Monday, February 2, 2015

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

As you know I have been writing about the last DowTheory signal in four posts.

The essence of those posts was analyzing the friendly discrepancy between Dow Theorist Schannep (of “”) and I when evaluating what for me constituted a primary bear market signal. Schannep was of the opinion that no primary bear market signal had been signaled.

The friendly discussion that followed is important for several reasons:

1)     It is a privilege to have the best Dow Theorist alive in order to discuss with him practical issues pertaining to the application in real time of the Dow Theory. Alas, we cannot do this with Rhea anymore. So I am very fortunate, and so are readers of this Dow Theory blog by implication.

2)     As Rhea wrote, the closing chapter of the Dow Theory has to be written yet. The more market experience we gain, the more useful it becomes. So many aspects of the Dow Theory are susceptible of being further clarified with the passing of time.

3)     Schannep’s Dow Theory, while being very close to Rhea’s, has some quirks of its own, which may result in interpreting some of Rhea’s rules (like my last market call) in a different fashion. More about this at the end of this post and in a future post.

4)     The brainstorming between Schannep and I prompted me to further cogitate the nuances that differentiate Rhea’s Dow Theory and Schannep’s. The result is threefold: (a) I have gained even more confidence in the absolute superiority of the Dow Theory (be it Rhea’s or Schannep); (b) I am further reassured of Schannep’s superiority over Rhea (which is not Rhea’s fault, as Rhea was writing in the nineties thirties without the benefit of many years of market action), (c) I have gained many insights about how the pros and cons of differing from Schannep when it comes to interpreting the Dow Theory.

You can find the hitherto four chapters of the saga here:



and here:

So, let’s get started with this closing chapter.

Let’s recap the origin of our friendly discrepancy.

On October 10, 2014, the Industrials, Transports and SPY broke below the closing lows of the last completed secondary reaction. See chart below. So, even though, stocks were undergoing a new secondary reaction, no setup for a “classical” primary bear market signal had occurred yet, as the then ongoing decline had not been interrupted by a +3% rally. As I documented in my post, according to Rhea, there is an “alternative” primary bear market signal, namely the closing lows of the last secondary reaction (that is the preceding one, the last completed one).

Even though, Rhea wrote that there are exceptions to the rule (so a judgment call must be made on each specific instance), I saw no grounds to make an exception, as, on a general basis, exceptions are to be interpreted restrictively.

If you are really intend in grasping the subleties of this post, I encourage you to read all the posts whose hyperlinks have been given above. My best efforts are no subsitute for your own toil. Your reward will be inmense as all the things that are being written on this Dow Theory blog cannot be found in any investment book.

Lows of last completed secondary reaction (left orange) followed by red horizontal line were violated

Schannep, while acknowledging Rhea’s alternative signal (the lows of the last, completed, secondary reaction) said that he preferred in this specific instance to derogate from the rule.

One of the reasons he gave, was that stocks had recently made higher confirmed closing highs, which, as per Rhea, is a bullish indication. However, higher highs, while bullish per se do not negate Rhea’s alternative primary bear market rule: violation of the lows of the last completed secondary reaction. Thus, higher highs merely helped Schannep to make a judgment call and apply the exception to the rule.

From reading Schannep’s monthly newsletters, I think that some factors not pertaining to the Dow Theory helped him tilt his judgment in the direction of ignoring the lows of the last completed secondary reaction. Please mind that what follows is just my "feeling" and does not necessarily represent Schannep's opinion.

Which external factors did Schannep use in order to ignore Rhea’s rule and apply the exception thereto?

Well, in past newsletters, Schannep has established by different methods some price targets (which have not been reached yet, but we are getting close). Schannep is very aware that price targets, no matter how intelligently calculated, are no substitute for price action and hence he is willing to reverse his bullish stance if the Dow Theory and his timing indicator tell him that the trend has changed.

However, his price targets, served him to interpret Rhea’s rule (the lows of the last secondary reaction) in a restrictive manner and hence, apply the exception (allowed by Rhea) to the very rule, which implies disregarding the violation of the lows of the last completed secondary reaction.

I've written that Rhea’s Dow Theory is mostly ruled based. However, the specific rule which says that an alternative way of signaling a primary bear market is by violating the lowest points encountered during the last major secondary reaction of the market, is subject to exceptions, as Rhea himself wrote that “occasional exceptions can be found”.

How to decide when to apply the “occasional exception”? Well, Schannep has a very clear view of likely price targets, and in October 2014 such targets were not reached yet. Thus, I feel that Schannep decided to ignore the alternative primary bear market signal. He had the right to do so, as Rhea himself allowed for “occasional” exceptions.

Furthermore, Schannep is bullish on the economy based on leading indicators. I know this is “fundamentally-based” thinking, but such fundamentally-based thinking may be useful when deciding whether or not to apply the “occasional exception."

Successful investing is an art. The Dow Theory is the best toolset we can use to determine the primary trend. I am convinced that even a mediocre investor, not being gifted with market instincts, can be a reasonably successful investor by merely letting the Dow Theory rules soak in and applying them with discipline.

However, we must bear in mind that the best Dow Theorists have an innate talent to discern the proper time to “modulate” or make exceptions to the rule. What puts Rhea (and I feel history will judge Schannep in a similar way) in a different league, is their ability to detect the times for “occasional” exceptions.

Having read most of Schannep’s work I know this is not the first time he makes an educated guess and departs from (or at least questions) a strict application of the rules. Subscribers to his service should re-read his November 2007 newsletter. Its name says it all “a real dichotomy”. In real time, when confronted with a difficult market juncture, Schannep shows that he is not an automaton.

As to me, the following reasons (which may be wrong) prevented me from applying the “ocassional exception”:

1)     I am not so bullish on the economy. I see many, many clouds on the horizon (or rather, I’d say that we are already surrounded by clouds).

2)     While I acknowledge Schannep’s ingenuity when it comes to calculating targets for the current cyclical bull market, I am very skeptical as to any price objective. I believe (and Schannep is aware of it) what Rhea said: “neither the duration nor the extent” of a price move can be known in advance. I always say that I prefer sheer market action to guide me (rather than consideration of being the bull/bear market old or over extended according to historical standards). Why? Because the underlying fundamentals change. What if this time the US goes into high inflation? Wouldn’t this bull market last longer? Wouldn’t price targets be exceeded? What if deflation holds the upper hand? Wouldn’t such price targets never be attained?

3)     The violation of the last “significant” lows is a major tenet for good technicians in order to declare a change of trend. I am reading a master piece written in 1935 “Profits in the Stock Market” by H.M. Gartley. The author was keenly aware of the significance of such lows. So it is not just a casual observation made by Rhea.

Rhea’s alternative primary bear market rule was one of the first hidden treasuries I found when reading Rhea. I have always been deeply aware of it, and, hence in order to disregard it (even though the very Rhea allows it) I should have very powerful reasons which in this case were absent. What would be those powerful reasons?

a) A secular bull market behind. I may be wrong but valuations do not warrant tailwind. For the sake of disclosure I must say that Schannep is convinced (based on technical reasons) that we are in the midst of a secular bull market. He made this clear in his January 31, 2015 newsletter (which is a real tour de force).

b) The cyclical bull market is not old (yes, I know, I am resorting to past statistical record).

c) The economy looks brilliant.

d) No drums of war. 

Alas, I see nothing of the above (maybe, after reading Schannep's January newsletter, a secular bull market, if we are to judge on a pure technical basis, since valuations impair a secular bull market and represent headwind for it. Furthermore, the action of broad indices do not warrant optimism and my short term trading has adjusted for "weak" upthrust. My daily trading of the markets tells me there is less underlying strength or thrust than one year ago). 

Furthermore, even under this scenario I’d be uncomfortable ignoring the signal. What if a big decline is around the corner? My trader background betrays me: In doubt, get out.

Nonetheless, each investor has a different risk tolerance (for psychological and liquidity reasons). Thus, for some investors, it may be proper to cut losses short, even too short, as I did; for others, with more risk tolerance, it may be proper to accept the risk of a somewhat greater loss in exchange for more return (as some whipsaws are avoided). Personal circumstances also influence the judgment call to be made when we are confronted with a difficult market juncture.

I leave for a future post something which may intrigue you.

After reading this post you may think that it will be very difficult for me in the future to ignore Rhea’s alternative primary bear market rule (lows of the last completed secondary reaction). Not so. After almost three months of pondering and comparing Rhea and Schannep, I have reached the following astounding conclusion:

When applying Schannep’s rules, and under strict technical ruled-based considerations, it may be sensible to ignore the lows of the last completed secondary reaction more frequently than the “occasional exception” advocated by Rhea. I am not saying to ignore the rule, but the amplitude of such a last completed secondary reaction (which under Schannep's Dow Theory tends to be of lesser magnitude than those appraised as per the Rhea/classical Dow Theory) will help us decide (among other factors) whether to apply it or ignore it.

The development of this conclusion will be made in a future post of this Dow Theory blog.


The Dow Theorist

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