Saturday, April 13, 2019

Dow theory Update for April 13rd: Once again back to divergent interpretations of the Dow Theory

 Trends unchanged for stocks, gold, silver and their miners

My new post concerning Schannep’s capitulation indicator will have to wait as more “divergent interpretations of the Dow Theory” (more than I could ever conceive) pop up. I have already analyzed some questionable interpretations of the Dow Theory here and here.
Hence, the next post of the “capitulation” saga will have to wait, as I have to write concerning a new “divergent interpretation” of the Dow Theory.

This time the “” website has published an article penned by Marie Anne & Pamela Aden according which bears the title: “The Adens See a Dow Theory Buy Signal”. Well the title may be a little bit misleading as the article itself says:

“A Dow Theory bull market was just confirmed on April 3rd when the Dow Industrials and Dow Transportations both closed above their February highs”

Well, with all due respect, I beg to disagree. And it pains me because the Aden sisters provide good financial advice. I disagree, though for two reasons. 

Firstly, because such a breakout occurred on April 1st, not on April 3rd (on a closing basis, which is the proper way to apply the Dow Theory). So I guess the date April 3rd maybe a typo. The date of the penetration of the February highs was April 1st, 2019.

Secondly, it is true that in this specific instance the February highs (Feb 25th for the Industrials and February 21st for the Transports) were the valid pivot points to be penetrated for a primary bull market to be signaled. But these were the valid price levels because they were the top of the (bullish) secondary reaction that started against the primary bear market since December 24th, 2018. Such highs were important not because they were “monthly” highs but, rather, because they were the top of a secondary reaction which was followed by a proper pullback (orange rectangle) and a final breakup.

Here you have a chart depicting the February highs and subsequent price action to date.

February highs were the top of a secondary reaction against the primary bear market

I feel that taking monthly highs as a valid price level to be bettered in order to declare a new bull market or to consider it confirmed is quite a “divergent” interpretation of the Dow Theory.

Unless my memory betrays me, in which case, I urge readers to correct me, I never read that Rhea wrote that the confirmed breakup of monthly highs was indicative of a primary bull market. What Rhea wrote is that new highs is a bullish indication. But a “bullish indication” may in many instances fall short of a real primary bull market.

In my last post, I explained in depth the only three proper ways to signal a primary bull market:

1)     The first one (and normally occurring first) the typical secondary reaction against the primary bear market, pullback, and confirmed penetration of the secondary reaction closing highs. This is the signal we got last April 1st.

2)     Absent a pullback following the secondary reaction, breaking up the last completed (the previous one) secondary reaction is an alternative entry level.

3) Absent “1” and “2” the last recorded primary bull market highs serve as the stopgap, last resort, primary bull market signal. 

Here you have my “pedestrian” chart depicting the three alternative entry points:

Please mind that under no circumstance the penetration of monthly, weekly or whatever highs is a proper price level to be bettered for a primary bull market to be signaled.

More to the point, Rhea, by quoting Hamilton, wrote the following:

“Whenever a series of rallies and declines have occurred in the day to day movement, always confirmed by both rail and industrial averages, and the rallies carry above immediately preceding high points, with declines failing to penetrate recent lows, the implication is bullish for the immediate future, but not necessarily indicating a primary bull trend” (emphasis supplied)”

Hence, Rhea does not give lots of credence to higher highs which merely better “immediately” (that is “recent”, as monthly highs are) highs. The “bullishness” of such breakup is just for the “immediate future” (so no guarantees of a good follow through) and it does not imply a primary bull trend.

And what happens when within an established primary bull market a (bearish) secondary reaction develops and subsequently new highs (that is highs above the last recorded highs prior to the start of the (bearish) secondary reaction) are made? Rhea, once again quoting Hamilton, wrote:

“The significance of rallies in a secondary reaction in a bull market is explained by Hamilton as follows: “…On the well tested rule of reading the averages, a major bull swing continues so long as the rally from a secondary reaction establishes new high points in both averages” (emphasis supplied)

Hence, Rhea stresses the importance of the highs of a secondary reaction (not any “high”) in order to infer the continuance of an already signaled primary bull market.

Just “higher highs” (whatever they are) is a bullish indication. But “bullish” in what timeframe? A follow through of just one week or one year? Bettering monthly highs may imply some follow through in most instances. However, the subsequent advance may not warrant the risk taken. After a bullish indication we need a strong follow through for a trade to be successful. Monthly or for that matter weekly highs may have “some” momentum left but not enough to be tradable (the money won when successful does not compensate the risk taken). Furthermore, if we trade according to monthly highs we really don’t know what kind of sensible (please mind the word) stop should we put below our entry (maybe the lows of the past month, the lows of the last two months?) We would be left in uncharted waters.  

Availing oneself of monthly, weekly, n-days highs in order to infer a bullish indication without regard to the highs of secondary reactions (the real significant points) dangerously brings the Dow Theory closer to breakout systems (which are used in futures trading, a subject that deserves a post of its own) and more perilously distances the Dow Theory from the time and extent requirements. Yes, you can have a monthly high on the 28th day of any given month, and subsequently on the 2nd day of the next month such monthly high may be broken up. Do 4 days suffice for the breakout to be “strong” and “reliable”. I doubt it. What if the decline following the high of the 28th month is a mere 1% and after four trading days it is broken out. Did we have enough pullback? Breakout systems don’t contain the time and extent requirement embedded in the Dow Theory and I assert that they are less reliable (although you can make money with them if you trade futures, control your risk and have a good bull market as tailwind. However, breakout systems are not the most ideal way to trade stocks or its indices). I wrote a bit about the flaws of breakout systems here.

Another question comes to my mind: What is the proper stoploss point if one opens a trade based on the breakout of last month’s highs? Should we take last month lows (even though they might be either to close or too far away from the entry point)? Once again we don’t have a valid reference. On the other hand, if we trade according to a “non divergent” (aka orthodox) interpretation of the Dow Theory we will always have a proper stoploss, neither too tight nor too wide (either the primary bear market lows or the lows of the secondary reaction).

Finally, in order to be successful in the markets (not an easy feat, though) you have to have some idea about what to expect when taking a trade. Schannep tabulated the advances made by the S&P 500 following a primary bull market signal (page 107 of his book) so that one knows that, at least empirically, his pivot points to be penetrated (secondary reaction highs) are points where the odds favor advances which result in profits. However, nobody knows the further advance following the breakup (even a confirmed one) of a monthly or weekly high. Its tabulation would be time consuming as there are 12 months each year, whereas we have on average less than one buy signal per year when based on the breakout of a secondary reaction high. However, my gut feeling says that the further advance must be much modest to the point of not being tradable. Bear in mind my quote above of Rhea. The breakout of any high is bullish but not any “bullishness” has enough follow through.

By the way, one day I’ll perform a test of a mere breakout system demanding confirmation (applied to the Industrials and Transports). I’ll demand the breakout of, i.e, 22 days high (one trading month), 44 days, etc. I am almost positive that the results will be much worse than those obtained with a “non divergent” interpretation of the Dow Theory.

The Dow Theorist

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