT and SPY).

2)     Secondly, it must at least be 3% movement. As per Dow Theory a rally or a decline to be meaningful must result in a net reversal of direction exceeding 3%.

3)     Two indices must confirm. The movement of one index unconfirmed by the other leads to deceptive conclusions.

There is a fourth requirement that comes in handy when appraising secondary reactions. A secondary reaction tends to retrace 1/3 to 2/3 of the previous primary up movement. However, this rule is to be interpreted with flexibility. If a reaction retraces just 20% of the previous primary movement, but it lasted three months, then I’d tend to label such a movement as a full secondary correction in spite of not having retraced 1/3 of the prior movement".

Therefore, if we apply the preceding rules to current market action, we can see:

1)     10 trading days elapsed between the lows of 11/15/2012 and the highs of 11/30/2012 for  the SPY and the Industrials.
2)     Both indices exceeded the minimum threshold of 3%.

Accordingly, the rally that started on 11/15/2012 must be labeled as a bullish secondary reaction against the primary bear market trend.

Here you have a chart that helps you visualize the ongoing secondary reaction (highlighted with blue rectangles). 

The rally contained in the blue rectangles qualifies as a secondary reaction under Dow Theory
What about the Transports? As we can see, the Transports only rallied for 8 days.  However, as you know if you are a follower of this blog, given that the Industrials and the SPY have rallied for a minimum of 10 days, we may safely declare the market as undergoing a secondary reaction. Confirmation merely means two indices confirming, not three.

Let’s have a look at the retracements from the latest highs. The retracements are measured taking into account the percentage “lost” from the latest highs (09/14/2012 for the SPY and 10/05/2012 for the Industrials) to the latest lows (primary bear market lows 11/15/2012) and the percentage “retraced” or gained since such lows until the rally highs of 11/30/2012.

SPY: ca. 55% retracement of the prior bear market swing.
Industrials: ca. 46% retracement of the prior bear market swing.

So roughly ½ of the previous primary bear market decline has been recovered. This is fully in line with the typical retracement of a secondary reaction.

So, we can safely conclude that the stock market is undergoing a secondary reaction. If this secondary reaction is followed by a new decline (in at least one index) exceeding 3% (which seems likely according to today’s market action), and such decline is followed by a new upward thrust jointly breaking the 11/30/2012 highs, then we would have a new primary bull market signal.

If, conversely, the markets fail to break the 11/30/2012 secondary reaction highs and violate the 11/15/2012 primary bear market lows, then the primary bear market will be reconfirmed.

I’d like to finish this post by stressing that the issue of appraising secondary reactions is a tricky one. For those of you willing to learn more about them, I suggest you read my post in this Dow Theory blog “A primer on secondary reactions under Dow Theory” which you can read here.


The Dow Theorist

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