After the dust hast settled: Commentary to the Dow Theory primary bear market signal

 Its implications for investors

As I announced earlier today on this Dow Theory blog, today a primary bear market has been signaled. Those really interested in understanding the intricacies of this primary bear market signal, and the setup that preceded it, are encouraged to go here (for today’s description of the primary bear market signal), here (to know why yesterday I was reluctant to declare a primary bull market), and here (to know the basics of the technical Dow Theory setup).

These are the implications for investors:

Those following the Dow Theory would have been long stocks (for non professionals I advocate to keep it simple, and buy the SPY), since the primary bull market signal of January 2, 2013, which you can find here.

 Here you have the chart that depicts the action of the three indices I monitor in the last few weeks. It says it all.

A primary bear market has been signaled

How did followers of the Dow Theory fare?

The entry point was 146.06

The exit point was today’s close at 159.07

Thus, the SPY has made 8.91% since the primary bull market was announced (dividends, slippage and commissions not included) on January 2, 2013. If we bear in mind that this percentage gain has been made in less than 6 months, it is quite remarkable.

So the last primary bull market signal clearly belongs to the 70% of successful signals (those signals that end up in profits).

The position taken in pursuance of the Dow Theory signal lasted 170 days, this is slightly less than 6 months.

Since this blogger truly yours follows Schannep’s Dow Theory “flavor” (more on this “flavor” here and here), 170 days is significantly less than the average transaction duration at 639 days for winning trades. However, averages are misleading, as this figure is the average of winning transactions irrespective of the secular condition of the market. Trades last significantly less when there is a secular bear market. While classifying secular bull and bear markets is always subjective, there are some guidelines like “q” “PER” or dividend yield, which may come in handy. In a nutshell, secular bull markets start when stocks are very good values. While determining value is always elusive (and this accounts for my being interested in cyclical bull and bear markets with an average duration of less than 2 years), we need a frame of reference. Personally, I am skeptical as to PER and dividend yield for reasons to be explained in a future post on this Dow Theory blog. However, having read, and, more importantly, digested, Smithers and Wright book “Valuing Wall Street” (which you can buy here), I personally feel that the “q” ratio a quite dependable measure of the cheapness or dearness of a market on a secular basis.

 

Financial writer Doug Short, whom I respect, has recently updated the “q” ratio as you can read here. According to him “q” is currently overvalued, which implies that it is likely that we are still mired in the secular bear market that began in year 2000.

If we are under the spell of a secular bear market, we should look at the average trade during bear markets. According to my calculations, transactions taken in pursuance of Schannep’s Dow Theory during secular bear markets lasted on average 283 days, which is significantly less than the average duration figure regardless of the secular condition of the market.

Thus, the current transaction lasted slightly less than the average trade during secular bear markets. 170 days versus an average of 283 days.

The astute mind should be asking:

 “What about the duration of transaction taken during secular bear markets according to the “classical” Dow Theory? 

The answer is: Trades taken according to the “classical” Dow Theory last significantly longer, even during secular bear markets the average duration stands at 436 days.

Thus, we can sum up as follows:

Average Trade duration during bear markets

Classical: 1.19 years (436 days)

Schannep:     0.7 years (283 days)

Some people I have in mind would immediately jump on Schannep and say: 

“You see…transactions following Schannep's Dow Theory last too short, as the “classical'” Dow Theory signals last significantly longer. This proves Schannep’s Dow Theory is not so effective"

Well, this is very bad analysis. Very bad and superficial analysis, indeed.

During secular bear markets the “gravitational force” intensifies, the market is prone to false breakouts, and even successful cyclical bull markets tend to be smaller in extent (and time, as there is a direct correlation between profits and duration of the trade). Under these adverse circumstances overstaying the market is not advisable. The investor should be ready to leave as soon as there is any hint of danger. This is why transactions taken as per Schannep’s Dow Theory flavor last less during secular bear markets. We are ready to turn on a dime.

Furthermore, the duration of each transaction is not so important, what really matters is how much money we make. So now let’s look at the average gain following each Dow Theory “flavor”:

Average gain made in each transaction during secular bear markets.

Classical: 6.52%

Schannep: 5.46%

Now the crowd gets more vociferous against Schannep:

“You see, your trades last too short, you don’t give your trades enough time to build profits. Can't you see that the classical Dow Theory has a larger average profit!”

Well, once again wrong, plain wrong, since we have to look at the total number of transactions during bear markets. From 1954 to 2013 there have been the following number of transactions:

Total number of transactions during secular bear markets:

Classical: 13

Schannep: 20

Thus, Schannep’s Dow Theory, signaled more buy and sell signals than the classical Dow Theory during secular bear markets. This is neutral. It rests to be seen whether so much “activity” was noise or resulted in more profits to the investor than the less restive classical Dow Theory.

To this end, we have to look at the total percentage points gained during secular bear markets by each Dow Theory “flavor”:

Total percentage points gained during secular bear markets:

Classical: 84.77

Schannep: 109.10

So, surprise, surprise! Schannep’s Dow Theory manages to extract more profits from the market during secular bear markets. This implies that:

a)  Schannep’s Dow Theory is much more effective during secular bear markets than the “Rhea/Classical” Dow Theory in determining when to get “in” and, more importantly, when to get “out”. If market conditions do not warrant a long strong trend, so be it; Schannep’s Dow Theory will not be remiss in terminating a trade, even if this means a shorter average trend duration than the classical Dow Theory.

So by being more attuned to market conditions, Schannep’s Dow Theory flavor managed to make more money for investors during secular bear markets. Schannep’s made 28.7% more profits than the “Rhea/classical” Dow Theory during such fateful periods.

b)     If we divide the average percentage made in each transaction by the total average time, we see that Schannep’s Dow Theory, in spite of trades that last on average 35% less than "classical" ones, manages to “extract” from the market more money per time unit. If we divide the average trade by the average duration of each trade, we can see the average profit extracted from the market each day. Let’s do the math:

Classical:

6.52% (Avg Trade) /436.54 (Avg time) = 0.01493687% per day.

Schannep:

5.46% (Avg Trade) /283.45 (Avg time) = 0.01924533 % per day.

Thus, Schannep’s Dow Theory manages to make 28.86% more than the classical Dow Theory on average per day.

Therefore, we can conclude:

1.   Schannep’s Dow Theory tends to produce shorter transactions during secular bear markets because it is better attuned to prevailing market conditions.

2.    Shorter transactions are compensated by more frequency. This is the proper response to challenging market conditions. Any trader worth his salt knows that the weaker the trends, the more the trader is in need of shortening the investment time horizon. 

3.   The efficiency of Schannep’s Dow Theory is proven by being able to extract more money during bear markets both on an average daily basis, and for the sum of all percentages gained during secular bear markets. 

4.    If we put a figure to Schannep’s outperformance during secular bear markets, we can say that his “timing” is almost 29% more effective than the “Rhea/Classical Dow Theory." Not bad, if we take into account that the “Rhea/Classical Dow Theory is excellent in its own right.

Just a final note to my analysis of Schannep’s outperformance over the “Rhea/classical” Dow Theory during secular bear markets. The total time spent on the market by the “classical” Dow Theory amounts to 5675  days. Schannep’s total time amounts to 5669 days. Thus both Dow Theory “flavors” spent and strikingly similar, almost exact, amount of time on the market. Given that Schannep’s Dow Theory could  make 29% more during the time invested in the market, it is clear that it was niftier in selecting when to be “in” and when to be “out."

Thus, the current  8.91% gain made by the SPY is well beyond the average gain made by any Dow Theory flavor during secular bear markets. No reason to complain.

Let’s move on to another aspect:

How much has lost the SPY since its market highs of 05/21/2013 at 167.17?

Here is the answer: -4.84%.

I feel few timing systems can beat the Dow Theory when it comes at being responsive. A loss from the top of just -4.84% implies excellent timing for a system designed to trade cyclical bull and bear markets. Please bear in mind that official lore says that a bear market is signaled when stocks have gone down by 20%.

So I think that, once again, the Dow Theory has done a remarkable good job at “letting profits run", and, more importantly, "cutting losses short."

How long is supposed this new primary bear 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 rally off these lows as happened on mid November 2012) or it may last one or even two years. Nobody knows.

What we do know, however, is that being invested in stocks when a primary bear market has been signaled will more likely result in losses than in gains. The empirical record of all signals since +115 years attests to this. Whatever the Dow Theory “flavor” of your fancy, it is not advisable to be long when a primary bear market sets in.

We do know something, though. While we do not know how long this bear market is going to last, we know from past experience that primary bear markets last on average 6.2 months after the primary bear market signal has been flashed. We, investors, are indebted to Schannep for his research on this matter, which is freely available under on his website “thedowtheory.com”.

If you go to the link I gave you, you will see that a bear market may last as little as a few days or more than 20 months. In any instance, don’t argue with the bear and get out of the way.

How deep is supposed a bear market to go?

Again we have no way of knowing beforehand. But if history is to serve us as a guide, Schannep states that the average decline after the primary bear market signal averages 14.8%. But don’t get fooled by averages, a bear market can entail losses exceeding 30, 40 and even 50%. So again, my piece of advice is: Don’t argue with the bear!

Should I short the market?

No. A future post on this Dow Theory blog, will show you with hard figures why it is not advisable, once you factor in shorting fees and dividends that you have to pay when being short.

Only skilful short term traders who know their trade (pun intended), could attempt well timed shorts. The rest of mortals are advised to leave this market alone.

What should an investor do?

As it is written in the disclaimer at the footer of this blog and the additional disclaimer I post on specific important posts, I am not a financial advisor, and I am not engaged in advising people. This blog merely serves an intellectual pursuit and hopes to get people thinking about the market.

Personally, my line of thought is as follows:

·        For medium and long term positions (i.e. anything lasting more than a few days) I would be out of stocks completely. No questions asked. 

·     The position to be is cash or very short term debt. However, I would be mindful of the balance sheet of the bank in order not to be cyprused. 

·       I would have very short term US and German debt, and would be mindful of the legal fine print to be sure that I am the real owner and not a mere creditor of a financial institution.

·        As to paper gold and silver and their miners, followers of this blog now that we are in a primary bear market. So don’t touch them until the primary trend turns bullish.

·        I’d have, though, a healthy measure of physical gold, as explained here. Physical gold has optionality in case there is a reset. 

·        And I would be very patient, under the current circumstances with bonds also falling out of bed. Cash and very short term debt shouldn’t burn a hole in our pockets. 

 

  - Those that are able to extract profits off the market with short term trading may continue trading stocks (being long) provided: (a) they know what they do, (b) have predefined stops and exits and (c) if possible adjust their strategy settings to a primary bear market condition (i.e. by demanding less powerful rallies when selling into strength).

Conclusions:

·     In spite of today’s primary bear market signal, those invested under Dow Theory have managed to make a healthy profit nearing 9% in less than 6 months.

·     The Dow Theory, again, has been able to keep losses short.

·     A bear market has been signaled at less than 5% off the market top. This is certainly excellent timing.

·     All medium and long term investors should at the very least sell down or get out completely of stocks.

Have a wonderful weekend.

Sincerely,

The Dow Theorist.

Disclaimer: Dow Theory Investment and its author is not a financial adviser. Dow Theory Investment and its author does not offer recommendations or personal investment advice to any specific person for any particular purpose. Please consult your own investment adviser and do your own due diligence before making any investment decisions. Please read the full disclaimer at the bottom of the footer of this blog.