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.
Why?
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
(http://www.dowtheoryinvestment.com/p/face-off-schannep-versus-classical-dow.html
) 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?
2)
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.
Sincerely,
One Dow Theorist
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