Trying to make
sense of them
This is a long
post and a quite difficult one to digest. However, if you want to really
understand how secondary reactions are to be appraised under a strict reading
of the Rhea/Classical Dow Theory, please bear with me.
Readers of this Dow Theory
blog know that one of the virtues of Schannep’s Dow Theory is that it has set a
definite set of rules in order to determine the existence of a secondary
reaction. If properly understood, Schannep’s Dow Theory leaves little margin
for divergent interpretations. While this can be bad some times by eliminating
the “art” of the trader, its track record attests to its effectiveness. Furthermore,
the trader that dwells in me tells me that to successfully “time” the market
one needs a definite set of rules, know them inside out (and understand them) so
that one has the courage to stick to them through thick and thin. Blurred
definitions eventually lead to subjectivity, and subjectivity, unless one has
the makings of a very successful trader, leads to inconsistency and eventual
defeat.
The concept of secondary
reaction is essential for the successful application of the Dow Theory, as
secondary reactions are intimately related to the actual primary bull and bear
market signals. Secondary reactions are the pivot points. Hence, our accuracy
in calling the turning of the tide will depend on how we appraise the existence
of secondary reactions. If we see one where there is none, and its highs (or
lows) are broken up/down we will be getting false signals. By the same token, if we recognize a secondary reaction too late, we will get belated
signals (which erode performance). As you know from this post, the earlier the
sell signal, the more outperformance versus
buy and hold (BAH). Conversely, the more belatedly the buy signal is given,
the more underperformance versus BAH.
Therefore, under the “Rhea/classical” Dow Theory, secondary reactions
don’t have hard and fast rules. Hence, in my last post I quoted Rhea’s book “The Dow Theory (Fraser Publishing Company 1993, page 61):
“Probably
no two students would agree on any rule for selecting and tabulating the
important secondary reactions which have occurred (…).
Rhea himself was adamant to
“box” the definition of a secondary reaction inside a specific set of rules.
This might have worked for Rhea as he was genetically designed for trading. He
was born with the innate talent (which he perfected with thousands of hours of
study). One thing is clear. I’d say that a meager percentage of all those who
attempt to time the markets (be it short or long term) succeed. However, even a
more modest 0.1% are innate traders born with the skill. Rhea (and I feel
Schannep) are on this league. For the rest of mortals, there is the chance of
being a good, long term profitable, trader provided we remain disciplined and
stick to a good trading system (rule based system with a proven track record
under many market conditions). We, the “normal” traders, would succumb if we
just attempted to trade based on our subjective interpretations. Our demise
would come when the first or second drawdown hit. As the second guessing would
destroy us.
I have written in the past
that this is why I am enthusiastic about Schannep’s Dow Theory. The fact that it
has a better track record than the Classical Dow Theory (more performance and
less drawdown) is not, in my opinion, what really made me a “believer”. Rather,
it was that Schannep’s Dow Theory had a definite set of rules with very little
room left to subjective interpretation (the “subjective” side, is where normal
traders screw things up). In addition, and given the existence of hard and fast
rules, Schannep could come up with a verifiable real track record. All in all,
Schannep’s Dow Theory fulfilled the two requirements needed by ordinary (not
the specially gifted) traders: A sound trading system with a proven track record
(back tested and even forward tested with many years of actual trades).
Hence, the
“Rhea/classical” Dow Theory lends itself to divergent interpretations. Thus,
what if we took just 2 weeks to appraise a secondary reaction instead of 3? We would find
reactions where other practitioners see none because they demand three weeks.
The same applies to the extent requirement.
Therefore, it is no surprise
that Schannep’s in his letter to subscribers of January 1st, 2019
wrote that several “classical” Dow Theorists considered the primary bear market
signal to be given at the following levels:
a)
Schannep himself, and I
agree: December 10, 2018 at 24423.26 (Industrials). More about this
interpretation, here.
b)
Another Dow Theorist
considered the primary bear market signal was not given until the November lows
were breached on 12/14/2018 at 24100.51.
c)
Another one waited until
the March 2018 lows were breached at 23,323.66 12/19/2018.
While, I acknowledge that
the “Rhea/classical” Dow Theory allows for more subjectivity, I beg to respectfully dissent
with the other Dow Theorists and I will explain why.
With such wide divergences,
no wonder the classical Dow Theory gets a bad rap.
In order to set the record
straight, let’s begin with what Rhea wrote (Fraser Publishing Company 1993,
page 52):
“[a]
secondary reaction is considered to be an important decline in a bull market or
advance in a bear market, usually lasting from three weeks to as many months,
during which interval the price movement generally retraces from 33 per cent to
66 per cent of the primary price change since the termination of the last
preceding secondary reaction”.
Thus, requiring a time requirement of three weeks or more
is a reasonable interpretation of the Dow Theory. Quite to the letter. We may
in some circumstances even shorten the time period (which is where we begin
with “interpretation”). However, once we have 3 weeks of price action, the time
requirement for a secondary reaction has been met. Period.
Of course, there is an additional requirement to declare the existence of a secondary reaction. The retracement of the previous bull/bear market swing
must “generally” be 1/3 to 2/3. Once again the specific figure may be open to
interpretation (i.e. 30% is enough, if we have had 2 months of time
requirement?). However, as with the time requirement, if we see a retracement
of the previous bull/bear swing of at least 1/3 the literal application of the
Dow Theory tells us that the extent requirement
has been met.
All in all, if we got at least three weeks and at least
1/3 confirmed retracement, there should be no doubt about the existence of a
secondary reaction as per Rhea’s Dow Theory, no matter who the implementing Dow
Theorist is.
Nonetheless, in real life,
this is not the case. Even when confronted with text-book, literal secondary
reactions, Dow Theorists come up with different interpretations.
To start my (constructive)
criticism. Let’s start with my own interpretation.
I will strictly apply the
Dow Theory as per Rhea’s book. Now I forget Schannep and even my own appraisal of the last secondary reaction that led to a primary bear market.
As you can see on the chart
below the Industrials declined for 18 trading days (orange rectangle on the right
side of the top chart). The Transports declined for 31 trading days. (orange
rectangle on the right side of the bottom chart) Hence, without doubt, both
indices declined more than 3 weeks. Hence the time requirement was more than met on 10/29/2018. No need for
demanding more days of declining prices. Here you have a chart zooming in the
relevant time period.
 |
| The logical appraisal timewise for the secondary reaction that led to the primary bear market signal |
As to the extent
requirement, we have to take into account the total magnitude of the last primary
bull market swing (that the total advance from the last hitherto recorded secondary
reaction until the primary bull market closing high) and the amount retraced by
the subsequent decline. At least 1/3 of the previous swing should be retraced
on a confirmed basis. The closing lows of the previous secondary reaction
(point upon which the new rally is to be counted) were made on 03/23/2018 for
the Industrials at 23533.20 and on 04/09/2018 at 10119.36 for the Transports.
Please mind I am determining the last recorded secondary reaction by applying strictly
the classical Dow Theory (orange rectangles on the left side of the chart). As
you can glance from the charts below (with Fibonacci retracements), at the
11/23/2018 closing lows, the Industrials had retraced ca. 70% of the previous
bull swing (which started on 03/23/2018). As to the Transports, they violated
their secondary reaction closing lows of 04/09/2018 on 12/10/2018 unconfirmed and, hence, no primary bear
market was signaled. However, there is no doubt that there was retracement
(exceeding 100%), and hence the extent
requirement was met.
 |
| Retracements of last primary bull market swing amply exceed 1/3 on a confirmed basis |
Hence, in my humble opinion
there is no doubt that on 10/29/2018 the Industrials and Transports had made
the secondary reaction lows. From such lows the Industrials rallied for 8
trading days (which should suffice even for the strictest Dow Theorist) and the
Transports for more than 7 trading days. Hence, no doubt that the rally
following the secondary reaction lows (blue rectangles on the right side of the
charts) was a proper setup for a primary bear market signal.
On 11/23/2018 the Industrials
violated their 10/29/2018 secondary reaction closing lows (small red arrow on
top chart). The Transports did not confirm until 12/10/2018 when a primary bear
market was signaled. The level at day that for the Industrials was 24423.26
I insist. This primary bear
market signal has been derived by strictly applying the classical Dow Theory
and, by the way, coincides with the analysis I made (which tends to ignore
retracements and focused on a decline of at least 3%) in this post.
So how can a Dow Theorist
interpret that the primary bear market signal was signaled four days later on
12/14/2018? At that date the Industrials closed at 24100.51, which implies an
additional -1.32% lost (compared to the exit at 24423.26, as per my
interpretation) due to not so good timing when exiting.
The only way to determine
12/14/2018 as the date of the primary bear market signal is by defining a
longer secondary reaction for the Industrials. If we took the 11/23/2018 lows
as the relevant lows to determine a secondary reaction, then we would get a
different rally setting them up for a primary bear market (blue rectangles on
the right side of the charts below), and, of course, we get a different date
for the signal. Thus, the Transports violated their secondary reaction lows on
10/12/2018 unconfirmed. Whereas the Industrials broke the 11/23/2018 lows on
12/14/2018. Here you have a chart which
also shows the retracements amply exceeding 1/3 of the previous bull market
swing:
 |
| Orange rectangles on the right side of the chart: Too large a secondary reaction |
However, I cannot understand why it was necessary to
wait so much time (until the 11/23/2018 for the Industrials) to declare a
secondary reaction. As explained above, even under the strictest application of
the classical Dow Theory there was no doubt that on 10/29/2018 the Industrials and
Transports had made the secondary reaction lows once we had a rally (blue rectangles) that clearly exceeded 3% and many days. So with all due respect, I
understand that declaring the primary bear market on 12/14/2018 goes beyond
what constitutes a reasonable interpretation of the classical Dow Theory.
And what about the date of
12/19/2018 which has also been suggested as the date of the primary bear market
signal? Well, this date is even more difficult for me to understand. I know it
is based on the violation of the Industrials’ 03/23/2018 closing lows (and
04/09/2018 lows for the Transports). While such distant lows may seem quite
outlandish, there is so germ of truth in them. However, partial truth is not
tantamount to total truth, and hence, once again I consider that this market
calling goes beyond a reasonable interpretation of the classical Dow Theory.
The partial truth of this
signal is that it is based on the lows of the previously completed secondary reaction.
I have written profusely about the previously completed secondary reaction as a
valid pivot point to declare bull and bear markets here. You can find something
close to a PhD on this subject here (and look also at the links contained in
that post). All in all, the lows of the last completed secondary reaction are
not to be disregarded easily and may serve as a valid pivot point to declare a
change of primary trend.
There is no doubt that if
we define a secondary reaction requesting at least 3 weeks, the orange
rectangles on the left side of the charts below constitute a secondary
reaction (the "previously" completed one). No doubt about it. No arguing. This is the previously completed secondary reaction. And hence the Industrials’ 03/23/2018
closing lows (and 04/09/2018 lows (for the Transports) are valid secondary
reaction lows (the red horizontal lines display the relevant levels to be violated). Furthermore, according to such very strict reading of the Dow
Theory, there was no primary bear market signal in all the months that followed March and April, as you can clearly see on the
charts below. Furthermore, both
indices managed to exceed the hitherto recorded primary bull market highs
(round blue arrows near the middle of the charts) and hence, as per this
reading of the Dow Theory, the primary bull market was reconfirmed.
 |
| Incorrect lows to signal primary bear market: Last completed secondary reaction when a new one exists (green rectangles) |
The lows of the previously completed secondary reaction would be a valid
level to be jointly violated if, after the last primary
bull market recorded highs (middle of the chart, blue arrows) there would not
have been a secondary reaction against such a primary bull market and hence no
subsequent rally setting up stocks for a primary bear market signal.
However, as I show with
green rectangles on the charts above, we had such a secondary reaction after the last bull market highs, and
enough rallies (blue rectangles) setting up stocks for a primary bear market
signal. As I have previously explained, there was no doubt that after the
primary bull market highs there was a secondary reaction. Even the
interpretation that led to the signal of 12/14/2018 (which I have criticized) constituted
nevertheless a secondary reaction. All in all, any way you cut it, the
existence of a secondary reaction after the highs of 10/03/2018 (Industrials)
and 09/14/2018 (Transports) cannot be disputed.
And there’s the rub with
this erroneous interpretation: The lows of the last completed secondary reaction are only
valid as a level to be violated only if
there is no more modern secondary reaction followed but a rally that sets up stocks for a primary bear market But this is not the case in the
current juncture.
It is true that Rhea did
not wrote about a hierarchy of signals (i.e. if we have a recent secondary reaction, the lows of the last completed one cannot be used). In this specific instance we are
confronted with a secondary reaction (green rectangles) with a rally and hence
a setup for a primary bear market signal, and simultaneously the lows of the
preceding last completed secondary reaction (orange rectangles and red
horizontal lines). So any Dow Theorist could tell me that one can disregard the
most recent secondary reaction and avail himself of the previous one as a valid
signal point, as Rhea didn't estalish any particular hierachy. However, my whole understanding of Rhea makes me feel that when
confronted with two alternative signals, we should take the one that implies an
earlier exit. Why?
All traders are aware
of the adage “keep you losses short” which implies having tight stops or exit
points. It goes against my trader instincts to choose the ample stop (the last
completed secondary reaction) whereas I have the recent secondary reaction
which implies a tighter stop. This is especially true in this specific juncture
because, as I have shown, the Industrials had retraced more than 70% of the
previous advance, and hence, nobody can say that it was a tight stop (that is
that the lows of the recent –green rectangles- secondary reaction were too
close to the bull market top). I might even accept to lows of the last
completed secondary reaction (the orange rectangles on the left side of the
chart) if the lows of the new secondary reaction were, i.e. at a mere 4% off the
bull market highs (more risk of being whipsawed). However, in this specific
juncture, demanding an even more ample stop seems outlandish to me and contrary
to good trading principles.
Furthermore, we should not
forget that the Dow Theory has even another exit point at an even lower level:
The last recorded primary bear market
lows. Of course, it stands to reason, that such exit level becomes only
applicable when we don’t have any secondary reaction which serves us to
determine an exit level. No one in their right mind would disregards the lows of the most recent secondary reaction and also the lows of the last completed secondary reacition to wait for a violation of the primary bear market lows to exit. This same logic applies to prefering the lows of the most recent secondary reaction instead of those of the previously last recorded one.
The "pedestrian" graph below illustrates what I am trying to explain. We have three alternative exits. The lows of the most recent secondary reaction (Exit 1), the lows of the prevoiusly completed secondary reaction (Exit 2) and the primary bear market lows (Exit 3). Exit 1 is the exit level to be honored, unless something very powerful advocates for Exit 2 or Exit 3.
The only way to validate in
this specific chart the lows of the previously completed secondary reaction (orange rectangles on the left side of the charts) as
valid lows to be violated for a primary bear market signal would be to acknowledge
that after the primary bull market highs there was no secondary reaction followed by a rally
whatsoever. However, not discerning a secondary reaction after the primary bull
highs amounts to not properly applying
the Rhea/classical Dow Theory which leads to a further
loss due to a belated exit. An exit at 23,323.66 for the Industrials on
12/19/2019 represents a further loss of -4.5% compared to the exit at 24423.26
on 12/10/2018, as per my interpretation.
Conclusions: It is true
that Rhea’s Dow Theory allows for more room of maneuver when appraising
secondary reactions that Schannep’s. However, even under Rhea’s Dow Theory
there are some basic tenets which are carved in stone. Departing form such
tenets is more than interpretation and morphs into something different.
Having said this, I remain
attached to Schannep’s Dow Theory. Less drawdowns, more profits, and more
importantly, less subjectivity.
Sincerely,
The Dow Theorist
