Wednesday, September 3, 2014

Dow Theory Update for September 3: Transports made higher closing highs (yesterday) and confirm the SPY

Did the primary bull market get reconfirmed?

Today’s post focuses exclusively on the US stocks. No news on the precious metals front today, as trends remain unchanged.

Yesterday, the Transports bettered their July 23rd, 2014 closing highs and, accordingly they have confirmed the SPY, which exceeded its July 24th, 2014 closing highs on August 20th, 2014.

So if my count doesn’t fail me, it took nine trading days for the Transports to confirm. I would have liked an earlier confirmation, as the longer it takes, the more dubious its character. Furthermore, today, September 3rd, the Transports closed down.

As per my Dow Theory interpretation, it is not necessary for another index (in this case the Industrials) to confirm. With just two indices exceeding their previous primary bull market closing highs is enough. However, to be honest, this is “my” interpretation of the Dow Theory, which is akin to my personal “flavor." As you well know I am an ardent follower of Schannep’s Dow Theory, and I have profusely documented its advantage over the “Rhea/classical” Dow Theory.

However, when it comes to deciding when to put an end to the ongoing secondary reaction and decide that the primary bull market has been re-confirmed, I slightly diverge from strict Schannep’s Dow Theory. As per Schannep (while this is not so explicitly explained in his book, but rather through the day-to-day application of his Dow Theory to actual market action which subscribers to his excellent timing service can follow), we cannot declare the primary bull market as reconfirmed until the three indices we monitor break up to new closing highs. So Schannep does away with the principle that just 2 indices suffice to provide confirmation in this specific instance. He is of the opinion that confirming a primary bull market requires more decisive market action and hence the three indices should confirm. Furthermore, he is well aware that some big past declines were preceded by just two indices breaking to new primary market highs.

Thus, as per Schannep’s Dow Theory, the primary bull market has not been reconfirmed, as the Industrials remain below their July 16th, 2014 closing high. This also implies that we cannot start looking for the next secondary reaction.

To depart from Schannep is not an easy task for me giving my deep understanding of his improving of the classical Dow Theory and his net superiority. Thus, I'd better provide my readers with a seasoned explanation that justifies my own small departure.

What is the difference for practical purposes between declaring the primary bull market re-confirmed and the secondary reaction finished (because two indices confirmed higher highs) or declare that the primary bull market has not been reconfirmed yet and, hence, no new secondary reaction is to be appraised from the current highs?

Well, for practical purposes there is little difference. Even if the lack of triple confirmation would entail a monster bear market in the making.

Since neither Schannep, nor I, advocate for a “fresh” entry when the primary bull market gets reconfirmed, reconfirmation plays no role in deciding to enter a trade. Thus, I am not advocating taking a long position at this stage of the game.

The only difference is that by being “earlier” than Schannep, I am already monitoring the development of a new secondary reaction from the current highs (since for me, the last secondary reaction has been declared finished by the higher highs). This means that if a new secondary reaction develops from these higher highs, it is likely that the resulting new secondary reaction low would lie at a higher level than the current one. All in all, we would have a tighter Dow Theory stop and being risk averse, I think this is not a bad thing. More about the Dow Theory trailing stop here.

What if the new secondary reaction refuses to put its lows at a higher level than the last recorded secondary reaction? Wouldn’t this mean that we risk a higher loss? No. Because, in such a case, the last secondary reaction lows continue working as a valid stop loss. Rhea explained this in his book (page 77, “The Dow Theory, Fraser Edition 1993) when he explained that the last recorded secondary reaction lows followed by higher highs continues being an alternative stop loss when the market collapses without developing a new secondary reaction. I quote Rhea:

“When declines in a primary bull market result in violating the lowest points encountered during the last major secondary reaction of that market, it may generally be assumed that the primary trend has changed from bullish to bearish”

Thus, there are three Dow Theory stop losses:

            1) The “typical” secondary reaction lows.

2) The last secondary reaction lows prior to the market making  higher highs and suddenly collapsing without developing a new secondary reaction.

3) During the first swing of a new primary bull market (which hasn’t developed the first primary reaction yet), the primary bear market lows.

Furthermore, if it is true (and it is) that the lack of triple confirmation heralded in some instances (not all, please mind) precipitous declines in the past, then my appraising a new secondary reaction from the current (or future) higher price levels, which may result in a higher Dow trailing stop, is a sensible course of action, as any trader worth its salt knows. My interpretation of the Dow Theory results in allowing the market to dictate a tighter stop or, at worst, to stay with the current one. So when the likelihood for a reversal increases, my interpretation opens the door (if the market co-operates) for a narrower stop.  

All in all, we have little to lose by declaring that the primary bull market has been re-confirmed, since:

1) We do not initiate a new position.

2) We have not changed our Dow Theory trailing stop, which continues fixed at the last recorded secondary reaction lows, and, hence our stop coincides with Schannep’s.

3) We can, however, have a tighter stop in the future, should a new secondary reaction develop from the current (or future) highs, which puts its lows at a higher level than the last recorded one.

Of course, I would have more faith in the current primary bull market if we had had “triple” confirmation. But, I insist, our sticking to the current long position does not depend on considering the primary bull market reconfirmed or not. We will be “out” when the secondary reaction lows get violated, and this is not changed either by strict Schannep’s rules or my more flexible interpretation (which I find is strict enough, as I require “double” confirmation, which is one of the tenets of the Dow Theory and most of Schannep's work).

Here you have an updated chart:

It is a bull market....after all!
As you can see both the SPY, and Transports managed to break above the blue horizontal line which represents the previously last recorded primary bull market closing high. 


The Dow Theorist

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