Dow Theory Update for July 19: Two typical Dow Theory misconceptions (I)

And setting the record straight

Many badmouth the Dow Theory, and I must say for a good reason.

Yes, criticism aimed at the Dow Theory does not surprise me because it is casually studied and applied. It appalls me to read many “experts” getting things half right, which is tantamount when investing money to half or fully wrong. While it is true that neither Dow, nor Hamilton and even Rhea (although the latter came very close to it) did not produce a definite set of rules, and hence there is room for human interpretation, I feel that many confuse legitimate interpretation with outright misunderstanding (or merely lack of deep knowledge) of the Dow Theory.

I am just talking about the “classical” Dow Theory as applied by Hamilton, and, more importantly, Rhea.

I am going to address two frequent misconceptions.

Misconception 1: A primary bull (bear) market signal require the previous formation of a secondary reaction.

In other words, once we are in a primary bear (bull) market, for the trend to be changed it is necessary that a secondary bullish (bearish) reaction against the primary trend be formed. Once the secondary reaction has materialized, then we wait for the pullback (rally) and subsequent breakout of the secondary reaction highs (lows). Absent this sequence, we cannot declare a change of trend even though stocks may jointly be making higher closing highs (lows).

Go to this MarketWatch article and you will basically read what I have just described.

The article goes on to say that Schannep is one of the few Dow Theorists which, absent the development of a secondary reaction, would declare a change of primary trend, if the stocks indices break out the last recorded primary bull (bear) market highs (lows).

The article is correct when it comes to stating the dismal situation of the Dow Theory fraternity. However, the classical Dow Theory has the "alternative" bull market signal too, namely: The Industrials and the Transports, without the "normal" setup shoot up like a rocket (what we are seeing right now) and jointly better the closing highs of the last primary bull market. This signal is very often ignored or neglected but it pertains to the "classical" Dow Theory as well; not only Schannep's. Rhea makes this clear in his book (page 77 of my Fraser Edition).

Thus, it is not right to infer that Rhea did not mention the confirmed breaking out of the last recorded primary bull (bear) market closing highs (lows) as a valid primary bull (bear) market signal. In other words, if you read Rhea carefully (and any Dow Theorist worth his salt is supposed to having done so) you will find that Rhea clearly had in mind that sometimes the market does not oblige with a secondary reaction in order to setup stocks for a primary bull (bear) market signal.

Of course, not all “highs” and “lows” are born equal, and hence, not the breaking out of any “high” or “low” that stands out in a chart serves to declare a change of trend. This is a typical misunderstanding made by many casual Dow Theorists. There are only three types of closing highs and lows which are relevant in order to signal a change of the primary trend:

            The first one, is the typical sequence, which I have just explained: Secondary reaction against the primary trend, subsequent pullback (rally) and final breakout of the secondary reaction closing highs or lows.

            The second one, is the confirmed breaking out of the closing highs (lows) of the last recorded primary bull market highs/lows (in our juncture, the April 20^th closing highs)

            The third one, is the breaking out of the closing highs (lows) of the last   completed secondary reaction. This is a very tricky one, which should be used with lots of caution. I have written profusely about it in the past (here), and I plan to write even more in the future (giving hints as how to us it depending on market conditions). Here you have the graph depicting this often neglected Dow Theory signal (which I used, by the way, to signal the new primary bull market of gold and silver miners on March 3^rd.)

  

In my next post, I will address the second typical misunderstanding. No wonder that many people get their fingers burned when miss-applying the Dow Theory.

Well let’s have a look at the markets we monitor.

US STOCKS

The primary trend turned bearish on June 24^th, as was profusely explained here.

The secondary trend is bullish (secondary reaction against the primary trend), as all three indices (Industrials, Transports and SP 500) have been rallying for more than 8 trading days (average of the three indices) and each of them has rallied more than three percent. As of this writing we don’t know whether we can declare the end of the secondary reaction, as no index has pulled back more than 3%.

As I explained here, if the Transports were to break out above their April 20^th closing highs (primary bull market highs), a primary bull market would be signaled. The longer it takes for the Transports to confirm the SP 500 and Industrials higher highs, the more likely a decline is in the making.

GOLD AND SILVER

The primary trend is bullish (Dow Theory signal of March 17^th, 2016), as reported here and here.

The secondary trend is also bullish as explained here

GOLD AND SILVER MINERS ETFs

The primary and secondary trend is bullish as explained here, and more recently here

Sincerely,

The Dow Theorist