Wednesday, November 20, 2019

Dow Theory Update for November 20: Why aren’t out there any Dow Theory based hedge funds?

 I don’t like stock’s action as per the “Classical Dow Theory”

Breakout systems, moving averages and the Dow Theory:

Hamilton wrote that the Dow Theory could also be applied to any asset traded in an organized (and free) market. This is why when I started this blog some 7 years ago, I decided to appraise the trends of precious metals and their ETFs as per the tenets of the Dow Theory. I hope to publish soon the comparison between buy and hold and the Dow Theory for precious metals over the last 7 years which is a reasonable period. From eyeballing the charts I see that the Dow Theory is likely to be the winner versus buy and hold.

Furthermore, I am planning to toy with several pairs of ETFs (i.e. big cap ETF with small cap; value/growth, etc.). Some days ago, I took USO (crude oil ETF) and XLE (Energy Select Sector), and applied the classical Dow Theory (I cannot use Schannep’s as I only had two indices) to that pair. I was astonished at the results. Outperformance of ca. 1.5% p.a. and a huge, really huge, drawdown reduction versus buy and hold. Hence risk-adjusted performance much better. I hope to pen a post as soon as I have time. It is pity that I have some many occupations and so little free time available, as the more I know the Dow Theory, the more I unearth its net superiority over all trend following methods. I know firsthand of trend following futures funds (mostly based on breakout systems) that are having a very tough time with deep (ouch!) and long (double ouch!, as time decimates one’s psychological makeup more than depth) drawdowns.

In spite of all the praise bestowed upon breakout systems, it is my contention that it is a very inefficient way to follow the trend. Of course, a rising tide lifts all boats, and when there are clean (please mind the word “clean”) trends (as those seen, i.e. in the 70’s and part of the 80’s) people tend to get fascinated with such primitive ways of trend following. However, we should know that markets are not always “clean” and obliging to brute force trend following. Markets can be range-bound or even trend full of noise (reversals which results in whipsaws) and they can stay in that noisy state longer than you can stay solvent. I wonder why nobody in the investment trend following community has ever attempted to launch a Dow Theory based fund. This is why, little by little, I plan to explore how it would have performed the Dow Theory when applied to many asset classes. I plan to compare it to breakout systems and moving averages (we already tentatively know that the Dow Theory beats the pants off them, as explained here and here)


The primary and secondary trend turned bullish on October 25th, 2019, as was explained here and here

If we appraise the trend under the “Rhea/classical” Dow Theory, the primary trend is bullish since April 1st, 2019, as was explained here

The secondary trend is bearish, as there is an ongoing secondary reaction against the primary bull market. The orange rectangles display the secondary reaction. On 06/20/2019 the Industrials bettered their secondary reaction closing highs unconfirmed by the Transports. On 08/27/2019 the Transports violated their secondary reaction closing low unconfirmed by the Industrials, and, hence, no primary bear market was signaled.

The Industrials has continued making higher highs and the Transports have been badly lagging behind unable to break up above their secondary reaction closing highs. The longer it takes for confirmation to occur, the more suspect the primary trend becomes. We should not forget that the failure to jointly better the secondary reaction highs entails that we cannot declare the secondary reaction as extinguished, and hence the secondary trend remains bearish.

Here you have an updated chart:

However, we live and die by the actual signals. Reality is that as per Schannep’s and the “classical” Dow Theory the primary trend is bullish. There are some clouds on the horizon but clouds are not signals to be acted upon them.


The primary trend and secondary trend is bearish as was profusely explained here

I also explained that I’m doubtful as to whether this particular primary bear market will have long legs, as the trend, when appraised using weekly bar (longer time frame) is bullish. The resistance of the gold and silver miners ETFs to signal a primary bear market seems to confirm my qualms.


The primary trend is bullish since 12/18/2018 as explained here. No changes. 

On 09/04/2019 SIL and GDX made its last recorded primary bull market closing highs. From that date both ETFs declined and the secondary trend turned bearish  (secondary reaction against the primary bull market) as explained in-depth here.

On 10/25/2019 the setup for a primary bear market has been completed as explained here

The Dow Theorist

Saturday, November 16, 2019

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

When and how much to buy. Transitioning from a 25% to a fully invested position

As a reminder, I have been writing about capitulation in the following posts.


Well, I finally squeezed some time out of my agenda to pen another post concerning Schannep’s capitulation indicator.

Today we will address the vital issue of position sizing. How much to buy and how to transition from partially invested to fully invested.

Position sizing with capitulation depends on the way you use all the teachings contained in Schannep’s book “The Dow Theory for the21st Century

Schannep describes in his book three main “tools”. The first one is what I call “Schannep’s Dow Theory”, this is the venerable Dow Theory updated (and improved, as explained here) by Schannep. These are the typical “buy” and “sell” signals which follow primary bull and bear market signals. The second one is “capitulation” which we are explaining in this saga. The third one is the so called Schannep’s “timing indicator”. Even though Schannep gives us in his book some explanations about such an indicator, the fact remains that it is not fully made known to readers, and it has nothing to do with the Dow Theory (it incorporates some trend following –momentum- but also monetary policy). In my personal trading and in this blog, I don’t use the timing indicator. Not because I consider it bad (its track record is as good as that of Schannep’s Dow Theory), but because I don’t know its entrails. And without full knowledge I cannot go all in. And it is pity because the timing indicator provides more “smoothing” as it is an additional source of signals. Readers of this blog know that I always insist that the more good quality signals (aligned in our time frame, without becoming short term traders) we get, the better, as it is likely to smooth out our equity curve (less drawdowns, and more importantly, less time in drawdown). The “timing” indicator has been particularly useful since 2011 when Schannep’s Dow Theory, while remaining positive and containing drawdowns, has had a tough time (some whipsaws, which is something totally normal in trading), even though it remains clearly positive. All in all, given the extraordinary run-up of the S&P 500 since 2011, almost all trading systems are doomed to underperform. As I have written many times the Dow Theory outperformance is made when buy and hold stutters. We need big declines in buy and hold for any only long trend following system to outperform.

However, Schannep’s timing system has encountered less whipsaws than his Dow Theory. It is not because the “timing “ indicator is superior to the Dow Theory but merely the specific market juncture from 2011 has been more favorable to the “timing” indicator. It is very likely that in the future things change (i.e. the pattern of declines) and Schannep’s Dow Theory outperforms both buy and hold and the “timing” indicator.

As an aside, this is why I am so fervently studying ways of generating more signals. The more experience I have the more I am convinced that when doing trend following it is impossible to be successful at all times. Trend following tries one’s patience. In the long run, trend following will shine, but the “long run” is indeed very “long” when one has real money on the table. One of the things I like of my short term trading (1-4 days) is that I generate many trades. Hence, even if my system (or blend of systems) is not the best one in the world, by having many strategies working together I make sure that, even though market conditions change, I always have at least one strategy that is doing well. And those that do “less well” do not decimate me, as any good trading system manages to win big when the tide is favorable and lose little when things are tough. Hence my short term trading works (at least for me) because I have several strategies and, at the same time, I generate many trades. A normal day may entail buying or selling short between 4 and 10 stocks. Most of the days, I get some longs and shorts. If the market rallies my shorts will be modest losers most of the time but my longs will do really good. All in all, on average is a profitable system. But what I especially like is that so many trades tend to result in modest drawdowns both in time (i.e. longest drawdown 6 months) and depth (i.e. deepest drawdown around 10%).

Of course, such modest drawdowns in time are almost impossible to obtain with long term trading (i.e. The Dow Theory). Hence, I am quite obsessed with generating more trades (provided they are quality ones, which I am trying to attain by diversifying markets and alternative definitions of secondary reactions). Therein lies the importance of the timing indicator and capitulation. Both provide a little bit of diversification (more rules to define an entry, and with the timing indicator an exit).

I explained all this, because Schannep himself trades with both his Dow Theory and the “timing” indicator which results in what he calls the “composite” indicator. The position sizing for “capitulation” trades when using the composite indicator is, as per, Schannep 50%.

However, when just using his Dow Theory, the position sizing, the initial commitment when capitulation occurs is just of 25% (page 102 of his book).

As I explained here, the time requirement for a secondary reaction gets shortened when capitulation has occurred.

Hence, once we have a rally following capitulation of at least one week (on a confirmed basis), we will declare the existence of a secondary reaction. Following the secondary reaction we will wait for a pullback of at least 3% in one of the three indices. Once the 3% pullback occurs we will immediately buy an additional 25% (this is the only instance in Schannep’s Dow Theory where we anticipate the bull market signal). The final 50% is bought when the pullback stops, a new rally follows which breaks up the secondary reaction highs, thus signaling a primary bull market signal.

The “pedestrian” chart below illustrates the specific process of transitioning from a cero position to a 100% invested position following capitulation.

Theoretically, once I have explained how you go long following capitulation, I could finish here this capitulation “saga”. However, it is now, after initiating or completing a long commitment following capitulation when things get interesting. Now you have to manage your position. What happens if the market starts to go down? Where we will get out? When a new primary bear market signal gets signaled? Later? How do we ride “capitulation” during the market meltdown of 2008? What if the decline is coupled with a new capitulation? These are questions that will besiege us when doing real trading. We better have a clear roadmap before we are confronted with them. The next posts will focus on what happens next.

The Dow Theorist

Saturday, November 9, 2019

Dow Theory Update for November 9: Primary bear market for gold and silver signaled on November 8th, 2019

Likely secondary reaction in US treasuries

This is going to be a long post. It took time and dedication to write it, and to fully apprehend its implications (especially for precious metals and interest rates), one should take also time to read it. No pain, no gain.

The primary and secondary trend turned bullish on October 25th, 2019, as was explained here and here


The primary trend (and secondary one) turned bearish on November 8th, 2019

As was explained here following a secondary reaction against the then existing primary bull market, the setup for a primary bear market was completed (rally shown with blue rectangles). On November 7th, 2019 GLD violated the secondary reaction closing lows, and on November 8th SLV confirmed, and hence a primary bear market was signaled.

Here you have an updated chart. The orange rectangles depicts the secondary reaction which followed the last recorded primary bull market highs. The blue rectangles show the rally that followed and which set up both precious metals for a primary bear market. The red horizontal lines display the secondary reaction closing lows which had to be jointly violated.

The now defunct primary bull market has lasted almost one year (since it was signaled), as the primary bull market was signaled on 12/24/2018. The total bull market swing has lasted more: From 11/13/2018 for SLV (starting point of the swing) and 08/16/2018 for GLD.

Here you have the charts displaying all the market action since the 12/24/2018 (date of the primary bull market signal) to date. As you can see (orange rectangles on the middle of the charts) there was a secondary reaction which did not result in a primary bear market as higher highs ensued. 

This trade has been a winner. From the date of entry (12/24/2018) to the date of exit (11/08/2019) SLV has made 13.19% and GLD 14.47%. Here you have the calculation on the spreadsheet below:

By the way, I always insist that the on source of outperformance for the Dow Theory is the further decline following a primary bear market signal. If following a primary bear market signal, there is no further decline, we can remain profitable, but we will never outperform buy and hold. More about this vital insight here

Hence, in order to really determine whether the trade closed yesterday has really outperformed buy and hold, we have to wait until we know when this new bearish swing comes to an end. Now we have a “winning” trade, but we don’t know whether it has outperformed buy and hold yet. To know this, we have to wait until the next primary bull market signal which will establish the final primary bear market lows.

Thus, the following calculations do not relate to the outperformance of this trade, but serve to keep track of the important issue of “further declines following a primary bear market signal”.

Well, let’s go back in time to assess whether the preceding primary bear market signal (not this one, the preceding one) did have follow through. That primary bear market was signaled on 07/07/2017. The spreadsheet below displays the decline that followed the primary bear market signal of 07/07/2017. 

Let’s look at SLV. On the one hand, the decline that followed the primary bear market signal was quite OK (-10.73%). This was lost to buy and hold, and “won” by trend following (Dow Theory). Furthermore, you can see in the charts that the entry price (12/24/2019) was at a lower level than the previous exit price due to the bear market signal (07/07/2017). Moreover, SLV has made an absolute gain (exit minus entry price) of 13.19%, which is a very good trade for slightly less than one year time.

GLD had a more modest further decline following the primary bear market signal of just -3.63% (nonetheless, this adds to the “outperformance” side). Given that the “further decline” was modest the entry price on 12/24/2019 was at a higher level than the previous exit price. This notwithstanding, GLD managed to win 14.47% on this trade.

Since one never knows in advance which of the two precious metals is going to result in better performance, my piece of advice is to split 50% the trading funds to each of the ETFs. If we had done so, our average performance SLV+GLD would have been of 13.83%.

All in all, a winning trade. Furthermore, and I hope to give more precise figures in the future, the Dow Theory has been particularly good at outperforming buy and hold during the long secular bear market that plagued precious metals since 2011. While, of course, it is difficult to extract positive performance when the secular tide is bearish, the Dow Theory has clearly outperformed buy and hold. In the past, I did yearly appraisals of the performance, which you can find here, here and here

However, due to lack of time, and more specifically because I feel that to truly determine whether the Dow Theory really works we need to take a longer perspective (at least 5 years), I discontinued such annual analysis (even though the Dow Theory tends to outperform buy and hold in most years). When time allows, I plan to make an assessment of how the Dow Theory versus buy and hold since I started the blog in 2012.

As an aside, the much longer term trend when appraised with weekly bars is bullish. Yes, on 07/01/2016 the primary trend (appraised with weekly bars) turned bullish. To this date it has not been reversed. This implies that, it is quite likely that we will not see lots of further decline following the current primary bear signal. Time will tell. However, as I’ve written in the past, I trade based on the signals arising out from daily bars (closing prices), not on trends discerned when plotting weekly bars. However, it is always informative to have a bigger timeframe. The bigger picture tells us that the trend is bullish. Below the weekly charts for SLV and GLD

The trend when appraised using weekly bars: Bullish


The primary trend is bullish since 12/18/2018 as explained here. No changes. 

On 09/04/2019 SIL and GDX made its last recorded primary bull market closing highs. From that date both ETFs declined and the secondary trend turned bearish  (secondary reaction against the primary bull market) as explained in-depth here.

On 10/25/2019 the setup for a primary bear market has been completed as explained here


While US interest rates is not the main focus of this blog, it should be so if I had more time. I have written in the past that interest rates are even better suited to the Dow Theory (or trend following in general) than even US stock indices. I’d further add that given that US interest rates tend to fluctuate slowly, the daily volatility of interest rates ETFs (especially for those in the short term spectrum) tends to be substantially lower than that of US stock indices. It is my contention (derived from my short term trading) that the lower the volatility, the less likely is to experience whipsaws (and hence the more profitable will be trend following versus fading the trend). Thus, interest rates are less prone to reversals which, in more volatile markets, can lead to false Dow Theory signals. Of course, the relationship between volatility and the Dow Theory is a subject to be dealt with in a future post of this Dow Theory blog.

Well, TLT and IEF have had a beautiful bull run. Depending on the way I appraised the secondary reaction leading to the setup for the primary bull signal, the bull market was signaled either on 11/19/2018 or 12/18/2018. From those dates there has been a bull run that wasn’t even interrupted by a secondary reaction.

However, on 11/08/2019, I feel that one could conclude that a secondary reaction has been signaled. The time requirement has been amply met. We have had more than two months of declining prices. As to the extent requirement, TLT has retraced ca. 36% of the bull market swing that started at the primary bear market lows of 11/02/2018.

IEF has roughly retraced 27.5% of the bull market swing that started at the primary bear market lows of 10/05/2018. So IEF has not managed to retrace the famous 1/3 alluded to by Robert Rhea. However, as even Rhea himself suggested (page 61 of his book “The Dow Theory”, Fraser Edition 1993) the definition of secondary reaction is not carved in stone. Furthermore, as I wrote here, I feel that the more “time” we have, the less “strict” (but be cautious!) we can be with the extent requirement.

In this specific instance, we have had more than 2 months of declining prices which greatly exceeds 3 weeks. Furthermore, we have had almost a year (since the signaling of the primary bull market) without a secondary reaction (which is not normal, as bull market swings get often interrupted by secondary reactions). Hence, when I consider all factors, I consider that the current decline may be qualified as a secondary reaction. One option for the actual trader of IEF and TLT could be to split its capital. One half considering that a secondary reaction has been signaled (which might lead to a primary bear market signal in the future) and one half as if nothing has been signaled (waiting for the 1/3 retracement on a confirmed basis). Readers of this blog also know that I am a firm believer in generating many trades in order to reduce drawdown duration. Hence, in doubtful cases, such as this secondary reaction, there would be nothing wrong with trading ½ of capital in different ways.One half assuming that there is right now a secondary reaction (which might be followed by a bear signal); the other half waiting for more declines in IEF so that the 1/3 retracement requirement is also fulfilled.

Here you have an updated chart. The orange rectangles on the right side of the chart display the current secondary reaction. The darker orange rectangles within the lighter and larger rectangles depict the first decline that did not manage to fulfil the time requirement for a secondary reaction.

US interest rates. A primary bull market which after ca. one year advancing seems to be under its first secondary reaction

The Dow Theorist