Monday, March 16, 2020

Dow Theory Special Issue: Back to Divergent interpretations of the “classical” Dow Theory (IV)

Primary and secondary trends unchanged for US stocks, precious metals and their miners ETFs and US interest rates


When I thought that all was said and done concerning this saga (see here, here and here). Once again, I feel that some remarks concerning what I consider to be a quite “nonreactive” interpretation of the Dow Theory are in order.

One well-known Dow Theory service (not Schannep’s) is still struggling with the signaling of a primary bear market signal.


1)     Because if one uses the “Rhea/classical” Dow Theory we need three weeks of declines and a rally thereafter. When the newsletter writer penned his thoughts were we not yet at three weeks of confirmed declines, even though losses were already mounting. So up to here, there is nothing to comment. I have already explained ( ) that the classical DT is less reactive than Schannep’s, and it was not the Dow Theorist’s fault to “suffer” because no secondary reaction had been signaled while stocks continued falling. He was right in sticking to the rules. As a reminder Schannep’s Dow Theory is more reactive because of two rules: Firstly, secondary reactions need less time (8 days as the average of the three indices and at least 2 calendar weeks on 2 indices) and extent (just 3% confirmed, not a 1/3 retracement); Secondly, because Schannep’s DT has the so-called bear market definition (-16% confirmed decline of both the Industrials and the S&P 500) which acts as a stop of last resort. I would tentatively add, subject to nuances to be further explained on this blog, a third rule, namely, the lows of the previously last completed secondary reaction, which, i.e. in our present juncture would have saved the day. Did you know that those selling on the lows of the last completed secondary reaction (01/31/2020) closing lows, would have made a profit of +3.66% on the last trade? 

All in all, because of the above mentioned features, by design, Schannep’s Dow Theory is much more reactive than the classical Dow Theory. Thus, the suffering of some Dow Theorists (seeing the market collapse and not being able to declare a primary bear market) could have been avoided (or at least mitigated) by applying Schannep’s Dow Theory. Hence, no criticism to all those classical Dow Theorists out there that are licking their wounds.

By the way, at the risk of repeating myself (as old Russell did under the excuse of explaining old things to new subscribers), the reactiveness of Schannep’s Dow Theory comes for free. It is not at the expense of performance. Schannep’s Dow Theory has consistently outperformed the classical Dow Theory with less drawdowns, and with just a small increase of trades. Read the link below to get fully convinced. 

3)     However, and here I allow myself to do a small criticism directed at some “classical” Dow Theorists, the lack of reactiveness of the classical Dow Theory is partially mitigated by the use of the lows (highs for buys) of the last completed secondary reaction. I always refer to page 77 of Rhea’s book (Fraser Edition 1993), and of late it’s become almost an obsession in this blog (not because of me, but because many markets at the same time have broken down the lows of the last completed secondary reaction. Thus, I feel that “classical” Dow Theorists have no excuse in forgetting to apply such lows as a valid exit point. This is particularly poignant for classical Dow Theorists as:

1.      They don’t have the -16% stop of last resort (bear market definition fully explained here)

2.      The added time and extent required for the formation of a secondary reaction (translation: slowness)

Hence, if “classical/Rhea” Dow Theorists applied in full all the tenets of the classical Dow Theory, they’d heed the lows of the last completed secondary reaction as depicted by Rhea. This is not an invention of this blogger truly yours. It is there for all to see (and apply) since 1932. All in all, classical Dow Theorists should take into account the lows of the last completed secondary reaction if they want to avoid being befuddled when the market starts falling like a knife. Classical Dow Theorists need such a stop much more than Schannep’s Dow Theory.

As an aside, this is why, at least for me with low drawdown tolerance, the Classical Dow Theory is almost untradeable. By design, it can have losing trades exceeding 20%. Of course, as far as I recalled this never happened in the past (although in 2008 the "classical" had a loss of -19.33% ) because the markets obliged and allowed for a timely exit (in the form of having enough time to form a secondary reaction, subsequent rally and final breakdown before the really big declines really set in). However, it should not necessarily be forever this way. I wrote several years ago that US stock markets had been very obliging and well behaved to investors for the last 100 years. As an example, Chinese stock markets are more unruly (noisy). As an aside I’m developing a “noise indicator” which shows me when, in spite of seeing a nice trend on the chart, noise undermines signal and makes whipsaws more likely. But this is another project in my pipeline. I mention my noise indicator, though, because US stocks have been noisier since 2009. In spite of the nice upward trend, noise as read by my indicator has increased. While it is true that my indicator shows some noise reduction as from 2012, I must stress that from the period 2006-2012 noise jumped from 5.37 to a whopping 18.60, a threefold increase in noise. No wonder that many shorts were whipsawed during the 2008-2009 bear market. Although since 2012 noise has declined it stands even now at a higher level than in 2006 (now it stands at 7.55 which is higher than the level in 2006). All in all, after a nice upward trend that has lasted many years, noise is still higher than that we had in an also trending market (2006). The takeaway is clear: Markets are noisier (less signal) now and, hence, more prone to whipsaws.

More noise is not the end of trading, as there is still signal left (and things can change), but it is headwind and brings us closer to “chinification” (not there yet though). Why I am so sure we are not “chinified” yet? Very easy: The current reading of noise for the large cap Chinese stocks ETF (FXI) stands now at 12.89, which is much higher than the 7.55 of the SPY. So in spite of everything the SPY remains a better vehicle for trend followers to trade. This is not to say that, with a view to constructing a portfolio, one should not commit a specific percentage of the available funds to Chinese indices (as one can do with “noisier” gold, GLD, currently with a noise reading of 13.47). However, if I had to choose just one stock index, I’d unhesitatingly choose the SPY or DIA.

Portfolio construction under the Dow Theory is another project in my pipeline.

The bottom line is that looking forward the “classical” Dow Theory is more likely to undergo big losses (of which it will recover, no doubt, but it temporarily hurts) that previously seen in the past. The current market juncture attests to that. This is why “classical” Dow Theorists if not killed by the current decline (still waiting for the sell signal?), are going to be killed by the next one if they don’t adopt the lows of the last completed secondary reaction as an alternative exit point.

As a reminder, by using the lows of the last completed secondary reaction, I declared a primary bear market under the “Rhea/classical” Dow Theory on March 9th, 2020, as explained here. From that date to the close of March 16th, the Industrials have “bled out” an additional -15.35%. I don’t want to pontificate but I feel the proper application of the “classical” Dow Theory demands not ignoring those vital lows.

And here you have a chart which show the exit and subsequent further decline:

If we avail ourselves of all the rules pertaining to the classical Dow Theory we can survive unpleasant market shocks
On the other hand, Schannep’s Dow Theory will likely suffer less as it reacts more quickly. If we add the lows of the last completed secondary reaction to the arsenal of Schannep’s Dow Theory rules we are likely to be even better equipped to deal with noisier markets. See below the chart showing the two alternative exists. The pink horizontal line shows the lows of the last completed secondary reaction and the read horizontal line shows the typical set up: secondary reaction (orange rectangle, followed by a rally, blue rectangle, and subsequent breakdown). In any instance, both alternative exits, were at a higher level than that of the “classical” Dow Theory.

More responsive Schannep's Dow Theory

I would have liked to pen a nicer, more elegantly written and organized post. However, I’m quite busy these days dealing with the markets. I traded style for efficiency.

One Dow Theorist

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