Tuesday, November 25, 2014

Dow Theory Special Issue: Schannep and I brainstorming about the last Dow Theory signal (II)

Part II: dissecting the readings of the market made by other Dow Theorists. 

 Continued from Part I:


This second part is a continuation of my email to Schannep. Here I dissect the reading made by other Dow Theorists. Some of them saw (as I did but maybe for the wrong reasons) a primary bear market signal, while others didn't. One can learn a lot by analysing what other Dow Theory practitioners have made. Since I was a bear, I display my email to Schannep in red.


Bearing this in mind, let’s dissect this link:

1) I see he seems to be a Rhea Dow Theorist. Accordingly, he insists that the 33% retracement was not accomplished.

2) Furthermore, I think he is only considering the ongoing retracement; unless I get him wrong, he is not considering the “last completed preceding” secondary reaction. Furthermore, even if he attempted to gauge the “last completed preceding” secondary reaction, he would not find any in the August-September time span, since as per Rhea, no secondary reaction would have existed (but YES under Schannep’s rules). So according to him, the current decline should retrace 33% of the advance since 2012 (because in a convoluted way, he seems to imply that the last secondary correction as per Rhea occurred in 2012). And a 33% retracement wouldn’t be the bear market signal, but merely the setup….

3) From clicking in one of the links he provides (

 , he clearly is miles apart from you. He disregards the existence of “buy” and “sell” signals and seems to suggest to add to long positions during secondary reactions (hoping that the primary trend will reassert itself) and not selling immediately when a primary bear market signal has been issued but instead waiting for the subsequent rally (if any, since 1/3 of signals as you report are falling knives, and some preliminary research of my own seems to confirm that the amount you “save” by waiting out for a rally is more than lost when that rally fails to materialize:  Ergo, cut your losses short and don’t let a small loss to turn into a big loss) . With all due respect to this gentleman, what he says (and I feel misreads Rhea) is a sure way to lose money in spades.

 Firstly, buying, as he suggests when after a declared primary bull market, a secondary reaction ensues (or selling into strength when the first rally after the primary bear market signal has occurred), means:

a) I cannot have a meaningful stop loss (namely, the last primary bear market lows when I “buy” the first primary bull market signal. If I don’t have a reference level to get out I am lost.

b) Trends tend to persist (even secondary ones), one never knows if it is the first leg of the primary bear market instead of a correction.

c) Waiting out for the first correction in many instances means buying at higher levels than the first primary bull market signal. In roughly 2/3 of the time, a primary bull market signal will be followed by a pullback which might offer a better entry point, but, alas, 1/3 of the time stocks will go to the moon, and one will be left stranded.  Once again, research (which I have to deepen and maybe your team could deepen as it is very important to debunk myths) seems to suggest that the first primary bull market signal is to be taken, and our exit point would be at the last recorded primary bear market low. Here the greatness of your rules comes in handy: Since your flavor is very reactive, the stop loss (confirmed violation of the last recorded primary bear market lows) tends to be a mere 5-7% below the entry price, since you spot secondary bullish reactions against the primary bear market whereas Rhea’s rules fail to do so. Of course, if we were to follow Rhea, this would not be the case (our exit point level could easily be 15% below the entry price). 

All in all, with all due respect, this gentleman is miles away from you and me. I would NOT invest one single dollar following his concept of secondary reaction or the slanted reading he makes of Rhea.

 All in all: No wonder he does not see a primary bear market yet: he even doesn’t see a secondary reaction since 2012….And he is not to blame: this is what happens when ignoring Schannep's improvements to the Dow Theory.

As to the Dow Theory Forecasts:

I see they disregard page 77 of Rhea’s book. They are fixated in the development of the current secondary reaction and the subsequent rally to set up markets for a primary bear market signal. My contention is that the last completed secondary reaction remains a valid exit point until we get the setup of the ongoing secondary reaction completed.  This is ignored by the Dow Theorist Forecasts.

Let’s dissect another link (favorable to my interpretation) :

He makes the valid point of keeping an eye on the last relevant lows, and this time, by chance, he’s been right. However, not the violation of any low, albeit significant serves to signal a primary bear market signal: It must be the lows of the ongoing secondary reaction (after the rally) or absent this set up, the lows of the last completed secondary reaction.  So they are right, but lack precision.

Same applies to this link:

He is right, but lacks a deeper explanation.

I don’t purport to pontificate, since we are not dealing with absolutes. However, and irrespective of the outcome of the current signal, I feel that more reasons advocate in favor of keeping the last completed secondary reaction lows as a valid stop (absent a tighter “normal” setup). This is especially true for Rhea’s Dow Theorists since they don’t have the -16% Schannep’s stop loss and secondary reactions are a rarer event than under Schannep’s rules.

Please don’t take me wrong. I consider you my mentor, as your book (and your newsletters) changed the way I see markets. Not even Rhea was able to accomplish this feat. However, as you rightly note, the Dow Theory offers leeway for several interpretations. I think what we have been discussing can be enlightening for other people to read and if you don’t object I’d like to post an edited version on my blog.

Nonetheless, I will re-read Rhea and Hamilton.

Looking forward to hearing from you.

All the best (really),

Manuel  Blay

P.S. Below graph which may serve to visualize what I mean.

Upper graph: lows of last completed secondary reaction violated. Lower graph "usual" Dow Theory signal.

to be continued