Monday, December 8, 2014

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

Schannep's answer to my explanations and further comments thereto

 Continued from Part I and II:

This thid part contains Schannep's answer to my email (see part II) where I dissected the reading made by other Dow Theorists.
This third part only contains Schannep's answer (in blue, as he was a bull). At the end of his email I will add some comments of mine (which are brand new and are displayed in red, as I was a bear).

Dear Manuel,

   I think we can boil our different readings of the Dow Theory down to just this:

I am relying on the italicized (and therefore most important?) first paragraph in Chapter XIII (p. 75) under "Determining The Trend" which you know what it says, in brief: "higher highs and higher lows offer a bullish indication. Failure of a rally (+3%) and ensuing declines below former low points, is bearish... to determine change of a primary trend".  Your chart shows the difference:

       I realize you are depending on the follow up discussion (p77-78) that clearly says, in brief: "When declines...violate(s) the lowest points encountered during the last major secondary reaction...GENERALLY ASSUMED..the trend has changed to ....bearish".  It is immediately followed by "Occasional exceptions can be found, and it is proper that this should be true...."

       I see this as one of those occasional exceptions.  I realize you (with your trader background) are very concerned about the market falling into "the abyss below" without a stoploss in place, but the fact is there is only one instance where the market has fallen so much as to require the 16% stop loss to come into play in the history of our Dow Theory for the 21st Century (and that is, after all, a stop loss).

      I've enjoyed your dissecting of the other Dow Theorist's readings, which we are generally in agreement, so I see no need to continue with that.  I DO believe the above is the heart of the matter.  Of course you have my permission to use any part of my various responses to you in your writing up the comparison.



Schannep rightfully mentions a general rule (page 75 Rhea’s book), namely that higher highs and higher lows is bullish.

It is true that all three indices made confirmed higher highs (see chart below) on 9/18/2014 coupled with higher lows (the lows of the August secondary reaction were higher than those of the preceding secondary reaction of 02/03/2014). So, as per the general rule which Schannep mentions (page 75 Rhea’s book) we had the indication that the primary trend was bullish.

Stocks made higher confirmed highs and then plunged below the last completed (left  rectangles) secondary reaction lows

Schannep provides a graph which is based on the one I submitted to him (in black) with his views superimposed in blue, which provides us with further illustration (see above).

Schannep is keenly aware that p. 77-78 of Rhea’s book contain what I’d label the exception to the general rule. In spite of higher highs and higher lows, if the “lowest points encountered during the last major secondary reaction, it may be generally be assumed that the primary trend has changed to bearish."

Exceptions to general rules exist to precisely qualify the general rule and be mindful of reality.

Thus, we can say that “higher highs and lower lows are bullish (general rule), provided the lows of the last completed secondary reaction are not broken, in which case we may infer the trend has changed from bullish to bearish (exception to the general rule)

Schannep is also aware of this. However, Schannep rightfully stresses that the exception to the general rule, has exceptions of its own. In other words, the exceptional rule (violating the lows of the last completed secondary reaction signals a new primary bear market) is subject to qualification. It is not black and white. This is why Rhea’s says, “generally assumed” and “occasional exceptions [to the exceptional rule] can be found.”

All in all, there are exceptions to the exception rule. However, no fixed rules exist concerning the exceptions to the exception. When deciding to override the exception rule (violation of the last secondary reaction lows=primary bear market) human judgment is involved and there are not hard-and-fast  rules.

Schannep in this specific instance was of the opinion that the exception to the exception was applicable, and hence we were in one of those cases when “occasional exceptions can be found", which is tantamount to saying the primary trend continued bullish.

My judgment call was the opposite. I saw no basis to ignore the violation of the last completed secondary reaction lows and, hence, I declared a primary bear market.

So, we can conclude that both opinions were correct under a Dow Theory standpoint. Please mind that the process (the right comprehension and application of the Dow Theory) is more important that the specific outcome of the last Dow Theory signal (a winning or losing trade), as any given trade is almost akin to tossing a coin. Even a fool has good chances of being right in any one trade. Consistency of results (which results from the right application of the Dow Theory over time) is an entirely different matter.

What prompted Schannep to take a bullish stand and consider that the exception to the exception was to be applied?

What prompted me to take a bearish stand? Why I didn’t apply the exception to the exception of the rule?

This is the subject of the next post of this saga. And it is going to be vital, because you will see the thought process followed in order to apply the Dow Theory in real time under challenging conditions. However, I give you an “entrĂ©e”:  Schannep is the closest thing to having Rhea alive. In other words, Schannep is the best Dow Theorist alive (of this, I have no doubt, and the more I know him, the surer I am), and, in my opinion, he matches Rhea’s acumen and investing instincts. However, Schannep has not only intellect. He, like any Dow Theorist of to-day, has a wealth of market data (the Dow Theory track record) not available to Rhea, which enabled him, standing on the shoulder of one giant like Rhea, to make further refinements to the Dow Theory.

So, and I say this in full spirit of humility, Schannep’s “gut feeling” when it comes to applying exceptions to the exceptions, as in the current signal is not to be easily disregarded.

In the next post, and based on what I have read in Schannep’s market newsletters for the last few months, I will try to explain why I think he took a bullish stand and decided to apply the exception to the exception of the rule.

To be continued in, hopefully, the last episode of this saga.


The Dow Theorist


  1. Dear Manuel,

    Thanks very much for all that you have been writing on the Dow Theory Investment blog - I've been following you for 2 years now, with great interest!

    This discussion with Schannep is highly fascinating. Basically, I think I'm beginning to see what the issue is (at least for me!)….the attraction of the Dow Theory is that it tries to avoid the emotional/qualitative aspects to financial investment decisions.

    However, from the discussions with Schannep we seem to have arrived at a situation where he took an intuitive/gut decision that the bull market was still intact, and therefore didn't sell; whereas, you took the trading decision (with which I agree!) that it was time to sell.

    However, such an intuitive/gut decision is always going to be highly psychologically influenced……..

    I wonder whether you are like me, in that I have a fear that financial armageddon is just around the corner…..there is lots of evidence that many markets (if not all of them) are manipulated and do not reflect the true economic reality of our current times. This being the case, there is the fear that as and when reality does catch up with the stock markets, there could be a truly major collapse. Perhaps this is the psychological context we are operating in?

    In which case, you are being very cautious (like me) and wanting to introduce a tight stop-loss, so as to minimize potential terminal losses; even to the extent of adding additional (trader-like) rules to the Dow Theory to create the tighter safety net.

    However, perhaps things really are NOT different this time? Perhaps, the usual rules (e.g. conventional, or 'Schannep' style) of Dow Theory still apply? Indeed, that is what Schannep is implying…..he is prepared to still entertain the possibility of having the 16% stop-loss in place, rather than the (more reasonable?) stop-loss level you set, of the low of the earlier secondary reaction.

    Indeed, it implies that Schannep still has complete faith in his rules of Dow Theory, despite the mounting evidence of manipulation (and potential resulting financial armageddon)….basically, it implies that this time it really is NOT different! This is an important psychological state to be in, and to be aware of being in.

    Perhaps markets have always been manipulated (i.e. that is the normal state of play), and the Dow Theory rules were therefore formulated in a period where markets were always being intrinsically manipulated; and as such, the Dow Theory rules therefore automatically already take such manipulation into account, i.e. the Dow Theory already implicitly takes manipulated markets into account - it's all baked into the cake. In which case, we really are in a current situation which is NOT different from any other time!

    From that perspective, perhaps that is why Schannep was 'sanguine' to not have your tighter stop-loss, but have it at 16% below the peak, since we really are just in a conventional market situation, and he has confidence that the usual Dow Theory rules apply.

    Just a thought……but this is where our psychological outlook will certainly affect our confidence in how to interpret and apply the Dow Theory rules.

    Mike Parker

    1. You raise so many interesting points that I will answer them in a separate post. So stay tuned!

      Thx for following

  2. By the way, I forgot yesterday to include the chart depicting the "last completed secondary reaction" (rectangles on the left of the chart) and the "higher highs" (which is bullish) made in September 2014 (right side just before the orange rectangle begins). Not shown in the chart is the secondary reaction preceding the "last completed secondary reaction" which lies at a much lower level, which implies that until September stocks were making "higher highs and higher lows," which confirms the primary bull market under the "general rule" I alluded in my post. However, what happened NEXT (the violation of the last completed secondary reaction lows) is the "exception to the general rule".