Monday, May 11, 2015

Dow Theory Special Issue: “Lines”. Classical Dow Theory and Schannep

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.

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 “”.

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. 


The Dow Theorist

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