Thursday, April 14, 2016

Dow Theory Update for April 14: More about the primary bull market signal for stocks





Trends for gold and silver and their stocks unchanged


This is going to be a long post. Please bear with me, and take your time to absorb it. Since writing this post has taken a good deal of focus and energy, I’d likely take a pause in the coming days (unless trends change).

Yesterday, a primary bull market signal was signaled for US stocks, as succinctly explained here.


Today, I am going to delve further into this signal.

On December 11, 2015, a primary bear market was signaled, as appraised by Schannep’s Dow Theory.


The final closing lows of the primary bear market were made on February 11, 2016 (Industrials and S&P 500), the Transports made their lows earlier on January 20, 2016. From such lows a secondary reaction against the primary bear market set in. The closing highs of the secondary reaction were made on March 18, 2016 (Transports) and April 1st, 2016 (Industrials and S&P 500). From that point, the Transports declined more than two days and more than 3%. The Industrials and S&P 500 did not manage to decline more than 3%. More explanations about the setup here.
 
Furthermore, it suffices just one index to decline more than 3% to setup stocks for the next primary bull market signal, as explained here.
 
Even though the S&P 500 and the Industrials did not decline by more than 3%, both indices declined for 4 days (minor closing lows made on April 7th, 2016), and hence confirmed the Transports as far the decline itself (not its extent) is concerned. The chart below displays such a decline with orange rectangles. Here I’d like to clarify one aspect. Schannep’s Dow Theory does not require the extent (more than 3%) confirmation when stocks set up for a primary bull or bear market signal. However, the direction itself of the decline/advance and time thereof (i.e. minimum of 2 days) should be confirmed. In other words, if the transports had declined more than 3% but the INDU and SPY had simultaneously advanced (hence refused to decline), there would not have been such a setup. Schannep deals with this unusual situation (one index declines more than 3% and the other two indices continue their ascent) in page 21 of his masterpiece (I do mean it) “The Dow Theory for the 21st Century”. It is the so-called “B-5” signal (page 21). Readers of this Dow Theory blog: If you are really intent on mastering the Dow Theory, please read Schannep’s book at least five times. Digest it. Absorb it. And you will do yourself a great favor.


After the closing lows of April 7th, stocks broke out their respective secondary reaction closing highs and hence a primary bull market signal was signaled. 


Here you have an updated chart:

Details of the primary bull market signal. Red orange rectangles display the pullback
 
I’d like to make some additional comments concerning this signal.

The SPY rallied ca. 13.75% off the primary bear market closing lows (SPY at 182.86). Hence we are talking of a powerful rally (secondary reaction against the primary bear market). This also implies that we have a very awkward risk reward ratio, in that our initial Dow Theory stop is likely to be at least -12.09% below an hypothetical (and for some “real”) entry point at yesterdays close (SPY at 208.00) or today’s open (SPY at 208.07). Here is the math:

Entry as per "buy" signal

208
Initial Dow Theory stop

182.86



Likely initial loss

-12.09%


Readers of this blog know that, following a primary bull market signal, the initial stop loss is to be set at the closing lows of the previous primary bear market. More about the Dow Theory stop here.

I’d say that in 75% of the buy signals, the initial stop loss (lows of the primary bear market) lies around 5-7% below the entry price. In this specific case, the torrid rally which followed the primary bear market low of February 11 (for the SPY) did not give a respite (that is a -3% decline) until the SPY had advanced 13.75%. Hence, we are not under the best initial risk/reward conditions. Should stocks begin to decline in earnest without staging a minor rally of +3% in at least one index, we would be confronted with a sizeable loss.

Of course, such an occurrence is unlikely, while the past is no guarantee for the future, the “usual” primary bear market signal is given some 5-7% below the top. In our case, even assuming that stocks started to collapse today, and never better yesterday’s close, this would mean that after having declined by 5-7% at least one index would oblige and rally by more than 3%, and, thus, our exit would imply much contained (and usual, average-like) losses.

However, we never know….

The torrid +13% rally, resulted in an entry price (SPY at 208.00) which is ca. 2.9% above our exit price of December 11, 2015. This is a rare occurence, as normally, and given the subsequent declines following a primary bear market signal, the next buy tends to be below the exit price. Here is the math: The average decline after the primary bear market signal to the final bottom amounts to ca. -12.97%. Since the "usual" entry price following a primary bull market signal is given at ca. 5-7% from the bear market bottom, we can derive that "normally" the entry price lies some good percentage points below the last exit price (primary bear market signal).

Now, I want to show my readers that I am not a computer, and that I have feelings. However, I will also show that I override them and stick to the rules.

I will confide: I feel very uncomfortable with this primary bull market signal. Not so much for the bad risk/reward, which, as explained above, is unlikely to result in a major loss, but for many other things, which I will list.

Technical misgivings.


1) The primary trend of the market, as appraised when using weekly bars, remains bearish. Primary trends when appraised with weekly bars tend to closely resemble “secular” trends (that is headwind in our case), albeit determined “technically”. Bottom line: The very long term trend is and remains bearish. More about the “technical-secular” trend here and the current bearish status here.

However, I live and die by “daily” bars (at least for me given my trading style), and hence, while very aware of the technical "weekly" headwind, I honor the buy signal. Furthermore, big reversals of “secular” bearish trends have always been foreshadowed by daily bars. So  investors should do their homework, understand the difference between “dailies” and “weeklies” (hence read the two linked posts)  and decide by themselves.

2) The cyclical bull market is aging. Schannep gives in his book the best definition of cyclical bull and bear markets (pages 61-67 of his book). Any decline exceeding -16% (confirmed by the S&p 500 and the INDU) will constitute a cyclical bear market, and any rebound exceeding +19% off the lows of the cyclical bear market will be defined as a cyclical bull market. In short, the current primary bull market started in 2011. As per the profiling of cyclical bull and bear markets made by Schannep (more on his website: https://thedowtheory.com/resources/bull-bear/historic-record/ ), the current cyclical bull market is old. Hence, statistically the odds favor a new cyclical bear market (which entails a median decline of -27.5%). However, things are not so straightforward, as in any given year, the likelihood for the cyclical bull market to survive an extra year is not so low (currently, it could  be a 50/50 probability), and, thus, an old cyclical bull market is not sufficient reason for me to disregard the current primary bull market signal.

As an important aside, please mind that cyclical bull and bear markets are the proper “overlay” for Schannep’s Dow Theory primary bull and bear market signals (roughly, very roughly, one cyclical bull may contain two primary bull markets as determined by Schannep’s Dow Theory). Hence, the bull and bear markets as determined by the Dow Theory (especially Schannep’s) tend to be of shorter duration (but more effective, as far a performance and drawdown reduction is concerned) than “cyclical” ones (which are those more often referred to in the media). As an example, the average duration of a cyclical bull market is 32.9 months, whereas the average duration of a primary bull market as determined by Schannep’s Dow Theory amounts to ca. (very rougly, as I don’t have updated numbers at hand, and lack the time to update them) 479 days (more about it here), which is ca. 16 months.


3) The Rhea/Classical Dow Theory remains in a primary bear market. Since the “classical” Dow Theory does not use the S&P 500, the Transports have refused to confirm the Industrials, and hence the trend has not changed. However, I’d like to note, that in most instances, Schannep’s Dow Theory by getting in and out earlier than the “classical” tends to reduce drawdowns and increase performance. So, as with “weeklies” the technical bearish status as per the “classical” Dow Theory is not powerful enough for me to disregard the signal given by Schannep’s Dow Theory.

Fundamental missgivings

1) This is nothing new, but I see the economy in very bad shape. Earnings are poor. However, countless bull markets have been missed by those focusing on the shape of the economy. So this is not a reason to ignore the primary bull market signal.

2) If we stick to valuation criteria, the US stock market is not cheap. However, being a trend-follower at heart, I know that expensive assets may remain expensive for a long time. Furthermore, one never knows whether we are on the brink of a massive devaluation (or a new high tech discovery like free energy) which would propel stocks higher. Nobody knows anything, me, of course, included.  

However, there are also some encouraging aspects, namely:

1) Technically, Schannep’s timing indicator (more about it, here), remains firmly in a bullish mode. This is technical tailwind.  


2) Maybe there is more demand for stocks than we suspect. Perhaps, there are deep reasons for creating artificial demand for stocks in order to prevent a collateral collapse (as Zero Hedge reported on April 12, 2016). I don’t care whether demand for stocks is “natural” (little Joe buying) or “artificial” (Fed orchestrated). Demand is demand. And I remember the adage “don’t fight the Fed”. If such an artificial demand were to falter, the Dow Theory would let us know sufficiently close to the top, so that we orderly exit.


3) One never knows what the government has in store for us. What if, i.e., S&P 500 constituent stocks were to be considered as good collateral as US debt? What if, at least, there were the firm commitment to support their price even if this implied outright monetization. We really don’t know, but we could be close to such an event. The Dow Theory “smells” change before we can fundamentally explain it.

4) I precisely think (maybe it is a crazy economic thought) that the worse things are economically, the greater the disparity between the “have” and the “have nots”, the better for big business (to the detriment of small business). Even under a shrinking economy there may be the winners, like big businesses which coincidently, are listed on the stock market. So the state of the global economy does not necessarily reflect the state of the particular big companies which are constituents of the S&P 500. Furthermore, since by its nature such indices drop the laggards, and include the “winners”, it is very likely that amidst a stagnating economy the stocks making the index will continue performing well.

5) In a disparity economy, it could be that stocks get to be owned by the bedeviled 1% (which is actually, 0.1%) and hence owned by strong hands not prone to sell. Hence, a declining economy with a tiny minority of overlords might result paradoxically in strong hands, which brings to my mind the following example:

During most of history, when massive poverty for the 99.99% was the rule, was the value of gold (the preferred vehicle for saving) low? No, of course, because, the rich, albeit few, were really rich, and hence they were “strong hands”. The overall level of prosperity is not necessarily the best indicator for the value of an asset. Its value (call it “price” if you want) will merely depend on the selling and buying pressure. I can well imagine (and fear) the society of the future and see an even more affluent 0.1% and a desperate, serf-like, 99.99%. In such an impoverished society I have no qualms that luxury items, and assets like stocks would command a high price because demand from the 0.1% would be strong whereas few of the 0.1% are willing sellers. Of course, it would be a “game” between the “haves” whereas the “have not”, the serfs, would merely live from hand to mouth with no meaningful savings. Under such an environment of disparity, many of the companies we currently know would cease to exist (but that would not greatly affect the S&P 500 as the “losers” would be dropped from the index). There would be no market for cheap airlines (as the middle class would go extinct), mass leisure companies (as nobody could afford a vacation), etc. whereas companies catering to the 0.1% would thrive (i.e. private planes, security –to protect the 0.1% from the 99.99%-, luxury hotel chains, luxury cars, etc.).

It goes without saying that my “fundamental” bullish arguments are most likely baloney. However, the bottom line is to heed the technical readings of the market. The market knows more than all of us combined.

All in all, even though, I feel kind of uncomfortable with the current bull market signal because I feel a deep reversal is at hand, I see no reason to disregard it. My feelings mean nothing. Furthermore, traders tend to say that the best trades are those most difficult to take. Will my uneasiness be harbinger of a good trade? We will know in the coming weeks. Nonetheless, each investor should do his homework. I am just writing my musings. Thus, some investors might pass (we are not obliged to be batting all the time), as the starting risk/reward is not optimal.

Sincerely,
The Dow Theorist

2 comments:

  1. Wonderful post. Thank you for sharing your personal thoughts.

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    Replies
    1. thx for following Algyros. And do your own homework..=)

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