Monday, August 24, 2015

Dow Theory Special Issue: Primary bear market for Chinese stocks signaled last Friday 21st

And some thoughts concerning US Stocks…

Market relevant events continue to pile up, while time remains in short supply.

Last Friday, FXI broke below the lows of the last secondary reaction (which were made on October, 10th, 2014), and, accordingly confirmed HAO, which had already done so on July 7th, 2015. Confirmed lower lows, means that the lows of the last completed secondary reaction have been violated, and accordingly a “type 2” primary bear market signal has been signaled (Rhea’s book, "The Dow Theory", page 77, Fraser Publishing). I say, “type 2," since the “normal” “type 1” primary bear market signal, is a secondary reaction that develops from the latest top, to be followed by a rally that fizzels out, and thereafter a violation of the secondary reaction lows. This, unluckily, and as was explained here, did not occur with Chinese stocks, as they plunged into the abyss with no intervening rally after the last secondary reaction. More about all this here.

Here you have an updated chart:

Anatomy of a market crash and an unmerciful market: Chinese stocks

The blue ellipses at the bottom of each chart show the violation points of the lows of the last completed secondary reaction (red horizontal lines). On the other, hand, the blue ellipses at the top of each chart display the unconfirmed higher highs, which was a yellow flag, as I wrote on June 18th, 2015:

HAO made on two occasions higher highs, which were not confirmed by FXI (highlighted by blue ellipses). Such a non-confirmation tends to be a harbinger of a trend change of, at least, secondary proportions (emphasis added)”

Of course, I am keenly aware that a “sell” (primary bear market) signal that comes so late is kind of worthless. I wrote about it some days ago, and such a setup should give us Dow Theorist pause for thought. What if it were to happen to the US market? Please go to my post and read my musings. By the way, the US stock market, has, once again, behaved on a becoming manner, and has allowed us to escape a collapsing market at a very short distance from the top. The SPY made its top on May 21st, 2015 at 213.50. As per my interpretation of the Dow Theory, a primary bear market was signaled at the close of August 20th, 2015 at 203.97, which amounts to a -4.46% decline. Not bad. However, we must humbly admit that the Chinese stocks market is not an easy animal to tame.

The practical implication I take from the Chinese primary bear market signal is:

a) There is headwind for equities, included US Stocks. The principle of confirmation does also work between markets. A primary bear market signaled on several worldwide stock indices adds to the bearishness of the US Stocks market primary bear market signal.

b) One never knows what lies ahead. Even though, it may seem that the primary bear market signal for the Chinese market, has come “near the bottom” (as FXI has declined from the closing top of 52.71 on 04/28/2015 to 36.56 on Friday 21st, 2015, which is a -30.64% decline), one never really knows. What if the market still declines by a further 30%? This has happened under some primary bear markets; not always, but has happened. In other words, I personally would not touch Chinese stocks, until things firm up, which means that I get a primary bull market signal. Why stick your neck out trying to catch falling knives?

Now, technically, there is a bleak picture for stocks, be it in China, Europe or US. When things change, I change, and, if it is finally a failed primary bear market signal, which forces me to reenter the market at a higher price. So be it. The small loss taken by having to reenter at a somewhat higher price from the primary bear market signal is the price I pay (like an option) for safety.

I’d like to post later (maybe tomorrow) some thoughts concerning the primary bear market signal for US Stocks which was signaled here and here.

I know, I know, I owe my readers the second part of my post concerning the Chinese stocks market; namely, the “meat”: What to do, when the market, as with Chinese stocks, refuses to setup sell signals at a reasonable distance from the top. Events are piling up, and the answer is not easy. I have some ideas, which hopefully, will be posted soon.

The Dow Theorist.  

Friday, August 21, 2015

Dow Theory Special Issue: Was it a primary bear market signal under the classical Dow Theory?

Bank of America seems to think so

As reported by Zero Hedge, BofA seems to have detected a primary bear market signal by applying the Rhea/classical Dow Theory, as you can read here.

However, I have my qualms as to the correctness of such a signal under the classical Dow Theory. On the other hand, under my own flavor of the Dow Theory (which is Schannep’s with some minor quirks), I see that a primary bear market signal was signaled on August 20, 2015, as explained here.

Furthermore, today, August 21st, 2015 under strict Schannep’s Dow Theory, a primary bear market has been signaled as well, as the SPY violated its January 2015 lows (which under Schannep's Dow Theory constitute a valid secondary reaction). All in all, both “pure” Schannep and my own interpretation of the Dow Theory, are in sync, and confirm the existence of a primary bear market.

Having said this, and having confirmed my “technical” bearishness, I am skeptical as to the existence of a primary bear market signal under “classical” Dow Theory, as reported by BofA. If I were to gauge the primary trend of the market with the only help of the "classical" Dow Theory, I could only say that the primary trend remains bullish, albeit with an impending secondary reaction. 

Those that are declaring the existing of a primary bear market signal are fixated on the January 2015 closing lows of the Industrials and the Transports. I agree that the time requirement under the classical Dow Theory was fulfilled (it lasted from high to low, almost one month).

As to the extent requirement, I beg to disagree. I feel that as a result of a strict reading of Rhea’s Dow Theory, the extent requirement is to be based on percentage retracements and not percentage moves measured in isolation from the highest high. Thus, according to Rhea, a secondary reaction corrects between 1/3 and 2/3 of the previous primary bull market swing. I agree with Schannep (p. 40 of his book) that one should have some degree of flexibility when applying the classical Dow Theory, and, hence, a 29% retracement might also be considered, according to circumstances, as a valid percentage retracement. However, Rhea’s idea is clear: For a secondary reaction to exist, such a correction should significantly undercut the previous primary bull market swing. In other words, the extent of the previous primary bull market swing will define the extent of the decline to qualify as a secondary reaction. The longer the primary swing, the deeper the decline to qualify as a secondary reaction. This is one inherent flaw in the classical Dow Theory, since the larger the primary bull market swing, the more difficult it will be to declare the existence of a secondary reaction, and accordingly, the more difficult it will be to declare a primary bear market (with the risk of being late). 
Please mind I am writing "swing": the distance traveled from the lows of the last completed secondary reaction to the last recorded highs before a new secondary reaction sets in, I am not meaning the whole primary bull market.

If the lows made on January 2015 by the Industrials, and Transports do not significantly retrace the previous bull market swing, then we cannot declare such lows as secondary reaction lows, and hence are not the significant points to be violated for a primary bear market to be signaled. Of course, such lows will be important lows, and their violation is “bearish” (but not necessarily “primary trend” bearish). This is why Rhea says that lower lows is bearish. However, there are several degrees of bearishness. The violation of minor lows may entail some bearishness, but not a monster bear market. Thus, the violation by the Industrials and the Transports of the January 2015 lows might entail “some” bearishness, which would furthermore help retrace significantly (being “significantly” 33%, maybe 29%) the previous primary bull market swing.

As per BofA, the primary bull market as per the classical Dow Theory was signaled on January 18, 2013. From a cursory glance at the chart which you can find here, it seems that neither index did manage to retrace 1/3 of the previous bull market swing. Furthermore, the retracement must be confirmed.

Please mind that BofA does not use the expression “secondary reaction." However, under proper Dow Theory, real primary bull and bear market signals require the joint violation of secondary reaction lows, not just any low (though significant it may be). The violation of “plain” lows, merely implies bearishness, but not a real primary bear market.

Granted: The classical Dow Theory is not so easy to apply, as it is more subjective than Schannep’s when it comes to gauging the extent of primary bull market swings, the percentage retracements, etc. This is why, among other reasons, I believe that Schannep’s way of gauging secondary reactions is a much better way of doing that, as it eliminates subjectivity. Here you have a more in-depth explanation of Schannep’s superiority (which empirically has been proven right):

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.

So ,while accepting that determining secondary reactions (which are our pivotal points to be violated for a primary bear market to be signaled) are kind of subjective when applying the classical/Rhea Dow Theory, I feel that under the classical Dow Theory:

a) The January 2015 lows did not retrace significantly the last primary bull market swing which started on November 2012 (as per BofA's chart)

b) Thus, the decline we saw in January 2015 would not qualify as a secondary reaction. Just a decline.

c) The violation of the January 2015 lows merely would signal weakness (bearishness), but not of “primary” proportions. However, such a bearishness might result in the Industrials and Transports retracing significantly (let’s say at least 30%) the total advance from the lows of 2012 (primary bull market swing), thereby seting up stocks for a primary bear market.

d) If, true to the weakness that implies the violation of the January 2015 lows, the Industrials and Transports retrace significantly the last primary bull market swing, then we would get a proper secondary (bearish) reaction. The lows of such a secondary reaction would be the relevant lows to be violated (after a rally on at least one index) for a primary bear market signal to be signaled.

This is how I honestly see things under the classical/Rhea Dow Theory. To dispense with the requirement of retracements (of at least. ca. 1/3) when applying classical/Rhea Dow Theory is, in my opinion, tantamount, nullifying the ve ry classical Dow Theory. I repeat: Not all lows, no matter how significant they look on the charts, are the valid lows to be violated to signal a primary bear market. Only the violation of secondary reaction lows serves to this end. And to declare a secondary reaction, under Rhea/classical Dow Theory, we need retracements of the previous bull market swing, not just percentagewise declines from the top.

Of course, this is why I prefer Schannep’s Dow Theory.

The Dow Theorist.  


Dow Theory Update for August 21 (II): More about the primary bear market signaled for US stocks at the close of August 20

Some hours before, I wrote that yesterday, as per my reading of the Dow Theory (which is Schannep’s with some minor quirks) a primary bear market was signaled.

Let’s delve further into it.

Here you have an updated chart:

Anatomy of a primary bear market signal.

As you can see, on the left side of the chart, on January 15, 2015, there was a secondary reaction (orange rectangles). Such a secondary reaction was determined both by Schannep, of and I. Thereafter, the SPY (on May 14) and Industrials (on May 18) made higher closing highs, whereas the Transports failed to do so (blue arrows on the chart). As per Schannep’s Dow Theory, such a double confirmation does not suffice to declare the then ongoing secondary reaction as finished. A triple confirmation was required, and, hence, the secondary reaction lows of January 2015, remained the valid lows to observe. However, as per my own interpretation of the Dow Theory (basically: just two indices should confirm), higher highs confirmed meant that the secondary reaction of January 2015 was to be declared extinguished, the primary bull market as reconfirmed, and, thus, our “clock” set to zero, when it comes to counting days and declines in order to appraise a new secondary reaction. All this was explained here.

Some days after the higher highs, the SPY and Industrials started to decline (and the Transports extended the decline which began on 12/29/2014). On June 29, 2015, a secondary reaction was signaled, as explained here:

From the secondary reaction lows made jointly on 7/8/2015, all three indices rallied by more than 3% (the Industrials was de first one to do so), as explained here and here, and accordingly setup US stocks for a primary bear market signal (the rally is shown by blue rectangles on the right side of the chart).

On July 27th, both the Industrials and Transports were below the secondary reaction lows. However, the SPY refused to confirm, and for the reasons explained here (and more in-depth here), we could not declare a primary bear market.

Yesterday, the SPY violated on a closing base its 7/8/2015 lows, and, hence provided the needed confirmation and with it, a primary bear market was signaled.

According to a strict reading of Schannep’s Dow Theory, a primary bear market signal has not been given yet, as (according to Schannpep) the valid secondary reaction lows to be taken into account are those of January 15, which have not been broken yet by the SPY. However, as Schannep himself has noted to his subscribers, under the “Rhea/Classical” Dow Theory, a primary bear market has been signaled yesterday.

What to do now?

Schannep himself is skeptical about the validity of the signal, as the Transports were diverging (that is after having violated its secondary reaction lows some days ago, started to go up). Furthermore, Schannep times his trades with the help of his “timing indicator," (not related to the Dow Theory) and, at best, he would only sell one-half of any hypothetical position until his timing indicator turns bearish.

It is up to each trader/investor to decide what to do. I do not pretend to know the future, much less to be a guru. I am just a private individual who tries to form his own judgment and separate the signal from the noise. Furthermore, psychological and financial risk tolerance depends on each investor’s circumstances and makeup. Investors with a very long term horizon and good tolerance for drawdowns, might wait until the January 2015 lows are violated by the SPY. Shorter term traders, might consider adjusting  their trading parameters to the new market situation (that is trading under the assumption that there is a primary bear market).

One thing is clear (at least) to me: I personally honor all Dow Theory signals and try not to make second-guessing.

So now, let’s briefly recap the outcome of the last “buy” signal.

After a whipsaw, and according to my reading of the Dow Theory, a primary bull market was signaled on October 31st, 2015. The entry price for the SPY would have been 201.66.

The close on August 20th, 2015 was 203.97, which is percentage wise a small win of 1.14%.

Not all trades are “stellar” trades. However, once again, we have seen that (at least for US Stocks) the Dow Theory has done a good job at containing losses. I don’t know whether the current sell signal harbingers a crash, "just" a -20% decline, or it is just a whipsaw. I don’t know. What I do know is that following a primary bear market signal (and especially when it follows a tight congestion, since it is not the same a signal after an already sizeable decline, than after months of ranging), the market is vulnerable to big declines. Sometimes they don’t occur, but when they do, losses can be devastating, and hence, the sensible course of action is to stay out of trouble.

As I wrote here:

“Experience says that ca. 2/3 of the time, a small rally follows immediately after the primary bear market signal. However, 1/3 of the time, such a rally fails to materialize, and we get an even steeper decline. The money won by not selling immediately is more than lost in the 1/3 of occurrences when a collapse follows a primary bear market signal (i.e. 1929 and 1987 crash among other instances).

Bottom line: One must react as soon as possible once a primary bear market signal has been flashed.

So now, it is a good moment to be sitting on cash (which cash, that’s another issue, as the primary bull market for the EUR, in spite of a recent correction, has not been reversed), and patiently wait for the next primary bull market signal.

Precious metals Universe

Both gold and silver and their miners ETFs are close to signaling a bullish secondary reaction against the primary bear market. However, as of this writing, the primary and secondary trend remain bearish as explained here.

The Dow Theorist