Saturday, April 25, 2020

Dow Theory Update for April 25: Setup for a primary bull market signal in US stocks completed

Rhea’s letters (a real gem) available


I am reading Rhea’s “Dow Theory Comment” which is a collection of the letters he wrote to his subscribers from 1932 to 1934. I could get this rare collectible from Alanpuri Trading


Rhea's "Dow Theory Comment" is the best companion to his book “The DowTheory”. I am impressed, to say the least. We have much to learn from the wisdom of Rhea. The same applies, of course, to Schannep. Read his book first, and then start reading all his letters. If you read both, you’ll become a much better investor. The books serve to give you the theoretical framework. The letters provide you with great insights into how to make decisions in real-time when under fire. 

Of course, reading all these books and letters to subscribers takes time. However, there are no shortcuts to becoming a moderately good investor (Rhea never boasted of being a good one, even though he was). The only way I know to escape from mediocrity is by modeling those that succeeded.


Schannep’s Dow Theory

The primary and secondary trend is bullish since April 6th, 2020 (bull market definition), as was explained in-depth here

By the way, even though we don’t need a “typical” Dow Theory signal consisting of bear market low, secondary reaction, pullback, and breakup, as the April 6th signal was given before, we’ve got a setup for a primary bull market signal. 

Here you have an updated chart. The blue rectangles show the secondary reaction against the primary bear market and the orange rectangles show the pullback which completed the setup.

Here you have an updated chart:

“Rhea’s /classical Dow Theory

The primary turned bearish on March 9th (once again: the lows of the last completed secondary reaction violated), as explained here. As a reminder, the classical Dow Theory does not use either “capitulation” or “bull market definition of +19%”. Hence, despite the torrid rally off the 03/23/2020, we have to wait for a change of trend until:

  • Either a secondary reaction develops, followed by a pullback and subsequent breakup.

  • Or, if no secondary reaction develops until the last primary bull market highs are broken up (which would be a horrendous and improbable entry).

In my last post, I explained that it was not outlandish to consider that a secondary reaction existed on 4/17/2020. From the secondary reaction highs of 4/17/2020 there has been a pullback (amply exceeding 3%). Hence, the setup for a primary bull market under the “Rhea/classical” Dow Theory has been completed. 

Here you have an updated chart:


The primary was signaled as bullish on 02/19/2020, as explained here.

Following a sharp decline, SLV penetrated its last recorded primary bear market lows on 3/12/2020. GLD declined but on a much more muted basis and did not confirm.

One could consider the decline as a secondary reaction. An in-depth explanation about it here.
Hence, no primary bear market signal. Rhea (page 77 of his book, Fraser Edition 1993) recognized as a valid exit point the closing lows of the last primary bear market (red horizontal lines on the charts below).

On 4/9/2020 GLD bettered its last recorded primary bull market highs unconfirmed by SLV, so the primary bull market has not yet been reconfirmed. 

Here you have an updated chart:


One legitimate interpretation of the Dow Theory would let us conclude that the primary trend turned bullish on April 9th, 2020 (at least for a partial commitment) as explained here.

For those wishing to adhere to a more strict interpretation of a secondary reaction, the primary trend would remain bearish (signal given on March 11th, 2020), as explained here.

The more I deepen the Dow Theory the more convinced I become that one is not supposed to bet the whole ranch on any single appraisal of a secondary reaction. There are cases where only one legitimate appraisal of a secondary reaction emerges from the chart patterns. However, this is always not the case. In those less clear-cut cases, deriving two alternative entry/exit signals (which at the same time are derived from our appraisal of secondary reactions) is a sensible course of action. If we take alternative signals, I am convinced that in the long run, both will deliver excellent results. As I wrote recently, I am conducting a test with bonds by using two alternative definitions of secondary reaction (one 3 weeks no matter what, the other one more flexible taking into account the interplay between extent and time). My preliminary results show that both alternative signals are profitable. In many instances, on any given trade, both are profitable. Sometimes one is a loser and the other one a winner. By diversifying across two trades, we smoothen our equity curve (less depth and time in drawdowns), and, as a side effect, our patience gets less tested. My own experience tells me that we should not overestimate our capacity to endure drawdowns in actual trading. It is quite a different thing to see a -20% drawdown that lasted three years in a backtest than living through it in real life with real money on the line. Knowing my weaknesses, I evolved my trading towards minimizing (in this order) time and depth of drawdowns. To achieve so, the more (good quality) trades, the better.

Here you have an updated chart:


Depending on the way one appraises the secondary reaction that led to the setup that resulted in the primary bull market signal, the primary bull market was signaled either on 11/19/2018 or 12/18/2018. Rhea wrote that the definition of secondary reaction is not carved in stone. The signal of 11/19/2018 was obtained by being satisfied with just 14 trading days for TLT and 15 days for IEF. The signal of 12/18/2018 was obtained by being strict and demanding on a confirmed basis at least 15 trading days on both ETFs. It’s up to each investor to decide what to do (i.e. to commit to each signal 50% of one’s equity or go fully invested with just one signal). 

On 11/08/2019 a secondary reaction was signaled, as explained here.

On 02/21/2020 TLT bettered its last recorded primary bull market highs of 08/28/2019. On that date IEF equaled (but did not better) its previous recorded primary bull market highs of 09/04/2019, and hence there was no confirmation. On 02/24/2020 IEF did better its primary bull market highs and, therefore, we can declare the secondary reaction has ended, and the primary bull market as reconfirmed. From the reconfirmation date of 02/24/2020 TLT and IEF went parabolic reflecting the current chaos, which is plaguing all markets. 

From the 03/09/2020 closing highs, both ETFs declined until a bottom was made on 3/18/2020. Hence, there has been just 7 days of decline, and, thus, the time requirement for a secondary reaction against the strong bullish trend has not been met. However, given the magnitude of the shake-up, retracement of the last bull market swing, and the total percentage of the declines, I’d be inclined to shorten the time requirement so that the 03/18/2020 closing lows become the lows of a secondary reaction of just 7 trading days. One sensible trader might proceed as follows: Consider the 7 days decline as a secondary reaction, and, hence, as the basis for determining the setup for a primary bear market signal. At the same time, be more conservative and insist on demanding at the very least 10 days or even 3 weeks. Once we have two alternative setups, which may lead to actual sell signals, split the capital into two. 

All in all: both the primary trend remains bullish, and the secondary trend continues bullish if we stick with a 3 weeks time requirement for a secondary reaction.  However, if we consider the last pullback as a secondary reaction, the secondary trend would be bearish. Up to you to decide! Both alternatives set the basis for good trading and are not mutually exclusive.

On 04/01/2020 IEF bettered its last primary bull market closing highs of 03/09/2020 unconfirmed by TLT. Hence, the primary bull market has not been reconfirmed and, if we consider the last pullback as a secondary reaction, the secondary reaction has not been canceled. 

Here you have an updated chart. The grey rectangles display the “dubious” secondary reaction of just 7 days but associated with big declines both in terms of retracement of the preceding bull market swing  (ca. 75% for TLT retraced and ca. 50% for IEF) and the total percentage of the pullback (huge volatility, so a big movement percentage-wise). In my opinion, the charts are screaming at us “please shorten the time requirement for a secondary reaction; at least for half of your capital. Don’t ignore Rhea’s flexibility”. 

Here you have an updated chart:

One Dow Theorist

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