Dow Theory Update for November 3: Primary bear market signaled for US Stocks on November 3rd, as per Schannep’s Dow Theory

Trend under classical/Rhea Dow Theory unclear

US STOCKS

Two days ago I was reporting that the Industrials were very close to signaling a primary bear market signal.

Well, on November 2^nd, at the close, the Industrials deigned to confirm the SPY (SP 500) which had violated its secondary reaction closing lows on 10/13/2016.

As per Schannep’s Dow Theory, it just takes two of the three indices (but the SP500 must always be present, as explained here) to signal a primary bull/bear market signal.

All in all, the September 9/14/2016 secondary reaction closing lows have been jointly violated by the Industrials and the SP500, and hence, a primary bear market has been signaled.

Here you have an updated chart:

Primary bear market signal on November 2nd, 2016 as per the original Schannep's Dow Theory

As Rhea was fond of saying nobody knows the extent or duration of the current primary bear market. It could be a whipsaw in that stocks begin to rally again after the signal or the primary bear market could have some follow through. At this time, we really don´t know.

What we do know, though, is that past primary bear market signals since 1960 had a further decline following the day of the signals of ca. 12.5%. until the final bottom was made. Of course, averages are misleading. Under such an average, we see instances where the subsequent decline exceeded 20% and even 40%. On the other hand, especially since 2011, there have been many sell signals with almost no follow thru.

Thus, the average further decline following a primary bear market signal for the period spanning 1960 to 2004 (as recorded on Schannep’s book) was -14.63%.

The same average calculated from the period spanning from 1960 to 6/24/2016 (last completed primary bear market signal) amounts to just -12.52%, which implies that most recent primary bear market signals have had less follow through.

Thus, if we calculate the average further decline for the period spanning from 8/14/2007 (primary bear market signal that was harbinger of the 2008-2009 turmoil) the average further decline until the bottom was made amounted to a more modest  -8.8% (even though there was a further loss to the bottom of -42.48% in 2008).

If we avoid the 2008-2009 huge primary bear market, and we focus on the signals given since 2010, we get a very modest average of only -3.86%. Furthermore, there were two instances where there was zero further decline following the day of the primary bear market signal. In other words, the very same day of the signal was the primary bear market bottom.

I come back to Rhea: In real time nobody can predict the extent or duration of the primary bear market. What we know is that if we take the longer term view, primary bear market signals have:

a) been met with significant follow through (in spite of recent market action).

            b) avoided several market crashes.

In real time, when we have to pull the trigger and take decisions (Sell or adjust parameters to primary bear market conditions or ignore it at one’s own risk), we don’t know what is going to happen tomorrow. If there is a big crash we will look intelligent for having avoided a big hit. If it is a mere whipsaw (i.e. no or scant further decline following the primary bear market signal) we will look stupid.

Of course, one could argue that the Dow Theory is broken, as recent signals (since 2010) have been met with scant follow through. I insist that the main source of the Dow Theory outperformance is predicated upon the further decline following a primary bear market signal. This is the essence of timing. Given that we tend to enter at ca. 7-9% above the bottom, we make up for the percentage lost when entering by witnessing further declines which afflict buy and hold after the primary bear market signal has been signaled. A further decline of ca.7-9% is enough for the Dow Theory to match buy and hold (in terms of performance). If the subsequent decline exceeds 9% we will be in most instances outperforming buy and hold. On the other hand, if the further decline following the primary bear market signal is less than 7-9% we will be faced in most instances with underperformance (unless our entry price following the primary bear market bottom is at a percentage even smaller than 7-9%).

Let’s be clear about one thing: If I were to believe that from now on future primary bear market signals would be met with scant follow through, then I ‘d be better deserting the Dow Theory for good (at least Schannep’s which in the only “flavor” with reliable statistics and hard and fast rules, as the “classical” sadly is plagued with many subjective interpretations). In other words, if further declines following a primary bear market signal as determined by Schannep's Dow Theory were an oddity of the past (“oddity” which has persisted since 1960 even in recent times, albeit to a more mitigated extent), we should declare Schannep’s Dow Theory as dead, as the main source of outperformance versus buy and hold (further declines following the primary bear market signal) would be cut short. At the very least, we should start "tweaking" the rules in order to avoid being whipsawed, which, of course, would be tantamount to a new Dow Theory "flavor". From his November 1st, 2016 Newsletter to subscribers and email alert of November 2nd, it seems Schannep himself is adept at tweaking the rules in order to try to avoid in the future the last string of subpar trades we have been experiencing of late. Personally (and I risk being more popish than the Pope), I strongly feel that Schannep's Dow Theory need not be "tweaked". Any trading system, any, goes through challenging market environments. I will write more about this on the next few days. Key is though to contain losses during the rough patches in order to keep powder dry when markets begin to oblige once again (i.e. when we see big declines following bear market signals, and breakups which have some follow through).

It is a judgment call. I don’t have a crystal ball but, after having thoroughly studied trend following empirically and aprioristically I feel that normally trends tend to persist. The momentum effect, even though it may be muted in specific occasions (as we are currently seeing where breakdowns and breakups fail), is well grounded on psychology and the very financial makeup of market players, and hence I believe (maybe wrongly) that sooner (hopefully) or later (regrettably) it will reemerge.

Hence, I believe that this bothersome ranging in stocks going nowhere will sooner or later end. Once trends come back (and more specifically, once further declines following primary bear market signals gather once again momentum), we will begin to see outperformance, and, hence we will see that Schannep's Dow Theory is not so easy to be broken.

The last trade taken in pursuance of Schannep’s Dow Theory has been a loser. The primary bull market signal was on 8/11/2016 at 218.65 (SPY) and the exit was yesterday, November 2^nd, at 209.74. Hence, a loss of -4.07%. If we take the S&P 500 our loss has amounted to -3.89% (entry at 2182.87 and exit at 2097.94). Within this context, it is good to remember the outcome of the other two trades taken since the narrow range condition began. If my calculations don’t fail me the previous trade (closed on 6/24/2016) resulted in a -2.83% loss (-2.34% for the SPY). The preceding trade which was opened on 10/7/2015 and was closed on 12/11/2015 resulted in a  modest win of  1.23% (for the SPY). Thus, even under the toughest scenario hitherto seen for the Dow Theory losses and overtrading has been under control. Of course, it hurts, as in real life, even contained losses, are just this: “losses”, and it hurts especially because such losses are coupled with underperformance versus buy and hold. It is not the same to have a drawdown of -5% whereas buy and hold loses -30% than having the same modest drawdown whereas buy and hold is slightly in the green. The ranging conditions is also undermining high relative strength stocks, which are also lacking follow through, and even shorter term swing trading. All trend following systems are suffering right now (and this is fully normal if one takes the long term view).

The ranging that began in early 2015 has resulted hitherto in three closed trades. Of course, this is a trading frequency much higher than usual, as on average we should expect less than a trade per year. Even though, as I explained here, we see that even under an environment prone to false breakdowns and breakups, the Dow Theory has managed to avoid overtrading.

What is the situation under the “classical/Rhea” Dow Theory? Answer: Confusing. Dow Theorists are divided. It depends on the way we appraise secondary reactions. Depending on the way we determine secondary reaction we are either in a primary bull market with no sell signal yet (Schannep's interpretation which I make mine), or still caught in the previous primary bear market (thus, no primary bull market signal would have been flashed for a long time). In any instance, no matter what interpretation you take, no sell signal has been given by the classical Dow Theory.

The trend as per the classical Dow Theory will be the object of my next post. It will be a very interesting thought exercise. 

GOLD AND SILVER

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

GOLD AND SILVER MINERS ETFs

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

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