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.  


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