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
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