Why Schannep's Dow Theory needs no lines.
Trends for US Stocks, gold, silver and their respective miners EFTs remain unchanged. The primary trend for Stocks remains bullish, and the precious metals universe remains bullish. Gold, silver and their ETFs remain caught in an endless secondary reaction. What I wrote some weeks ago remains a faithful description of primary and secondary trends.
http://www.dowtheoryinvestment.com/2015/04/dow-theory-update-for-april-2-primary.html
So, once again, and taking advantage of the market's lull, I will further analyse vital Dow Theory aspects.
I feel this post is important. So you need time (always in short) supply, to read and re-read this post until its message finally soaks in. There are no shortcuts and a know my posts are no easy read. This post is the result of
many years of perusing charts, and more importantly applying the Dow Theory
relentlessly, and further pondering to the point of near exhaustion.
As far as I am aware of, what you will read is not to
be found elsewhere. Nor in any Dow Theory book. And I feel it is important to:
(a) fully comprehend the classical Dow Theory (and the hidden nuances thereof);
(b) cement your faith in Schannep’s Dow Theory, of “thedowtheory.com”.
I feel a full understanding of the classical Dow
Theory is necessary in order to fully appreciate the superiority of Schannep’s Dow
Theory. You cannot build a house by the roof, and, hence, nobody can blindly
plunge into Schannep’s improvements without first knowing inside out the
workings (and small shortcomings) of the classical Dow Theory.
You will be hard-pressed in order to find the word “lines”
in Schannep’s book. To the best of my knowledge “lines” is an element of the
classical Dow Theory which has been discarded by Schannep. Does this make
sense? Has Schannep overlooked a gem contained in the classical Dow Theory?
The answer is: Schannep
has made no mistake. Under Schannep’s
Dow Theory we don’t need lines. Now, I will show you why.
First, let’s begin by Rhea’s definition of a “line” (narrow
range) (page 79, of “The Dow Theory”, Fraser Edition):
“A “line” is a price movement extending two to three
weeks or longer, during which period the price variation of both averages move
within a range of approximately five per cent. Such a movement indicates either
accumulation or distribution. Simultaneous advances above the limits of the “line”
indicate accumulation and predict higher prices; conversely, simultaneous
declines below the “line” imply distribution and lower prices are sure to
follow. Conclusions drawn from the movement of one average, not confirmed by
the other, generally prove to be incorrect”.
By the way, Rhea stresses once again the principle of
confirmation. All I will write (and the graph included) should be understood as
requiring “confirmation”.
In page 80, Rhea gives us a vital insight:
“Hamilton said that we could always depend upon the
breaking of a line as indicating a change of the general market direction of at least secondary, and occasionally
even of primary character”. (emphasis added).
The above quoted statement is vital.
Rhea is telling us that the breaking of a line is to
be equaled to a movement of secondary proportions. So Rhea is telling us that
the breaking of a line tends to have follow-through and that such a
follow-through is at least of
secondary magnitude. We know that secondary movements may easily reach ca.
10%. Thus, if a 5% line is broken, and its breaking foreshadows a movement of
secondary proportions, we should expect some additional 3- 6% decline/advance
from the breakout point. This is a vital insight.
If the breaking of a line is against the primary
movement, then the range of the line and the follow-through until the final
lows are made can be equated with a secondary
reaction against the primary trend. Please mind I write “equated with” and
not “is”. All in all, the whole movement from the top (bottom) of the line to
the final low (high) put as a consequence of the “follow-thru” after the
breaking of such line is similar to a secondary reaction. How do we know that
the final lows (highs) of the “surrogate secondary reaction” have been made? We
know it once a rally (pullback) exceeding three per cent ensues.
And here comes the second statement made by Rhea when
he says that “occasionally” the breaking of a line is “even of primary
character”. We know that Rhea knows that the breaking of a line and the
subsequent follow-thru have enough magnitude to be equated with a secondary
reaction (or just secondary trend if such line is broken in the same direction
of the prevailing primary trend). If the lows/highs of our “surrogate secondary
reaction” are broken, then we have a primary bear/bull market. This is why the
breaking of a line may be harbinger “occasionally” of primary trend changes.
So we have deciphered Rhea’s thought when he refers to
the importance of lines.
Then, why Schannep has done away with Rhea’s insight
concerning lines?
Under classic Dow Theory, where it may take
ample movement (more than under Schannep’s) to signal a secondary reaction and,
by implication, a primary bull/bear market signal, lines may be useful to
avoid overstaying a dying trend. This is why Rhea refers to movements of secondary
and “occasionally” primary importance.
Let’s remember that Schannep’s Dow Theory signals much swifter secondary
reactions. So when trading according Rhea’s Dow Theory, it may come in handy
an “earlier” detector for a change of secondary trend. Thus, the last lows/highs of the movement
following the breakup/down of the line could well be equated to the lows of an
ordinary secondary correction.
Rhea says of “secondary importance”, this means that
normally the breakdown/up of a line does not go so far. The total
decline/advance from the line highs/low may imply a global movement of let’s
say 10%. If we need 5% to establish a line, then we can normally expect an
additional 5% upward or downward movement from the breakout point (which short
term traders, may successfully trade, with a stop on the line highs/lows).
Furthermore, since the line and subsequent
breakout/down may be equated with a “normal” secondary reaction , if a +3% rally/pullback
follows the last recorded lows, then its violation may be regarded as a valid
primary bull/bear market signal (and hence, Rhea’s dictum”occasionally of primary
importance”).
Why I am saying that a secondary reaction may be
signaled under Schannep’s Dow Theory and not under the classical Dow Theory?
For the following reasons:
a) Time element. Schannep’s Dow Theory takes less time. It can be as
short as 8 trading days (or even less following capitulation). Classical Dow
Theory speaks of at least three calendar weeks.
b) Magnitude element. Schannep’s Dow Theory just requires a >3%
movement contrary to the primary trend. Classical Dow Theory requires a 1/3
retracement of the last primary bull/bear market swing. Please mind that if the last primary swing has been of great
amplitude (something which happens quite often in strong primary bull markets),
let’ say of 30%, then 1/3 retracement means that the market should advance or
decline ca. 10% for a secondary reaction to be signaled (which is more than three times the minimum movement required
by Schannep). Furthermore, here you
can see a small flaw inherent to the Classic Dow Theory: The longer the ongoing primary bull/bear market swing, the larger the
extent requirement for a secondary reaction to be signaled. This
implies that following a large primary bull/bear market swing, by definition,
the classic Dow Theory will tend to be “late” (or at least, not as punctual as
Schannep’s) in signaling a secondary reaction, which may be the precursor of
the real primary bull/bear market signal. Please mind that the lows/highs of
secondary reactions are our “pivot points” to declare primary bull/bear market
signals. More about secondary reactions being important to establish our
stop losses, here. So, a primary bull/bear market will be more timely signaled
(“timely” means: near the top of bottom of the primary bull/bear market) when
secondary reactions have, by the same token, been signaled earlier. Please
cogitate this aspect, as the “timeliness” of Schannep detecting secondary reactions
makes Schannep’s Dow Theory a better tool to time the market. Detractors may
argue that by signaling earlier secondary reactions (and hence, making it more
likely the signaling of primary bull/bear markets), Schannep’s Dow Theory makes
itself more prone to whipsaws and false signals. This is not the case, though,
as I have proven in this post.
All in all, Rhea was no fool. He perfectly understood
the entrails of the rules he taught. Casual staments made by Rhea contain hidden treasuries which take some time and effort to unearth. This is why, Rhea was fond of using “lines”,
as they may be used to signal surrogate secondary reactions, which is very
important when there is scarcity of the real ones (due to the larger time and
extent requirement to gauge a secondary reaction under the classical Dow Theory). If we
apply the classical Dow Theory without lines we run the risk of getting the
primary bull/bear market signal when it is too late.
While “lines” are thus an important tool in order to
exit dying trends earlier because they can help use “surrogate secondary
reactions” as our Dow Theory trailing stops, they are no panacea after all. Just a palliative means to a
not-so-perfect way to gauge secondary reactions. Please mind that, by his own
admission (page 61 of the Fraser edition of his book) Rhea had a hard time
determining what was to be considered a secondary reaction and what not. Secondary reactions are a hard bone to eat.
Accordingly, under the
classical Dow Theory we don’t have the assurance that secondary reactions will always form so
that we get “surrogate secondary reactions” (lines) which will allow us to signal
relevant lows and highs to be used to declare the “ocassional” change of the primary trend (measured from the highest high of the line to the
bottom following the breakdown of said line which will allows us to get out of
the market on a very timely fashion). Markets don’t always oblige, and we could
just see the market in a range of +8% which is too ample to be a line, but
not deep enough to constitute a secondary reaction because the preceding
primary bull market swing amounted to +30% and hence, the 1/3 threshold of the
Classical Dow Theory has not been reached.
Of course, Schannep’s Dow Theory does not need lines. His
definition of secondary reaction which does not depend on the
extent of the previous primary bull/bear market swing being always
fixed at a minimum of 3% movement, coupled with a shorter time requirement,
makes it react near the top/bottom of primary bull markets. It acts as a kind
of “intelligent trailing stop”. While not strictly fixed at a three percent
below the top (above the bottom), which would be parametric and flawed, it allows, when coupled with the time
requirement, for the formation of secondary reactions near enough the
top/bottom at percentages which may range from a mere 3% (very unusual) to ca. 5-8%
This is why in the past, I showed that the largest
lost under Schannep’s Dow Theory was roughly half of that as per the classical
Dow Theory. This should not surprise us now. Schannep's rules make a great job at determining the existence of secondary reactions.
The graph below
hopefully illustrates what I have been trying to convey about “lines” and “surrogated
secondary reactions” in Classical/Rhea Dow Theory.
Sincerely,
The Dow Theorist
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