Wednesday, May 22, 2019

Dow Theory Special Issue: Capitulation. The ultimate bottom indicator (III)

Performance after capitulation: Further advances and declines

At last I found some time to pen a new post concerning capitulation. 

The proof of the pudding is in the eating. In this post, we will describe what happens after capitulation has occurred. Do we get strong rallies after capitulation? If yes, then the indicator has some value. 

As a reminder, I have already written two posts concerning capitulation. If you are new to this blog, please read them so that you get acquainted with capitulation.

Disclosure: all the numbers I will show have been derived from Schannep’s book (“The Dow Theory for the 21stCentury) and, more importantly, their updated version to be found on Schannep’s website, "The Dow".

To begin with, capitulation is not signaled very often. As I derive from Schannep’s website from December 31st 1953 until December 24th 2018 (last occurrence) there have only been 16 instances. Hence, “capitulation” will not result in “overtrading”.

We will highlight two features that attest to the accuracy of capitulation detecting impending rallies. These features are:

·        Closeness to detecting bear market bottom.
·        Subsequent rally after the capitulation signal.

As to the closeness or accuracy of the capitulation indicator detecting the bear market bottom (that is catching the falling knife), it has called the exact bottom of the bear market on 4 occasions. The first one, the day of the 1987 market crash (October 19th, 1987). The second one, on August 31st, 1998  (the Asian financial crisis, another day when panic was the prevailing mood due to the suddenness of the collapse). The third one on October 9th, 2002 (the last confirmed bear market bottom of the 2000-2002 bear market) and, more recently, last December 24th, 2018, a date when, to say the least, optimism was not prevailing on the markets. On such four instances capitulation suggested the opening of a long position on the very day of the market bottom. Of course, in real time it is difficult to act on such a “buy” signal, as despondency and fear prevails. Hence, the importance of knowing inside out the entrails of this indicator, so that the trader overcomes fear when prompted to act. In theory it is very easy to look at the past track record (and especially at market crashes) and think that one will keep calm next time and pull the trigger. However, in real life, it takes a deep conviction to isolate yourself from the hysteria and go long. In the end of the day, Schannep’s long term outperformance is being built by buying on really nasty days (this also includes buying “normal” Dow Theory signals given when everyone is pessimistic). All in all, as with short term trading, you cannot “pass” any single trade because you don’t know which one is going to be the big winner.

Of course, not all capitulation signals are given at the exact day of the bottom. The median time from the signal to the actual bottom is 2.5 days, whereas the average time to the bottom is 13.4 days. The noticeable divergence between the median and the average is due to the fact that most of the capitulation signals are given very close to the market bottom. 9 out of 16 signals have been given within 3 days or less to the actual bottom. That’s accuracy! However, there have been some other instances where the final bottom was more distant in time (i.e. on July 19th 2002 it took an additional 57 days to reach the bottom). Such rare occurrences increase the average time to the bottom but, since most of the signals are close to the bottom, the median remains small (2.5 days). Therefore, the median is more representative of the accuracy of the indicator than taking the average.

Furthermore, we should not get too scared with those signals that were given too early as the decline that follows the signal until the final bottom is made tends not to be that big. In other words, even if in some instances we are a little bit early what happens afterwards is not catastrophic. Normally, there is no dramatic decline following the capitulation signal (the exception is the bear market of 2008-2009 which will be the object of a specific post, as it is good to see how Schannep sailed such turbulent waters). More specifically, the median percentage decline that follows the capitulation signal amounts to 1.4%. If we take the average, the subsequent decline averages 4.4%. Once again the average is larger than the median as in most cases the subsequent decline following the capitulation signal is muted. However, there are some few instances (i.e. the horrible bear market of 2008-2009 with three capitulation signals) where the decline following the signal was big (20%, 8.8% and 8%. More about such signals in a future post). However, we must bear in mind that Schannep does not recommend to go long 100% after a capitulation signal. Depending on the way you apply Schannep’s Dow Theory either a 25% or 50% position is opened at the close of the capitulation day (or next day’s open). In other words, even in those rare instances where catching the falling knife results in sizeable declines following the signal, the total loss is well contained. As an appetizer to my future post concerning the bear market of 2008-2009 and how Schannep sailed through it, it suffices to say that we greatly outperformed buy and hold.

As to the rally that follows capitulation, Schannep has tabulated the price advances in a 6 months, 1, 3 and 5 years window. For the full details, please go to Schannep’s website.

After six months the median advance amounts to 17%. The average amounts to 15.9%.

A six months window is important, as short lived Dow Theory signals tend not to reach one year. Hence, it is good to know what is likely to happen in case the rally fizzles out after 6 months. In other words, if we act on capitulation day, we are “long”. As per Schannep’s Dow Theory we will get out either if the cyclical bear market definition is met (-16% on both the Industrials and the S&P 500) or a primary bear market signal is given. As I wrote here, roughly just 5% of the exit signals correspond to the bear market definition being met. The overwhelming majority of signals correspond to the “typical” Dow Theory signal.

 Hence, while things can change in the future, we can reasonably infer that roughly 5% of the “exits” are going to be given by the bear market definition being met, which implies a loss from the highest point of the rally of ca. -16%. Please mind that this is not the total likely loss of the trade, since even if we got a modest +10% rally, the -16% is counted from the top, not from the entry on capitulation day. The average rally amounts to 15.9% from capitulation day. Hence, a loss from the top of ca. -16% would basically result in a very modest losing trade. 

As to the majority of “normal” Dow Theory exit signals we also know that on average Schannep’s Dow Theory exit longs at an average distance of 7.7% of the tops. In other words, even if we got a very modest rally of, say, 10% following capitulation day, that trade would remain a modest winner.

Thus, even under a quite adverse scenario trades taken under capitulation signals are very likely to be winners. 

After 1 year the median advance amounts to 26.5% and the average 25.7%.

A one year time frame is important because the average trade taken under Schannep’s Dow Theory tends to last between 1-2 years. In other words, a one year window shows us whether during the first year of life of a “normal” Dow Theory trade we will have enough tailwind. Please mind that on capitulation day, the trader is advised to open a 25%-50% commitment. However, a 100% long position will not be achieved until a bull market definition (+19% on both the Industrials and S&P 500) is met or a Dow Theory signals has been given. Hence, “capitulation” trades do not lie in a vacuum, as they either get closed out as losers or evolve into a full buy signal. Hence, it is important to know whether the new rally is likely to become a powerful one or not.

Of course, a ca. +26% one year rally does not imply the absence of turbulences (declines) during the development of that year. Thus, even though, we can have a powerful rally following capitulation day, it could happen that in between a cyclical bear market definition would be met, and hence the long position is to be closed out. However, this has only happened one time in the past (September 20, 2001). The other 15 capitulation trades were not aborted by a bear market definition signal, which means that the average ca. +26% rally did not meet a turbulence (decline) exceeding -16%. This attests to the strength of the rally that follows capitulation.

It would also be possible that, even if no bear market definition (-16% on both the Industrials and Transports) is met, a typical Dow Theory primary bear market signal is given and hence the investor cannot ride the average ca. +26% rally till the end (stopped out). However, even if one were stopped out, the likely outcome is a modest winning trade, as we know that, normally, we are “out” at a distance that normally averages -7.7% from the top. Of course, there are no guarantees and trading with real money is not easy. However, deep knowledge of the “odds” and the soundness of Schannep’s Dow Theory help us harness the strength and will not to flinch.

Once again, I encourage my readers to go to the original. Read Schannep’s book at least 5 times until it becomes dog-eared. Additionally, go to his website and immerse yourself in the numbers.

The Dow Theorist

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