Thursday, November 24, 2016

Dow Theory Update for November 24th: More about the primary bull market signal for US Stocks



How Jack and Bart Schannep avoided the primary bear market trap


In my last post I briefly mentioned that the primary trend had turned bullish as per Schannep’s Dow Theory. As explained, the primary trend was already bullish according to the “Rhea/Classical” Dow Theory, as was explained and summarized here



Before continuing, I’d like to make clear that Jack and Bart Schannep themselves did not heed the primary bear market signal of November 3rd, 2016, and hence they recommended their subscribers to remain fully invested. Even though they identified the signal on the charts, they decided not to act upon it. This decision was not whimsical and was really well grounded: Jack and Bart Schannep realized that past primary bear market signals lacked follow through. They realized that if one had demanded an additional 3% further decline following the primary bear market signal on both the S&P 500 and the Industrials before acting most recent whipsaws would have been avoided. 

The chart below displays both the primary bear market signal of November 3rd (not acted upon by Schannep) and the November 21st primary bear market signal (to be acted upon by those that exited the market on November 3rd):

Whipsaw avoided by those following Schannep's temporary new rule

Jack and Bart Schannep are aware that this “new” rule (demanding and additional 3% further decline after the primary bear market signal) is just temporary and meant to be applied only during this bothersome “fibrillation” spell. The one million question is: When will the fibrillation spell end? This is a tough judgment call. If “fibrillation” is to last for some more trades ahead and the behavior of US stocks indices close resembles what we have seen since 2010, then Jack and Bart Schannep are fully right. If either the narrow ranging ends soon or the narrow ranging continues but not exactly as it was until now (i.e. following the primary bear market signal, the SP500 and Industrials decline, i.e. a further 3.2% thus flashing a “sell” under the new rule just to see the decline end immediately thereafter) then the new rule would prove to be detrimental to performance.

Jack and Bart Schannep feel that the current market environment may last for a while, hence warranting the temporary “tweak” of the rules. This is, of course, a decision not based on technical analysis and involves gut feeling, something which is not measurable.

On the other hand, as it was explained to me in an email dated November 4th, it seems that Jack and Bart Schannep will be more likely to use the new “3% additional decline” rule when the original sell signal (not to be heeded) is flashed at a narrow distance from the last recorded primary bull market highs (as was the case with the bear market signal of November 3rd). This makes sense. It is not the same to require an additional 3% decline following a bear market signal that has been signaled close to the top (i.e. 4%) than a bear market signal flashed at 10% below the last recorded bull market highs. So it seems that the application of the “tweaking” will be nuanced (once again involving a further judgment call)

I know that goal number one in the markets is to make money (or avoiding being whipsawed which is the same), and hence one should not get too dogmatic about being reluctant to bend the rules if need be. Best traders have always had the right instinct to break or bend the rules when things change. The issue is determining whether things have really changed or it is merely a rough patch of trades which is about to end. This is what separates the best traders (i.e. Jack and Bart Schannep) from the rest of the pack.

My trader background is that of a strict rule-based trader. Hence, in my short term trading I abide to my rules. Period. No exception. Experience showed me (at least for me of course) not to tweak rules and to admit that the market will not always oblige.

Maybe because in the first place I am not a legend, and I lack the instincts of top traders I am forced to settle with strict rule-based trading if I am to survive in the tough world of investing and trading. Being my gut feeling not so gut, I need to rely on clearly defined set of rules.

Accordingly, I decided to heed the primary bear market signal as “it was” without second guessing. Maybe the best explanation for not having applied the “tweak” to the rules suggested by the Schannpe’s is that I lack the flexibility and acumen of the best traders. However, and since I do eat my own cooking, I’d like to summarily state the reasons that prompted me to strictly stick to the rules:

1) In general, the less rules the better (less degrees of freedom). The more rules the higher the risk of so-called over fitting, which means that the added rule may work for a while and cease abruptly to work in the future.

2) The new rule of demanding an additional decline of 3% (in both the SP 500 and Industrials) to act on the primary bear market signal is tantamount to eliminating the very source of outperformance of Schannep’s Dow Theory versus the “Rhea/Classical” Dow Theory. Of course, if the new rule is merely “temporary” and Jack and Bart Schannep apply it exactly when it needs to be applied, there is no risk of eliminating outperformance. My big issue is that in real time I cannot predict whether the sell signal is a false one (whipsaw) or whether a big decline will ensue. However, very good traders (and Schannep belongs to this league) may “sense” when is the right time to use or disregard the new rule.

3) If US stock indices where to go back to their “normal” behavior up to 2010 the average and largest losing trade is going to go up as a consequence of the new rule. By the same token, the largest drawdown is likely to increase.

4) The likelihood of being caught in a big crash is going to increase. The more time (and the more decline), it takes for us to exit, the higher the risk of being caught unawares by a crash. Of course, if we lose big one time (i.e. 30%) due to the new rule, and ten times we make extra 5% due to the avoidance of whipsaws, the new rule is worth (provided one’s drawdown tolerance accepts occasional huge drawdowns).  In real time nobody knows.

5) Even though in recent times declines have been more modest, there continues to exist further decline following Schannep’s Dow Theory primary bear market signals. Thus, following the exit of 12/11/2015 there was a further 9.11% decline.

6) Demanding an extra -3 % decline following the primary bear market signal, implies a reduction of the further decline, which is detrimental to performance. The tradeoff is as follows: In order to avoid whipsaws, one settles with larger losers (because one gets out later) and smaller winners (as the subsequent decline has been reduced and hence one is reducing the source of outperformance. Of course, the number of trades and specially, losing trades is reduced under the new rule. I concede. 

7) Basically, exiting at ca. -3% below the actual signal, implies giving up 3% performance if markets where to return to the pattern seen until recently. Eventually, we have to make a judgment call: Are narrow ranges being the norm for the next few years? Are US indices going to have ample swings soon? I don’t know, but I tend to lend credence to the historical record of swings. I feel we are living an aberration, albeit painful.

Of course, the above mentioned line of thought is worth nothing against a good trader with a well fine-tuned gut feeling.

Thus, for those following Schannep’s advice, the current primary bull market signal of November 21st was immaterial, as they had remained fully invested.

One thing is clear: These narrow ranging conditions are putting trend followers to the test. It is easier to write about underperformance than living through it.

When almost one year ago I decided to start the “Dow Theory stress saga”, I wanted to imagine hitherto unseen difficult scenarios for the Dow Theory. Well, markets have obliged, and the last year has been really challenging. It’s been a real stress-test. Not only for the Dow Theory but, in general, for all trend followers, as breakouts and breakdowns lack follow thru.

Thus, until the recent past, we could be very confident that following a primary bear market signal, stocks would further decline. By the same token, following a primary bull market signal, we could count that in most instances there were to be significant further advances. However, this has not been the case in the last few years which resulted in killing the very source of outperformance (the advantage of trend following versus buy and hold is to “cut losses short”, namely that following a bear market signal, the markets continue falling whereas one keeps powder dry). It is as simple as that. If no further decline following a primary bear market signal, no outperformance. Period. 


The one million question now is: Will future primary bear market signals be met with further declines (and hence the Dow Theory will continue to work after a temporary rough patch)?

Or put it alternatively, will US stocks continue to tease us and stop declining after primary bear market signals?

Here we must take a stand. If we believe that the market has changed its nature forever, we should make amendments to the Dow Theory (which for me is entering uncharted waters). If we believe that we are merely living through a rough patch (no matter how painful it is) then we should with discipline follow the Dow Theory as is. A third alternative, fully respectable, is that followed by Jack and Bart Schannep: On a temporary basis (until they deem that market conditions have changed) they will demand an additional decline of 3% in order to act on a primary bear market signal.

I feel this post was important to summarize where we stand now. 


The next post will focus on the analysis of the primary bull market signal.

Sincerely,
The Dow Theorist

Tuesday, November 22, 2016

Dow Theory Update for November 22: Primary bull market according to Schannep’s Dow Theory signaled at the close of November 21




I don’t have time to write. Most probably next Wednesday 23rd I’ll be able to pen a more in-depth post. However, it is worth mentioning that yesterday, November 21st, at the close, a primary bull market was signaled as per Schannep’s Dow Theory, as the S&P 500 finally confirmed the Industrials and Transports in breaking up above the last recorded primary bull market closing highs.

Thus, now both the “Classical/Rhea” Dow Theory and Schannep’s are in gear: The primary trend (and evidently, the secondary one) is bullish. More about the trend when appraised using the “Classical/Rhea” Dow Theory here.


When I find time I want to study the primary trend when using weekly bars. From a cursory glance at my weekly charts, I feel it has turned bullish. However, this is not a final statement, as I have to further study my charts and make some calculations.

Sincerely,
The Dow Theorist

Monday, November 14, 2016

Dow Theory Update for November 14: Primary bear market for Gold reconfirmed today





Primary bear reconfirmed for SIL and GDX on November 13


US STOCKS

The primary and secondary trend (when appraised using Schannep’s Dow Theory) is bearish as explained here.


The Industrials and Transports have amply exceeded their respective last recorded primary bull market closing highs. However, the SP500 (and SPY) have refused to do so, and hence no primary bull market signal has been given.  If/when the SPY confirms, a primary bull market will be signaled.

Look at the chart below. The red horizontal lines on top of each index displays the closing highs of the last primary bull market. As you can see both the Industrials (top) and Transports (middle) have amply bettered such highs. However, the SPY is lagging. 

The SPY (bottom) has not confirmed the Industrials (top) and Transports (middle): No new primary bull market yet (as per Schannep's Dow Theory)
 
If we were to appraise the primary trend as per the “Rhea/Classical” Dow Theory (which only uses two indices, namely, the Industrials and Transports), the primary trend is unambiguously bullish, as explained here.


As I explained here


[I]t is possible for different Dow Theory “flavors” (Rhea and Schannep’s) to diverge. At critical junctures (changes of trend) this may happen as one Dow Theory variation may be reacting earlier than the other. Furthermore, the current ranging environment favors contradictory signals depending on the Dow Theory “flavor” applied, as no clear and clean trend is able to emerge. Under such a hesitant market, is it perfectly possible to have contradictory readings, as, i.e. slightly changing the time requirement for a secondary reaction will result in totally different readings. This is due precisely to the lack of clear trends. If there were a strong trend, irrespective of measuring secondary reactions with two or three weeks or utilizing 2 indices (classical Dow Theory) or 3 indices (Schannep’s) we would have identical readings. In most instances Schannep’s would be somewhat earlier at signaling the new trend but the Rhea/Classical Dow Theory would follow suit.

Thus, the fact that we can derive so many divergent trends depending on the way we apply the Dow Theory is a warning as to the very unusual situation we are currently living. Something similar is happening with moving averages. If there were a clear trend, the gauging thereof would not be particularly parameter sensitive. In other words, irrespective of the use of 200, 150 or 230 days as lookback period, the trend is going to be bullish. However, when markets range, prices tend to cluster around the very same moving average, and hence slight variation of the parameters may result in different trend readings. Something similar happens to the Dow Theory, albeit, as I have explained before, it is much less prone to whipsaws than moving averages, and hence avoids overtrading.

Thus, those being tempted to lambast the Dow Theory (of any flavor whatsoever) as unreliable because I am displaying several alternative readings, should rather stop, think, and see that noise is overwhelming the signal.

As Schannep explains in his book “The Dow Theory for the 21st Century” (pages 97-99), the S&P 500 is a very important index and hence should not be neglected. 

Hence, I cannot see any real bull market which does not include the S&P 500. Either the S&P 500 joins the parade, or the current rally rather than a brand new bull market might be a vicious bear market rally. Time will tell and in the meantime each investor must take his own decisions. Follow the classical Dow Theory? Schannep’s? Schannep’s as per his current stance?

GOLD AND SILVER

The primary and secondary trend is bearish, as was explained here and here. The primary bear market was signaled on September 30rd, 2016

After what can be considered a secondary (bullish) reaction against the primary bear market (the rally retraced more than 1/3 of the previous decline on a confirmed basis), newer lows (breaking down below the last recorded primary bear market closing lows) has re-confirmed the primary bear market on November 14th, 2016. Look at the red horizontal lines on the right side of the charts. They display the previously last recorded primary bear market lows. The blue rectangles on the ride side of the charts display the secondary reaction which eventually fizzled out. The breakdown of such primary bear market lows is not a new bear market signal but merely a reconfirmation of the already existing primary bear market. 

Here you have an updated chart:

First two red arrows display the primary bear market signal. Red arrow on the right side displays bear market reconfirmation
 

GOLD AND SILVER MINERS ETFs

The primary and secondary trend is bearish, as was explained here and here.

After what can be considered a secondary (bullish) reaction against the primary bear market (the rally retraced almost 1/3 of the previous decline on a confirmed basis), newer lows (breaking down below the last recorded primary bear market closing lows) has re-confirmed the primary bear market on November 13th, 2016. Look at the red horizontal lines on the right side of the charts. They display the previously last recorded primary bear market lows. The blue rectangles on the ride side of the charts display the secondary reaction which eventually fizzled out. The breakdown of such primary bear market lows is not a new bear market signal but merely a reconfirmation of the already existing primary bear market. 

Here you have an updated chart:

First two arrows display the primary ber market signal. The red arrow on the right side displays bear market reconfirmation
 


General observation for US Stocks, gold and silver and their ETF miners

The trend, when appraised by the Dow Theory when using weekly bars, is bearish for all the above mentioned markets.

Sincerely,
The Dow Theorist

Friday, November 11, 2016

Dow Theory Update for November 11: The current trend as per the classical/Rhea Dow Theory (III)





Alternative (and truest ) "classical" interpretation as per Page 77 of Rhea’s book “The Dow Theory”


Please mind that I am writing before the close. Things might change.

In the past two post I analyzed the trend as per the classical/Rhea Dow Theory. The first post showed Schannep’s interpretation (not of his own “Dow Theory” but the “classical” according to him). According to this reading the primary trend was bullish since 9/7/2016.



The second post gauged the trend with the stricter reading followed by other Dow Theorists (three weeks at least for a secondary reaction to exist). According thereto, the primary trend was bearish as the Industrials had failed to break up their secondary reaction highs. Update: Recent past action by the Industrials resulted in their breaking up their secondary reaction highs, and hence confirming the Transports and accordingly signaling a primary bull market on the close.
  
However, there is a third way to apply the Rhea/Classical DowTheory which would have signaled a primary bull market in stocks on October 5th, 2016. According to Rhea (“The Dow Theory”, page 77 Fraser Edition), “when a series of such rallies and declines have penetrated the highest points previously attained in a primary bull market, it is generally safe to infer that the primary bull trend will continue for a considerable period of time”

 
If you look at the chart below you will see that a primary bear market was signaled by the Classical/Rhea Dow Theory on June 24th, 2016.

A primary bull market signaled on October 5th, 2016: Last recorded primary bull market highs broken out


The primary bull market highs were made on 4/20/2016 by the Industrials and Transports. Thereafter, a secondary reaction developed (more than three weeks of declining prices) as shown by the red rectangles. A rally (blue rectangles next to the orange ones exceeding 3% set up stocks) for a primary bear market signal. The secondary reaction closing lows were jointly violated on 6/24/2016, and hence a primary bear market was signaled (red arrows).

Following the primary bear market signal a rally set in. If we are to strictly apply the  “Rhea/Classical” Dow Theory no secondary reaction formed until 9/8/2016 (when the Transports finally deigned to confirm the Industrials' rally). Thereafter, there was a pullback exceeding three percent which set up stocks for a primary bull market signal. The Transports broke up their secondary reaction highs on September 30, 2016 fully unconfirmed by the Industrials, and hence no primary bull market existed on that date and in the following days (until 11/11/2016 when the Industrials finally broke up above their secondary reaction highs. The chart below displays the situation described on this paragraph.

Secondary reaction, pullback and subsequent break up (bull market signal) if we were to declare signals based exclusively on secondary reactions (hence ignoring the breakup of the last recorded primary bull market highs)


The takeaway from is clear: No primary bull market signal would have been signaled until 11/11/2016 if we were to appraise the Dow Theory exclusively based on the breakout of secondary reactions.

However,  if we go back to Rhea’s book, the breakup of the last recorded primary bull market closing highs constitutes a valid primary bull market signal. In other words, we don’t have to wait for a secondary reaction to develop (or for its closing highs to be broken out) in order to declare a primary bull market.

Please look again at the very first chart of this post (scroll up!). The red horizontal lines display the highs of the last primary bull market. On 7/8/2016 the Industrials broke up above their last recorded primary bull market closing highs. The Transports, though, did not confirm. On 10/5/2016 the Transports finally confirmed, and hence, according to this interpretation of Rhea’s Dow Theory a primary bull market was signaled.  Blair Wagner writing for “Downside Hedge” punctually signaled the existence of a primary bull market on October 5th, 2016. While he did not elaborate as much as I do, the diagnosis was fully right.


Thus, any way you cut it, according to the “Rhea/Classical” Dow Theory the primary trend is bullish.

On the other hand, according to Schannep’s Dow Theory, the primary trend is bearish, as was reported here.

If the SPY (SP500) manages to break up its last recorded primary bull market closing highs of 8/15/2016, then the primary trend would turn bullish as well. Hitherto, both the Industrials and Transports have done so. However, as per Schannep’s Dow Theory we need triple confirmation for a new primary bull market to be signaled.

I insist that we are living highly noisy (lack of a clear trend) and volatile (repeated ups and downs) market. Hence, it is no surprise that there is no unanimity when it comes to applying the “classical” and “Schannep’s” Dow Theory. Eventually, though, both will be in unison. Please mind that it is fully normal for both Dow Theories to occasionally disagree. Otherwise, they would be the same thing and there would be no way for Schannep’s Dow Theory to build its outperformance versus the classical Dow Theory (more about the Schannep's Dow Theory outperformance here)


Sincerely,
The Dow Theorist