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.

The Dow Theorist

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