Monday, August 15, 2016

Dow Theory Update for August 15: More on the primary bull market signal of August 11, 2016

Trends in precious metals universe unchanged

As it was reported here, last August 11th a primary bull market was signaled according to Schannep’s Dow Theory.

Here you have un updated chart.

Schannep's Dow Theory signaled primary bull market on August 11

It is important to note that the “Rhea/Classical” Dow Theory has not signaled a primary bull market yet. Why? Because the Transports remain below their July 14th secondary reaction closing highs. Since the “classical” Dow Theory only uses the Industrials and Transports, the failure of the Transports to better its secondary reaction highs implies no signal. Of course, it could be argued that Schannep’s Dow Theory is “too reactive”.  If past performance is to serve us as a guide, the “over reactiveness” of Schannep’s Dow Theory clearly outperformed the “Rhea/classical” Dow Theory. Both in terms of average performance (ca. +2% p.a.) and drawdown reduction. More about the comparison between both Dow Theory flavors here.

Thus, like in short term trading. We don’t know in advance the outcome of any given trade. This specific one might be a false signal whereas the classical Dow Theory by not signaling a primary bull market would look "smarter" this time. However, we have to look at the long term record, which clearly favors Schannep’s Dow Theory. Of course, it could be argued that past performance is no guarantee of future performance, and, hence, that the “Rhea/classical” Dow Theory is likely to outperform Schannep’s Dow Theory in the future. This could happen, but, as I wrote here, I find it very unlikely:

“I’d say that the very structure of Schannep’s Dow Theory is likely to continue outperforming the “classical” Dow Theory in the future. By design Schannep’s Dow Theory is more responsive (i.e. detects earlier the onset of a new trend) because:
1)     It uses three indices (it includes the S&P), instead of just two, whereas it requires just two indices confirming. 
2)  The definition of secondary reaction (which is vital to determine breakout points, which in turn, define primary and bear market signals) is “shortened” as, 10 days, or even less, is enough to qualify a movement as a secondary reaction. 
3)     In the same vein, by doing away with the 1/3 to 2/3 retracement rule (which is one of the requirements under classical Dow Theory for a secondary reaction to exist) and merely requiring a 3% move, many movements which under classical Dow Theory escape the definition of secondary reaction are labeled as such under Schannep’s Dow Theory. 
Thus, the very make up of Schannep’s Dow Theory makes it foreseeable that in the future it will continue to cut losses short (that is detecting earlier changes of the primary trend) because its very rules are designed to spot secondary reactions in an early fashion.
Of course, critics could say that everything comes at a price, and that premature labeling of secondary reactions makes Schannep’s Dow Theory prone to false signals or worse yet, reduced profits. 
However, such objections have been exhaustively debunked during this “face off” saga. Schannep’s rules, while being “early” both in signaling entries and exits, manages to increase profits, not reduce them.”

Therefore, it is perfectly possible for this specific trade to be a loser which would make look the classical Dow Theory “wiser” for having avoided this specific trade. However, I am focused on the long term record.

Of course, if the current signal is a valid one (by "valid" I mean that the trade is closed at a profit), then the “Rhea/classical” Dow Theory would look “dumb” as the primary bull signal would come later, and hence signaling an entry at a higher price.

The current signal offers a moderately bad risk reward ratio. The entry price for the SPY was 218.65 (close of August 11). Since the primary bear market closing lows of June 27th (199.60) the SPY has rallied 9.54%. Hence, our initial stop loss (more about the Dow Theory stop loss here) lies at -0.087% (This is the percentage decline from 218.65 to reach 199.60). Thus, the entry comes at a slighter higher level than the average entry which tends to be at ca. 7.4% of the primary bear market lows. On the other hand, and while nobody can predict the extent or duration of a primary bull market (Rhea dixit), I feel quite leery as to the “old-age” of current bull market cycle, which seems to reduce the “reward” (extent) side of the risk/reward ratio. Furthermore, the primary trend, as determined by weekly bars, remains bearish. Thus, the misgivings I expressed concerning the preceding primary bear market signal of April 13 remain fully applicable.

However, as I wrote on April 14th, 2016, the fact that I am leery about the signal does not imply that I will override it. Nonetheless, what works for me does not necessarily work for others. Each investor should do his own homeworks.

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

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


The Dow Theorist

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