Wednesday, August 6, 2014

Dow Theory Update for August 5 (II): Looking deeper at the secondary reaction in stocks

Trends for precious metals unchanged

Yesterday, I warned that if stocks closed below their August 1st closing lows a secondary reaction would be signaled.

Well, stocks did violate their August 1st lows, and accordingly, a secondary reaction has been signaled according to the Dow Theory (Schannep’s version)

Here you have the chart that says it all:

A secondary reaction has been signaled
The red arrows (highlighted by ellipses) display the latest recorded closing highs. From that point, the three indices that we monitor (The Industrials, Transports and the SPY) have declined by more than 3%, and as I explained yesterday, the time requirement has, likewise, been fulfilled.

We really don’t know how much will the secondary reaction last. Furthermore, this is none of our businesses. Our business is to spot changes of the primary trend. Of course, I could tell you that secondary reactions tended to last from a mere two weeks (in which case, this one would be nearing its end) to several months (in which case, more declines without intervening rallies exceeding at least 3% in one index are in sight). However, resorting to past statistical records in order to look smart and forecast the likely duration of the secondary reaction is a very “iffy” business. I insist we don’t need to make such a forecast, as it is immaterial to our determining changes of the primary trend of the market. Furthermore, I am very skeptical as to the predictive power of past statistics. I just prefer to rely exclusively on market action (the primary trend).

What I see on the daily and weekly charts is that volume seems to favor more bearish action for the next few days (please mind “few days”). More in detail: daily charts seem to imply that the next few days (let’s say 4-5) will be bearish, but we could see a small rebound in the next 1-2 days. Volume on weekly charts, tell me that the odds favor 1-2 more weeks of bearish action. However, take volume reading with a healthy dose of skepticism (as I do), since:

a) At best, volume marginally increases the accuracy of your technical readings based on price. In other words, if your trading system has a profit factor of 1.4, volume may result in improving your profit factor to 1.5. Several tests of mine show that volume tends to increase the accuracy of price-based technical signals. However, volume is no panacea or substitute for price action, and many times over volume is wrong (as well as price-based technical signals are).

b) The Dow Theory does not (and should not) use volume to gauge the primary trend of the market. It is good enough without volume, so there is no need to tamper with it (and make it more complicated). Furthermore, there are so little buy and sell signals that you cannot afford the risk of missing one buy signal on the dicey assumption that volume is not supportive. Volume for long term trades may be useful for those trend followers not using the Dow Theory and which have the luxury of being able to choose (and discard) many alternative buy/sell signals in a universe of stocks. However, the primary bull/bear market signals issued by market indices themselves should not be altered by volume considerations. In other words, you use the Dow Theory (without volume) to determine the primary trend of the market. If you don’t buy indices and, instead, you buy specific stocks based on the “green” light given by the Dow Theory, you may be clever, if you discard specific stocks because volume is bearish. The same applies to buying the specific stocks that show good relative strength. Please re-read this paragraph as it contains two good ideas that add several percentage points performance on top of the Dow Theory's outstanding out performance.

So what to do now?

The primary trend remains bullish. Furthermore, as I explain below, the current primary bull market has survived three secondary reactions. So we still don’t know what the market has in store for us. We should remember that one of the tenets of the Dow Theory is that the primary trend remains in force until reversed. This has not happened yet.

According to the Dow Theory (Schannep’s), at least one index should rally by more than 3% to set up the markets for a primary bear market signal. So we have to wait for such a rally to occur.

The SPY, Industrials and Transports closed down.

The primary trend remains bullish, as explained here, and more in-depth here

The primary trend was reconfirmed as bullish on October 17th, 2013, and November 13th, 2013 and March 7th, 2014, for the reasons given here, here and here.

So the current primary bull market signal has survived three secondary reactions.

The secondary trend is bearish, as explained today and here.

Gold and Silver

SLV closed, and GLD closed down. For the reasons I explained here, and more recently here the primary trend remains bearish.

For the primary trend to turn bullish, SLV and GLD should jointly break above the secondary (bullish) reaction highs. As a reminder, the secondary reaction closing highs were made on August 27th, 2013. From such highs the market declined without jointly violating the June 27th, 2013 primary bear market lows.

Here I analyzed the primary bear market signal given on December 20, 2012. The primary trend was reconfirmed bearish, as explained here. The secondary trend is bullish (secondary reaction against the primary bearish trend), as explained here.

On a statistical basis the primary bear market for GLD and SLV is getting old. More than one year since the bear market signal was flashed has elapsed. However, I am extremely skeptical as to the predictive power of statistics. I prefer price action to guide me, and the Dow Theory tells me that the primary trend remains bearish until reversed. However, the secondary bullish reaction against such old primary bear market is also getting quite old. Tie. 

Furthermore, the June 27, 2013 lows remain untouched. The longer this situation lasts, the higher the odds that something might be changing. But I wait for the verdict of price action.

As to the gold and silver miners ETFs, SIL closed down, and GDX closed up.

On July 11th, I alerted the followers of this Dow Theory blog that SIL and GDX were close to signaling a primary bull market. Go to the relevant post and chart here. On July 22nd, I explained that the signal did not materialize yet, as you can read here. As of this writing, things have not changed. SIL and GDX have failed to signal the primary bull market, but likewise have refused to break down. They remain caught in a trading range.

Please mind that a setup is not the real thing. So the primary trend has not turned bullish yet (or maybe “never”).

The secondary trend is bullish, as explained here. In spite of short term bullish accomplishments, SIL and GDX are not in a primary bull market.

The primary trend for SIL and GDX remains, nonetheless, bearish, as was profusely explained here and here.

The Dow Theorist


  1. You are 100% correct here! I use an index ETF strategy for the bulk of my investment funds, and I augment it with individual stocks, chosen on a price/volume relative strength basis. While the latter tends to follow the former, they are not based on the same signals. But when the market moves against holding stocks (as now) I will reduce stock holdings and hedge the remaining by selling short term slightly out of the money calls. If the stock is called away I don't mind as I have booked a profit, and if not it provides a downside hedge (the call premium). Your blog is an essential read in executing this strategy so thanks much!

  2. Hi Lukey,

    How long is your average holding period?

    Take care