Tuesday, July 23, 2013

Dow Theory Special Issue: Dissecting GLD and SLV secondary reaction

Yesterday, this Dow Theory blog voiced the existence of a secondary reaction for GLD and SLV, which means that the secondary trend has turned bullish.

Here you have the relevant chart. The blue rectangles highlight the ongoing secondary reaction against the primary bearish trend.

Blue rectangles show ongoing secondary reaction against primary bear market for SLV and GLD
We have to put things into context. On July 11, the secondary trend of GDX and SIL, the gold and silver miners ETF turned bullish as well. This “multi confirmation” is a bullish sign, albeit it lacks the magnitude to label the primary trend as bullish. It merely says that the odds favor further ascending prices in the days ahead (but not in the months ahead, true to the character of a secondary reaction). Thus, until the Dow Theory patterns defining a primary bull market are complied with (i.e. secondary reaction, pullback and breakup of the secondary reaction highs), the primary trend remains bearish. No allowance for wishful thinking.

It is good to remember that on April 29, the Dow Theory signaled a secondary reaction, which failed miserably, and subsequently, on May 15, the last recorded primary bear market lows were violated and, accordingly, the primary bear market was reconfirmed.

All in all, a secondary reaction is no substitute for the real thing, which is a primary bull market. Until a primary bull market signal is flashed by the Dow Theory, we will wait patiently.

However, secondary reactions are important as they constitute part of the set up for a primary bull market signal. Once a secondary reaction has been established, there are only three possible outcomes:

1.  The last recording closing lows (06/27/2013) are violated, and hence the primary bear market is reconfirmed, and with it, the secondary reaction gets extinguished.  

2.     A pullback follows, and subsequently, the secondary reaction highs are broken up (primary bull market signal).

3.    In the absence of a qualifying pullback, the secondary reaction highs of 04/29 (SLV) and 04/30 (GLD) get broken up (primary bull market alternative signal).

As you can see from the chart, SLV and GDX have been rallying for the last 16 trading days. Thus, the time requirement of a minimum of 10 trading or even calendar days has been met.

When dealing with stock indices, for a rally to be meaningful, the Dow Theory demands a minimum of a 3% in at least two indices. However, since we are dealing with GLD and SLV (quite a different beast), we have to adjust the minimum rally threshold to reflect the greater daily volatility of gold and silver. If we’d satisfy ourselves with a mere 3% rally, we would get lots of false signals given GLD and, especially, SIL larger volatility. It’d be like just demanding a 1% for the SPY or the Industrials. Noise would overwhelm signal.

So let’s measure first the percentage gained in this rally by GLD and SLV.


Pctg made

SLV has rallied 10.50% off the 06/27 lows, and GLD bounced 11.12%.

Let’s see whether such move is significant. To this end, we calculate the ratio of SPY’s volatility (30-day days standard deviation of close) with GLD’s and SLV’s volatility.

volt adjust

volt adjust

Min rally
Min rally

Thus, we can see that GLD’s volatility is 2.069 times larger than SPY’s, and SLV’s volatility is 3.27 times larger than SPY’s. If we apply this multiplier to the 3% minimum move for stock indices, we obtain a minimum rally of 6.20% for GLD, and 9.82% for SLV.

Accordingly, GLD’s and SLV’s rally of 11.12% and 10.50% do qualify as a meaningful rally according to the Dow Theory.

Given that both the time (more than10 trading days) and extent (more than 10.5% for GLD, and 9.82% for SLV) requirements have been met, we label rally that originated on 06/27/2013 as a secondary reaction against the primary bearish trend.

If at least either GLD or SLV undergoes a pullback exceeding 6.20% for GLD, and 9.82% for SLV (the volatility adjusted equivalent of 3% for the SPY), and after such a pullback both precious metals break above the secondary reaction highs (upper boundary of the rectangle), a primary bull market would be signaled. However, don’t forget, as it happened in the past, that if the rally fizzles, and both precious metals violate the last recorded primary bear market lows (06/27/2013), the secondary reaction would be declared dead, and the primary bear market would be reconfirmed for the nth time. So, once again, I will exert lots of patience, as good old Charles Dow counseled to investors.

So, now we relax and observe together GLD and SLV in the days ahead. Maybe a primary bull market will be signaled, maybe not…


The Dow Theorist

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