Trends unchanged.
This post was
overdue, but time was scarce.
While I am an
ardent believer in the Dow Theory (of any persuasion whatsoever), I try not to
be a fool. The Dow Theory is, in my opinion, the best mean to extract out
performance and diminish drawdowns, provided
the market obliges.
By an “obliging”
market, I do not mean a market that always goes up. It can go down, and it is
healthy that markets go down, as the new bull market that follows a bear market
offers good entry points.
Hence, when
it comes to US stocks, the Dow Theory has done remarkably well, in cutting
losses when stocks go down, and making money when stocks go up.
However, an “obliging”
market is one whose price movements and price structure have some degree of “smoothness."
Thus, we know that a primary bear market signal will be flashed if:
a) after the
signaling of a secondary reaction, a rally on at least one index of +3%
(lasting at least 2 days) must follow. Thereafter, a decline follows that
jointly violates the secondary reaction lows.
OR
b) If setup “a”
does not materialize, the lows of the last completed secondary reaction (Rhea’s
book page 77), when jointly violated. This vital
alternative exit was dealt with in depth in a saga of five posts. Here below you
have the link of the fifth post, which contains the links to the complete saga.
OR
c) The
empirically deducted -16% Schannep’s stop is jointly violated. More about this stop
here:
If we have an
“obliging” market, we can be pretty sure that one of the three alternative
stops will “quick in," and hence we will be out with moderate losses.
However,
there is no assurance that the market will “oblige” and we will have type “a”
or “b” Dow Theory stops at a reasonable level. As to the -16% stop, I have
written that:
“The
-16% stop is an empirically deducted stop which seems to do well with US
indices which normally have lower volatility than Chinese ones. Hence, I'd be
very careful to extrapolate the -16% stop to Chinese indices or for that
matter, to silver, gold or GDX or SIL”
In other
words, when dealing “outside” US stock indices, the -16% stop more than
doubtful since:
a)
Volatility may not be similar to that of US stock indices, and hence -16% may
be too loose or too tight.
b)
We lack the empirical record (and even empirical records when existing are
certainly no guarantee when looking forward. The past need not necessarily repeat
itself.
Therefore,
when dealing with Chinese stocks, I feel we only have stops “a” (the classical
Dow Theory pattern) and “b” (Rhea, page 77, lows of the last completed
secondary reaction).
The issue is:
what if the market does not “oblige” and stop “a” fails to materialize (which
means that stocks begin to go down and no rally of at least 3% occurs on at
least one index)? What if the alternative stop “b” lies too far from the last
recorded highs? Are we willing to accept -26% losses? (-26.10% was the loss for
FXI, iShs China large-cap ETF from top to bottom).
Even worse:
what if at the -26% level, the violation of the lows of the last completed secondary
reaction (stop “b”) are not confirmed? Do we stick with the trade and refuse to
sell?
This is
precisely what has happened to Chinese stocks.
They were in
a primary bull market (which was signaled here)
A secondary reaction was signaled by mid June 2015.
So, it seems
that Chinese stocks were nicely setting up for a primary bear market signal.
However, the +3% (or whatever value in volatility-adjusted terms) did not
materialize. Furthermore, no Chinese index managed to stage a two days
rally (which is the minimum time requirement for the subsequent rally to
complete the primary bear market setup). No sooner the secondary reaction was
signaled by the Dow Theory, there was just a one-day rally of negligible proportions, to be
followed by a precipitous decline. Hence Dow Theory stop “a” (the normal one)
did not materialize for Chinese stocks.
And what
about, the alternative stop, the lows of the last completed secondary reaction
(Rhea’s book page 77)? Well, I have more bad news:
To begin
with, the lows of the last completed secondary reaction were -28.93% below the
last recorded highs for FXI and -29.06% for HAO (China small cap ETF). Not a
very appealing stop, which for practical matters, is tantamount to no stop, as
theoretical losses close to 1/3 are not acceptable.
Furthermore, to add insult to injury, the violation of the
last completed secondary reaction lows (orange rectangles on the left side of
the chart) was not confirmed. Thus,
only HAO did briefly violate the lows of 10/1/2014, whereas FXI did not violate
its 10/1/2014 closing lows.
 |
| What would we do if the US Stock market behaved like this? |
In strict
application of the Dow Theory, lack of confirmation would mean that we could
not declare the primary bull market as death, and no primary bear market signal
would have been signaled.
So what to do
if the US market behaves so unbecomingly? I will try to address this thorny
issue in my next post. However, I would like to raise an equally interesting
point. Are investors in US stocks
technically and mentally prepared to deal with such an unruly market?
What would we, Dow Theorists, have done if suddenly the US stock market went
Chinese? Are we armed with the proper technical tools? Would we be frozen and do
nothing? Or we would run for the exits? But if we run for the exits, when? Well,
at least with US stocks we have the -16% uncle point. But, what if, in the
future, US stocks have a volatility resembling that of Chinese stocks? Would be
applied without hesitation the -16% stop? Would still be valid under greater
volatility?
And when it
comes with Chinese stocks, being deprived of the -16% stop, what would have you
done, had you been invested in FXI or HAO or both? Would you have applied the
-16% stop? Or -16% adjusted by volatility (which might be, depending on the way
you compute volatility in the vicinity of -25%)? Or just ignore such a stop,
and sit tight in spite of losses that might reach almost 1/3, since as of this
writing no primary bear market has been signaled?
We tend to
feel comfortable with US Stocks (and by implication with the Dow Theory)
because US Stocks have certainly behaved properly in the past, allowing Dow Theorists
for orderly exits when the tide was down (primary bear markets), what if we don’t
have the privilege of such “obliging” markets in the future? Thus, the Dow Theory managed to have investors out of the market before the crashes of 1929 and 1987 materialized, as explained here.
Of course, I
am not despising the Dow Theory, the fate that awaits buy and holders may be
even worse, but I am trying to take a very realistic view at the risks, we investors,
are confronted when looking forward.
In my next
post, I’ll try to offer some “solutions” to the thorny issue of when to get
out, when stocks set up in such a manner that both Dow Theory stops lie at very
distant levels from the top.
Sincerely,
The Dow
Theorist
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