Dow Theory Update for January 8: US Stocks in primary bear market (with secondary reaction)

Precious metals in primary bull market

I am writing during the trading session of January 8^th, 2019 so things (i.e. the length of the secondary reaction for stocks) might change by the close.

I apologize to my readers for my lack of posting. The second half of 2018 was not very conducive for posting. Health issues (not fatal, but time consuming) of one of my sons coupled with my riding accident in July and a broken finger in December (which still impairs me when I have to type) certainly did not favor my disposition to blog. Furthermore, as it is norm in my life, time was (is) in extremely short supply.

Thanks for the emails I received encouraging me to post.

Without further ado, let’s start our analysis of the markets as viewed through the lenses of the Dow Theory.

US stocks

In my last post of August 31, 2018 I wrote that US stocks were under a primary bull market. Here you have the chart I posted at that juncture:

 

Market situation at August 31st, 2018. It was a primary bull market

The bull market swing continued until September 14,2018 when the Transports made their last recorded closing highs. The S&P 500 made on September 20, 2018 its last closing highs whereas the Industrials did so on October 3, 2018. By the way, you can see in the chart below that higher highs by both the S&P 500 and the Industrials were not confirmed which tends to be a warning sign. Thus, the S&P 500 and Industrials extended gains whereas the Transports was subtly declining. Finally, only the Industrials continued making marginal new highs with even the S&P 500 refusing to do so.

From such highs the three indices started a decline which exceeded more than 3% thereby fulfilling the extent requirement for a secondary reaction. The decline spanned 6 trading days for the Industrials, 19 trading days for the transports and 15 trading days for the S&P 500. The average decline for the three indices amounts to 13.3 days, which is more than the 8 trading days required by Schannep’s Dow Theory. Please mind that according to the classical Dow Theory (which only uses the Industrials and Transports) there was no secondary reaction.

The decline finished on October 11th, 2018. All indices declined more than 3%.

Hre you have an updated chart. Top chart displays the Industrials. Middle chart, the Transports and bottom chart the S&P 500.

Primary bear market with ongoing secondary (bullish) reaction (blue rectangles on the right side)

The orange rectangles on the right side of the chart display the secondary reaction.

From that date a mini rally of three trading days ensued (small blue rectangles). As per Schannep’s Dow Theory it suffices 2 trading days to fulfill the time requirement for the rally following the secondary reaction. As you can see from the spreadsheet below only the Transports managed to exceed the 3% threshold. 

 


The extent requirement for the rally was also fulfilled as it is only required that one index exceeds 3%. Some readers versed in the Dow Theory may be leery as to not demanding confirmation, namely, than at least two indices rally more than three percent. However, the principle of confirmation does not apply to minor movements. For an in-depth explanation please read this post: http://www.dowtheoryinvestment.com/2012/11/dow-theory-special-issue-is-primary.html

All in all, the rally that followed the lows made on October 11^th, 2018 set up stocks for a primary bear signal. A joint (confirmed) violation of such closing lows would entail a primary bear market signal.

On October 24^th, 2018 the three indices violated their October 11^th, 2018 closing lows and hence a primary bear market was signaled as per Schannep’s Dow Theory.

Since according to the “Rhea/classical” Dow Theory there was no secondary reaction, no primary bear market was signaled according to such a Dow Theory “flavor”. In another post, I will analyze stocks as per the classical Dow Theory. As an appetizer it suffices to say that on December 10^th, 2018 the classical Dow Theory signaled a primary bear market too. Thus, both Dow Theory “flavors” are in unison, albeit, as it is usually the norm, the classical Dow Theory took a little bit longer to signal the change of trend (which occasionally may be good as whipsaws are avoided. However, as explained in depth here, in the long term Schannep’s Dow Theory results in much milder drawdowns and better performance than the classical Dow Theory).

By the way readers of this blog may remember that historically, primary bear market signals have had follow through. In other words, following the primary bear market signal, stocks continue declining until a bottom (end of the primary bear market) is made. For any Dow Theory “flavor” (or any Trend following device) to outperform buy and hold it is vital that following the sell signal there is follow through. Furthermore, such a subsequent decline should have enough magnitude to make up for the percentage lost when buying following a primary bull market signal, as trend followers never buy the absolute bottom since the change of trend is only discernible in hindsight. In other words, if on average the entry price as per the Dow Theory tends to be at ca. 7.4% from the bottom (in other words 7.4% “lost” for not being a “buy-and-holder” the subsequent decline when exiting should exceed such a percentage lost when entering). More about this important issue here and here.

Hence the source of outperformance for any trend following device is the decline that follows the sell signal. Absent such a further decline, trend following would be a losing proposition.

When Schannep published his masterpiece book “DowTheory for the 21st Century” he tabulated the subsequent declines following a primary bear market signal from 1960 to 2004. Then the average further decline amounted to ca. -14.6%, which clearly is more than the 7.4% “lost” on average when buying after a primary bear market bottom has been made.

However, things have slightly changed since 2004. I keep an updated spreadsheet. According to it, the average decline following a primary bear market signal after 2004 (and including the last primary bear market signal of 2018) amounts now to a more modest -8.41%. The average decline measured from 1960 amounts now to -12.15%. Much of the reduction in the subsequent decline is due to the market action following 2009. Thus, the average subsequent decline from 2010 onwards has been a meager -4.26%. Thus, since this blog was started in 2012 we have been plagued with primary bear market signals which lacked follow through and hence the Dow Theory has underperformed “buy and hold” for that period. For those wishing to throw in the towel, it is good to remember that the Dow Theory tends to underperform buy and hold most of the time. The contrasted outperformance is built on the long run and is made no by “out-winning” but by avoiding the big declines that occasionally decimate buy and hold (i.e. 1974, 1987, 2000-2002, 2008-2009). An in depth analysis of the outperformance of the Dow Theory versus buy and hold here.

However, this last primary bear market signal has had a follow through of -11.48% which is close to the updated historical average. In other words, the last primary bear market signal has the potential to build outperformance versus buy and hold, since the next “buy” primary bull market signal is likely to be made at a lever lower than the “exit” price (2656.10 for the S&P 500 on 10/24/2018). Now we have to wait and see how things play out in the coming days.

From the 12/24/2018 closing lows all indices have rallied (until Jan 7) for 9 trading days and more than 10 calendar days. Hence the time requirement for a secondary reaction has been fulfilled. The blue rectangle on the right side of the charts above displays the ongoing secondary  (bullish) reaction against the primary bear market. As to the extent requirement, it has been amply met will rallies exceeding +7% as shown in the spreadsheet below:

 All in all, US indices are currently under a secondary (bullish) reaction.

If at least one index declines by more than 3% (after a minimum 2 days decline) the setup for a primary bull market will have been completed. If the pullback fails to better the secondary reaction highs and jointly violates the 12/24/2018 primary bear market lows, then the primary bear market would be reconfirmed and the subsequent decline following a primary bear market signal would be even larger.

Please mind that Jack Schannep does also use his capitulation indicator (which is mean reversal) in addition to the Dow Theory. As I wrote here when explaining all the tools included in Schannep’s trading toolbox:

“When markets experience a dramatic decline (as measured by Schannep’s proprietary indicators), investors are advised to exceptionally deviate from trend following and, instead, bet for a trend reversal. In other words, when the market is severely oversold, buy and expect a new bull market soon. Of course, this is not trend following but, rather, mean reversal trading, which is in the antipodes conceptually of trend following. However, Schannep’s capitulation indicator (more about it here) has served him well in the past.”

Thus, on December 24^th, 2018, Jack Schannep advised his subscribers to open a 50% position since the “capitulation” level had been attained. However, this blog is not a substitute for Schannep’s newsletter, which I have always recommended, and, besides, its main focus is the Dow Theory (trend following). Thus, for the purposes of this blog, we have to wait until a primary bull market is signaled by the Dow Theory (in which case, I assume, Schannep would go from a 50% position to a fully invested position).

GOLD AND SILVER

The primary trend turned bullish some days ago. A big change of trend as I will explain in a future post.

GOLD AND SILVER MINERS ETF’s

The primary trend turned bullish some days ago. A big change of trend as I will explain in a future post.

Sincerely,

The Dow Theorist