Saturday, January 5, 2013

Dow Theory Special Issue: Assessing the current primary bull market signal




If you are a follower of this Dow Theory blog, you know that on January 2, a primary bull market in stocks was signaled. You can find the details here.

Well, today, I’d like to expound the intricacies of the current bull market signal.

First of all, on January 2, the new bull market was signaled. However such new bull market was on its way since the bear market lows of 11/15/2012.  In other words, the market did not turn bullish on January 2, but on 11/15/2012. As with any timing device, the Dow Theory “detects” the existence of a new bull or bear market with some lag. No timing system is able in “real time” to spot the emergence of a new trend. However, as I have previously written in this Dow Theory blog, the Dow Theory does a good job at signaling new bull and bear markets in a timely fashion. As I wrote in my post “Revisiting the 1987 crash”, which you can find here, “the Dow Theory tends to do a remarkable job at getting investors out of investments on a timely manner”. By the same token, the Dow Theory also excels at signaling new bull markets close enough to the bottom.

How much has won the SPY since its market lows of 15/11/2012?

On 15/11/2012 the SPY closed at 135.7.

On 02/01/2013, day when the primary bull market was signaled, the SPY closed at 146.06. Thus, the SPY won 7.63%.  As a result, it took a price advance of 7.63% for the Dow Theory to signal the onset of a new primary bull market. This is pretty close to the bottom.
 

Where lays the Dow Theory stop?

I have written extensively about the Dow Theory trailing stop here.
 
Our initial Dow Theory stop lies at the 15/11/2012 lows. This implies a loss of 7.63% in case the market would start to fall down in earnest without any intervening secondary reaction. Normally, this potential loss is a worst-case scenario. If the market advances and develops a secondary reaction, then our exit point will be lifted upwards.


How long is supposed this new bull market to last?

Rhea wrote in 1932 that:

“there is no known method of forecasting the extent or duration of a primary movement”

Thus, anything can happen. It may be stillborn (if the market stages a powerful decline that violates the 11/15/2012 lows), or it may last one or even two years. Nobody knows.

However, we do know that statistically, primary bull markets tend to last an average of one year or slightly more.

Within this context, it is worth bearing in mind what I wrote on January 2:

Firstly, “average” means “average." Thus, it is not expected that every Dow Theory primary market is going to match exactly the alleged “average”. Some primary markets will last longer than average (i.e. 1-2 years in bull markets; 6 months in bear markets) whereas others will last significantly less. So it is possible to see bull markets exceeding 6 years as it is possible to see bull markets fading after some few months.

Secondly, the distribution of the duration of primary markets around the average greatly varies according to the secular trend. In other words, when a secular bull market sets in (as we witnessed from the early 80s until 2000) primary bull market signals tend to last longer than average. Of course, it is not so easy “in real time” to ascertain the existence of a “secular” bull market. However, once the secular bull market is clearly over the pattern that emerges is longer than average bull markets.

Personally, I believe that we are undergoing a secular bear market since the year 2000; thus, it is not surprising to see primary bull market swings that end prematurely.

Thus, I wouldn’t be surprised to see this primary bull market suffering a premature death. However, one thing is clear to me: Even under secular bear markets and, accordingly, with greater likelihood of shorter and less profitable than average primary bull markets, the Dow Theory manages to extract profits off the market and, more importantly, keep the investor safe. I am not making this up. As you know, I’ve been strongly influenced by Schannep’s Dow Theory “flavor." Consequently, we only have to look at Schanneps’s publicized track record to see that during the current secular bear market that started in the year 2000, the Dow Theory (at least as interpreted by Schannep, who, at the same time, resembles Rhea) has managed to make over 6% annually (exclusive of dividends) whereas the SPY is basically flat.

The bottom line is: We shouldn’t outsmart the Dow Theory, and we must follow all primary bull and bear market signals irrespective of the secular condition of the market. 6% annual is quite a feat if we take into account that for most investors the last 10 years have been a lost decade. Furthermore, such remarkable out performance has been achieved with smaller draw-downs. Thus, the Dow Theory greatly improves the risk-adjusted profile of the portfolio. Please read my post “Why I like timing? Why I love the Dow Theory as a capital protector?”, which you can find here,  for a more in-depth explanation of the role played by the Dow Theory in protecting capital and improving the risk-adjusted performance.
  
Of course, assuming that one is certain and not wrong, the secular condition of the stock market serves the investor in weighing the amount of capital to be invested in the stock market. Thus, as an example, if the investor reaches the conclusion that stocks are in a secular bear market or that valuations are not compelling whereas gold is in a secular bull market, the investor can allot less capital to stocks and more to gold.

However, once a determined amount has been committed to stocks, the investor should not second-guess the Dow Theory primary bull (bear) market signals. Outperformance should come from allotting capital wisely between different asset classes (i.e. bonds, gold, and commodities) and occasionally (if one is in possession of the required skills) by selecting the stocks more likely to go up (instead of stock indices) within the framework of the Dow Theory signals.

How far is supposed this bull market to go?

Again, we have no way of knowing beforehand. However, gains averaging 30% and even 40% are not uncommon. However, we must bear in mind that we are within a secular bear market, so our primary bull market may fall short of expectations. 

Is this a “good” or a “bad” primary bull market signal?

In my opinion, a “good” primary bull market signal entails a tight Dow Theory stop. In other words, it implies that the entry signal is not too far from the last recorded lows. The tighter the stop, the higher the risk/reward ratio.

By definition, we don’t know the market's future advance. This is unknown. Thus, the “reward” side of our risk/reward equation can only be guessed. My best guess is to take the average primary bull market signal gain. Thus, we can take a reward in the vicinity of 30%. 

And what about our risk? As we know our Dow Theory stop is situated at the 11/15/2012 lows, 7.63% below the entry price. While the actual exit price is never known in advance, we know that our worst-case scenario is not likely to exceed 7.63%.

We also know that a Dow Theory stop of 7.63% is by historical standards a quite narrow stop. It is perfectly possible to see stops exceeding 10% and even 11%. It is not a narrow as the previous one we had (primary bull market signal of June 29, 2012 with a 6.25% initial Dow Theory stop which was subsequently raised as the market advanced and managed to exit the trade with a small profit) but, certainly, it is a narrow one.

Therefore, our risk/reward ratio stands at 30/7.63 = 3.93.

This is by all standards a very decent risk reward ratio. Even if the worst happens losses are likely to be contained.

In a future post, I will list all the initial Dow Theory stop losses to show that anything below 9-10% is quite a narrow stop and hence presents a good investment/trading opportunity.

Have a wonderful weekend.

Sincerely,

The Dow Theorist

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