If you are a follower of this Dow Theory blog, you know that on July 18, a
primary bull market in stocks was signaled. You can find the details here.
And here you have the vital
chart:
 |
| On July18, the Transports broke up the last recorded closing highs. A new primary bull market was signaled. |
Well, today, we’ll dig deeper, and explore the implications for the
investor of this new primary bull market signal.
First of all, let’s clarify our premises.
Followers of this Dow Theory blog are well aware that my Dow Theory
“flavor” is heavily influenced by Schannep. You can read more about Schannep here and here.
Thus, according to Schannep’s Dow Theory we were in a primary bear market.
On July 18, a primary bull market was announced as per Schannep’s rules.
However, under the “Rhea/Classical” Dow Theory, the primary bull market was
never interrupted by a primary bear market. It is even doubtful whether the
pullback we witnessed from the end of May until recently may even qualify as a
secondary reaction under the strictest reading of the classical Dow Theory.
Thus, the breaking up of the last recorded closing highs (of May), merely
re-confirms the primary bull market under the classical Dow Theory.
Therefore, when I announce that a primary bull market was signaled on July
18, readers should understand that this is true under Schannep’s Dow Theory. Under
the classical Dow Theory, the primary bull market has been merely re-confirmed,
which, in itself, is a bullish accomplishment as well.
Of course, one thing is clear: Both the “Rhea/classical”, and Schannep’s
Dow Theory are in sync, and signal the existence of a primary bull market. This
in itself is also bullish.
Some critics might object:
“Once again Schannep’s flavor is too
restive. The old Dow Theory by flashing fewer signals tends to be better
aligned with the real trend of the market."
Well, I am bound to report that such reasoning is not correct, and I hope
to prove it soon with the second post of the saga “Face off: Schannep versus“classical” Dow Theory”. My studies
have proven me that Schannep’s Dow Theory does a better job at separating the
wheat from the chaff (real trend form noise), and, more importantly, at
minimizing drawdowns. In doubt, stay out! And this is precisely where Schannep’s
Dow Theory excels to protect investors. Real investors have learned to respect
the market, and to abhor drawdowns. I rather prefer to lose occasionally a
couple of points due to a premature exit, and subsequent reentry at a slightly
higher price level, than overstaying the market and one day getting killed by a
drawdown. My experience and hard numbers show that what is won 10 times by
overstaying the market (i.e. with the classical Dow Theory or, God forbid!,
with buy and hold) is later lost when a monster bear market hits. This is why Schannep’s
Dow Theory manages to outperform the classical Dow Theory both in return and
risk. Please mind that I am not demeaning the classical Dow Theory, as it is in
itself an excellent timing device. I am merely comparing a Porsche Carrera with
an excellent BMW Series 3. Both are superb cars.
How much has won the SPY since its market lows of 06/24/2013?
On 06/24/2013 the SPY closed at 157.06.
On 07/18/2013, day when the primary bull market
was signaled, the SPY closed at 168.87. Thus, the SPY won 7.52%. As a result, it took a price advance of 7.52%
for the Dow Theory to signal the onset of a new primary bull market.
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 06/24/2013
lows. This implies a loss of 7.52% 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 06/24/2013 lows), or it may last one or even
two years. Nobody knows.
However, we do know that statistically, primary
bull markets under Schannep’s flavor tend to last an average of one year or
slightly more. Under the classical DowTheory, bull markets tend to last an
average of two years. Thus, the current “Schannep” signal is not at odds with
the ongoing primary bull market signal under the “Rhea/classical Dow
Theory." Please bear in mind that the classical Dow Theory flashed a
primary bull market on January 18, 2013, as was reported here on this
Dow Theory blog. Accordingly, under the classical Dow Theory, we are dealing
with a young bull market. Thus, statistically, there is no significant headwind
(i.e. an old bull market under the classical Dow Theory) against the new
primary bull market signal signaled by Schannep's Dow Theory.
Since I consider the secular trend of the market as bearish (more about the
bearishness of the secular trend here),
which is kind of “secular” headwind, I’d be tempted to say that the odds favor
a shorter life-span. My research shows that primary bull markets tend to be shorter
lived (but still profitable) when they occur in the midst of a secular bear
market. However, determining whether the market is in a secular bear or bull
market is not an easy feat, as it requires “fundamental” thinking (i.e. gauging
values), and one can be proven wrong. Ex
post facto is very easy to spot secular bull and bear markets on the chart;
in real time, it is quite another thing.
After such caveats, if we believe that we are under the spell of a secular
bear market, my research of Schannep’s Dow Theory signals shows an average
duration of 283 days (ca. 0.77 years). Therefore, secular
bear markets matter.
What I wrote on January 5, 2013, remains fully valid:
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. The
average gain made by each signal when following Schannep amounts to 22.07%
(no distinction between secular bull and bear markets). However, we must bear
in mind that we are within a secular bear market, so our primary bull market
may fall short of expectations. My research shows that Schannep’s signals
average ca. 5.46% during secular bear markets.
Such averages include winners and losers, as they
are the “average gain." However, if we focus on the winners (after all, if
it is a loser, we roughly know our stoploss), we know that the average
winner is 33.42% (no regard to secular market condition), and 19.01%
during secular bear markets.
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. Loss containment is vital. 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% (33.42% to be
exact).
And what about our risk? We know our Dow Theory
stop is situated at the 06/24/2013 lows, 7.52% 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 7.52%.
We also know that a Dow Theory stop of 7.52% is
by historical standards a quite narrow stop. It is perfectly possible to see
stops exceeding 10% and even 11%.
Armed with all this wealth of data, we can try to
calculate the risk-reward ratio. We have
a roughly known denominator (risk at 7.52%), and some guesses as to the
numerator (the reward). Let’s do the math:
Therefore, our risk/reward ratio stands at
30/7.52 = 3.98.
This is by all standards a good risk reward
ratio. Even if the worst happens losses are likely to be contained.
What are the odds for the
current trade to be a winner?
Again we don’t know. If we guide ourselves by the empirical record, we know
that ca. 71.85% of Schannep’s Dow Theory “buy” signals ended up in profits. If
we zero in on secular bear markets, 65% of “buy” signals ended up in profits
(which, once again, proves that one should take all signals irrespective of the
secular market condition, as our worst-case scenario, our stoploss, is equally
contained during secular bear markets). So, we just have to close our eyes,
and, full of aprioristic and empirical knowledge, confide in our trustworthy
and venerable Dow Theory.
Have a wonderful weekend.
Sincerely,
The Dow Theorist
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