Friday, July 19, 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 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.


The Dow Theorist

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