Saturday, October 24, 2015

Dow Theory Update for October 24: Is the current primary bull market signal for US stocks doomed to fail?





Trends for stocks, gold silver and their miners unchanged.


I have not posted in the last few days for the following reasons:

a) I was traveling so time was extremely scarce

b) Trends have not changed. 

c) I am re-reading Schannep’s book for the 10th time. I am in a period of introspection unearthing more jewels from this masterpiece.

During the last few days, I have received feedback from some readers of this Dow Theory blog who seem to be skeptical as to the current primary bull market signal for US stocks. The main argument is that we are in the midst of an aging bull market (stocks have basically gone up since 2009) and hence there is not so much free room left for the upside. So, according to many, we ought to disregard the primary bull market signaled that was signaled on October 7 (more about the signal here and here)


Well, here comes my answer:

It is highly dangerous to outsmart Dow Theory signals. Bull markets last longer than expected. Should a Dow Theory a primary bull market signal flashed in 1998 be disregarded because the bull was already raging since the start of the nineteen nineties? We really don’t know what particular outcome a particular signal will have. We roughly know that ca. 30% of the buy signals are failed signals. However, we also know that our winners (a 70% possibility, average winning trade ca. 33%) greatly exceed our losers (a ca. 30% possibility; average losing trade ca. -6.48%). More about odds and calculations here. All in all, it is a dangerous game to try to outsmart each particular signal.

However, for those still unconvinced, who feel that the stock market is due for a big fall, and that no tailwind will help the current buy signal, I would like to make the following observations:

We should bear in mind that specific Dow Theory signals occur within cyclical bull and bear markets. The cyclical bull and bear market may last as little as less than one year or as much as eight years (in the case of bull cycles). Schannep has achieved the best definition of a cyclical bull market: When from the bottom of a cyclical bear market both the S&P 500 and Industrials rise by more than 19%, we are under a cyclical bull market. Conversely, when the S&P 500 and the Industrials decline by more than 16% we are under a cyclical bear market. More details as to why these specific percentages, under Schannep’s book, “The Dow Theory for the 21st Century" (pages 53 and seq.)


The current cyclical bull market started on October 3rd, 2011 (you can find the whole cyclical bull/bear market record on Schannep’s web “thedowtheory.com”) and has not been interrupted by a decline exceeding 16% (which would have met the definition of a cyclical bear market). Thus, the current cyclical bull market is four years old.


You might think that a four years-old  cyclical bull market has all odds staked against its further progressing. However, this is not the case. If we are to judge according to the empirical evidence compiled by Schannep (page 55 of his book), cyclical bull markets aged four years have a 50% probability of reaching its fifth year. So we cannot talk of either headwind or tailwind. The current Dow Theory primary bull market signal has been signaled within a cyclical bull market that has a 50% possibility of lasting another year. Furthermore, the average advance on that additional year averages +31.9%. 

Let’s dig further. What are the odds for the current bull cycle to last just another six months? Well, since the odds for lasting another year are 50%, we can confidently say that there is approximately a 75% possibility for the current bull market to “survive” some six months. And what about the extent of the advance? A 15% advance does not sound illogical (ca. ½ of the average advance for one year).

And here things get interesting. Since the Dow Theory primary bull/bear market signals tend to be ca. 5-7% from the bottom/top, a +15%  advance would imply that the current “buy” signal has good odds (ca. 75%) of being a successful trade. By the way, 75% which is the figure derived from the probability for the current cyclical bull market to last some extra six months, is quite similar to the average probability for each Dow Theory signal to be a winner (70%).

According to Schannep, the average advance during the fourth year of a bull market is +19.4%. However, the 12 months from October 2014 to October 2015 are far from yielding such a percentage return. Furthermore, our Dow Theory buy signal was signaled well below the highest highs of the year. In other words, if the cyclical bull market were to last just some 6 extra months, and given that we bought very near the lows of 2015, there would be significant tailwind for a decent return. The primary bull market signal was signaled at a level quite close to that seen at the beginning of October 3, 2014. Since we know that the average annual advance from that date “should” have been ca. +19.4%, we know that, if the cyclical bull market is to survive it “should” catch up, as the last 12 months have been mostly flat. If we add +19.4%  (“due” for 2015) and +ca 15% (average advance to be expected in the next six months), we are talking of considerable tailwind for the current primary bull market signal.

Please mind that even a modest ca. +10-12% advance from the August 2015 lows would result in our current Dow Theory buy signal being a winner (ca. 5-6% “lost” when buying, as we don’t buy the absolute bottom, and ca. 5-6% “lost” when selling as we don’t sell the absolute top). Any movement, exceeding 12% from the August lows should under normal circumstances (“circumstances” being a “normal” secondary reaction retracing ca. 5-6%, which ends up above the August 2015 closing lows) result in a winning trade.

For those still skeptical, I would like to draw your attention to pages 154-155 of Schannep’s book. Pre-election years have yielded on average a +12.2% gain and have an 81% probability of being a winning year. Since the primary bull market was signaled ca. 5% off the lows, the stock market should catch up (and it is actually catching up). Furthermore, the election year has a 78% probability of finishing higher and has averaged a +9.5% advance.

While I am highly skeptical as to such empirical measures of the probabilities, and I prefer market action (aka: Dow Theory signals) to guide me as to when to be “in” our “out” of the market, and, thus, I don’t need the crutch of statistics (which might have no forecasting power, as things might change), one thing is clear for those who tend to distrust the power embedded in the supply/demand equation discerned by the Dow Theory signals: There is no solid reason based on past statistics of cyclical bull markets to believe that the current cyclical bull market is on its last legs.

Hence, we should not try to outsmart the interplay of supply and demand, which manifests itself under the form of primary bull/bear Dow Theory signals. A primary bull market signal (with is inlaid confirmation rule) implies that supply is outstripping demand, and that’s all we need to know.

However, for doubters, is good to remind that the underlying “statistical tide” is, to say the least, not negative.

And, if, in spite of everything, it is a failed signal (a distinct 30% possibility), we have our narrow stop loss (the August lows). Therefore, we should have the courage as good traders to stick to the rules.

Sincerely,

The Dow Theorist

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