Tuesday, December 9, 2014

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

 Comments to the comment posted by Mike Parker

An avid reader of this Dow Theory blog, Mike Parker, raised very interesting points concerning the last Dow Theory signal “saga”  which you can read here:

and here:

In the lines that follow I will include his comment (in black) whereas my answers are displayed in red. I feel that more can be learned from a free exchange of ideas than by merely reading my unilateraly written posts. I hope it provides further clarification to an issue (the last Dow theory signal) which I find is vital for the long term survival (please mind, "long term", not such any given trade) of investors.

Without further ado, I give you Mike and your blogger truly yours:

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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!  Thx.

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. It depends on the “flavor."  If you follow Rhea’s or Schannep’s flavor it tends to be quite objective (“rule-based”). On the other hand, if you follow Schaefer’s flavor (which invests along the secular trend, not the “cyclical” one) you must make subjective judgment calls (and qualitative ones) every now and then. More about the Dow Theory “flavors” here.

However, even Rhea’s and Schannep’s “flavors” allow for some measure of discretion too. As we have recently seen, the “exception to the general rule” (which itself is rule-based, non-emotional, namely “if the lows of the last completed secondary reaction are jointly broken, then a primary bear market has been signaled”), permits exceptions, which are not rule-based when saying, “generally assumed” or “occasional exceptions can be found."

Thus, the exception to the exception is not rule-based and leaves the door open to a judgment call, which hopefully will not be emotional. In the next post, I will give the reasons that prompted Schannep to stick to the bull market thesis, whereas I decided to take the exception to the general rule (violation of the last completed secondary reaction lows= primary bear market) to the letter.

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.

We both followed strictly Rhea. The difference lies in interpreting the exception to the exception to the rule (which is subject to a judgment call). Schannep decided that it was time to override the exception to the rule based on Rhea’s “occasional exceptions can be found," whereas I thought it was not time for such “occasional exceptions."

Of course, both Schannep and I had to follow our instincts or gut feeling (and here is where Schannep is not to be taken lightly) when deciding whether such a “occasional exception” was to be applied.

However, such an intuitive/gut decision is always going to be highly psychologically influenced……..Yes. Even though both Schannep and I militate in the technical camp (read his book or follow his newsletters if you have any doubt about it), deep, very deep inside him, he is fundamentally more secular bullish than I. While I profess to be the “neutral” “objective” Dow Theorist who derides fundamental analysis, I have my opinions about the economy (which may not be necessarily true, as I shed more confidence to technical analysis than on my own opinions).

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. Yes, I agree. Manipulation is rampant. However, when making this statement I am slipping into the fundamental, judgmental camp, something I really fear (we have met the enemy, and it is us). On the other hand, I don’t care whether this market is manipulated or not. Manipulation simply means that demand for stocks is present. I don’t care whether the Fed gobbles up all stocks or whether it is private investors. The key is that demand outstrips supply, and prices go up. Of course, I am not meaning that I am impervious to the deleterious effects it has on the economy, since in the fundamental camp, I tend (not in all aspects) to follow the Austrians (and their theory of misallocation of capital). However, being relatively well versed in Austrian economics makes me realize that neither von Mises, nor Rothbard made any fortune, and, hence, while trying not to be a moron and being interested in economics, I try that such knowledge doesn’t cloud my judgment when it comes to investing. 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. I agree 100%. Furthermore, according to the Austrians, an enormous amount of capital has been destroyed due to misallocation. So when  Willy coyote realizes, there is the risk of a big, big fall. However, timing is everything.  Will it occur tomorrow? In hundred years? Will free energy be discovered and save the day? Will a macro war destroy many countries but leave unscathed the US (thereby lifting US stocks up)?  I only know that I don’t know.  The Roman Empire took centuries to die. So I am very respectful of technical trends.. Perhaps this is the psychological context we are operating in? Yes.

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. I did not add any rule to the Dow Theory. I just applied the “exception to the general rule” contained in pages 77-78 of Rhea’s book (Fraser Edition). What is true is that the fundamental fears I share with you made me very cautious in interpreting whether it was time to override such an exception, as Schannep did..

However, perhaps things really are NOT different this time? I fear so: in real time the world always seems to be going under (even though, maybe this time…) Perhaps, the usual rules (e.g. conventional, or 'Schannep' style) of Dow Theory still apply? I firmly believe they always apply: demand is demand, be it from manipulation or genuine investors. Furthermore, the market knows more than us. Markets humbled me many times over. 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. Schannep’s stoploss, while not strict Dow Theory, is a well-researched stoploss (more about it here). My stoploss was a strict application of Rhea’s Dow Theory.

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)…so have I. .basically, it implies that this time it really is NOT different! It may be or it may be not, the Dow Theory will let us know. 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 To a greater or lesser extent markets have always been manipulated. Charles Dow wrote profusely about this. ; 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. I think so, and it seems Charles Dow, Hamilton and Rhea thought so too. In which case, we really are in a current situation which is NOT different from any other time! What you and I fear is a sudden collapse à la 1929 of the stock market due to our fundamental fears. However, while nobody can make forwards assurances, the Dow Theory always managed to keep investors out of stocks during the great bear markets (2008-2009 being the last clear instance). This post and this post are just appetizers. The bottom line is: if the Dow Theory doesn’t get us out stocks timely, nothing will do.

Furthermore, if you use Schannep’s Dow Theory (which “detects” secondary reactions much quicker than Rhea’s Dow Theory), and you always use the rule I used (lows of the last completed secondary reaction jointly violated=primary bear market), it is very unlikely that a crash will find you unawares. Only a sudden overnight gap exceeding -16% with no subsequent rebound would inflict damage to your stock investments (which would also affect all other market timers, buy and holders, etc.).  In the next post, I will further elaborate this vital insight, since this is, by far, the main reason that made me stick to Rhea’s rule and not apply “the exception to the exception to the rule”, which is tantamount to ignoring the violation of the lows of the last completed secondary reaction.

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. With full respect for Schannep, I find that his ignoring Rhea’s exception to the general rule (lows of the last completed secondary reaction jointly violated=primary bear market) may result in 10 successful trades, and one devastating loss. This is the same as in short term trading. If I trade with ample stops, I will avoid whipsaws and I will improve performance until……….the big loss occurs (maybe after many years). Short term traders know of what I am talking about.

Schannep made a judgment call and decided based on Rhea’s dictum “occasional exceptions can be found” to ignore a signal that was screaming at any Dow Theorist that really knows his trade. The fact of disregarding such a signal is fully correct (this is why Rhea opened the door for such judgment call). Thus, my tighter stoploss was fully in accordance with the Dow Theory. So was Schannep’s judgment call. The only difference is that I do fear being right 10 times and devastatingly wrong one time.

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. I agree. If I were deep inside me fundamentaly bullish, I would have thought like Schannep and would have decided that this was the time, based on Rhea, to disregard the primary bear market signal...or maybe not..:=)

Mike Parker


More is coming in the, hopefully, last post of this saga. 

The Dow Theorist 

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