Dow Theory Update for April 8th: New bull market for US stocks signaled on April 6th, 2020

Should we consider the existence of a secondary reaction in precious metals and US interest rates?

General remark:

Even if you usually only read "US Stocks", please read the sections concerning precious metals and US interest rates, since they contain several musings which I consider important in order to become more profitable (and drawdown contained) Dow Theory traders. Such thoughts are not final, as I am penning at least two important posts on the appraisal of secondary reactions, but are thought-provoking for sure. 

This "Dow Theory Update" is a lengthy one. Take your time to fully digest it. You'll have time for that, as I will not write for the remainder of this week. 

US STOCKS

Under Schannep’s Dow Theory

The primary, secondary and the higher-order (cyclical) trend turned bullish on Monday, April 6th, 2020. As I have already written in the past, I am making a habit to report about important changes in trends with some delay. The goal of this blog is not to be a timing service but rather a meeting point for deepening our mastery of the Dow Theory. Subscribers of Schannep’s Newsletter get in real-time the information concerning changes of trends.

The trend changed due to a powerful rally off the 03/23/2020 bottom. On April 6^th both the Industrials and the S&P 500 had rallied more than 19% and, thus, a so-called “bull market definition” was met. Bull markets when signaled through a confirmed rally exceeding 19% on both the Industrials and the S&P 500 tend to have long legs. This is why I say that this kind of bull market is a “higher-order” bull market than those determined by the “normal” signal (the one resulting from the breaking up of a secondary reaction; the “typical” one).

Here you have a spreadsheet containing the specific data:

While, on average, the “typical” bull market (what I call “primary bull market”) lasts on average slightly more than one year (more statistics here), bull markets established by a confirmed rally of +19% on both the S&P 500 and the Industrials have lasted on average 34.2 months (median 25.4 months). This is why I consider such bull markets as “cyclical” (just below secular) and not merely “primary”. Schannep’s website contains for free a wealth of information concerning this aspect.

 

Of course, if the cyclical, higher-order trend is bullish, the primary and secondary trend is bullish too; at least for now.

Furthermore, the new bull market has technical tailwind, as on March 9th, 2020, there was capitulation. What I explained in this post remains fully applicable to the current juncture:

“Furthermore, we should recall that the capitulation indicator tends to accurately signal the end of bear markets and predicts powerful rallies. Out of 17 signals since 1962, 16 showed profit 6 months after the day of the signal. Only the one of October 7^th, 2008, showed a loss six months after the signal but a gain of +6.6% after one year. The takeaway is clear: Capitulation is a powerful indicator and identifies deeply long term oversold conditions where a strong rebound is likely. Here you have the complete record of the capitulation indicator showing the subsequent gains 6 months, 1 year, 3 years and 5 years after the signal.

  

Thus, in spite of all the pessimism that surrounds us, if the S&P 500 manages to rally +19% off the 03/23/2020 closing lows, we would have a technically promising picture, as we’d have two simultaneous “up” waves:

a)     A bull market signal which in itself is a harbinger of strong and long rallies.

b)    A bull market signal given within the context of severely long term oversold conditions (compressed spring further providing tailwind to the new bull market)”

I just see two small negatives (in real trading very seldom we are served the perfect trade). The first one is the secular trend, which is bearish as explained here. However, we lack a sufficient amount of observations to derive conclusions as to how long a secular trend lasts. I tested ca. 21 years, and we just had three secular bear markets. If we had shorted such secular bear markets (something which I’d never do in real trading. Such a long term short is an invitation to disaster), two trades would have been winners (which means that the bear had enough follow-through) and one would have been a modest loser. However, three trades are not enough.

The second one is that the bull market has been signaled at a lofty level from the 03/23/2020 closing lows (around 20%). In terms of risk/reward this one might not the best trade. However, Rhea did not blink when it came to taking trades at ca. 20% off the lows, albeit it seems this was his upper limit (you’ll see why in my next post of this saga). Nevertheless, a lofty level is not equivalent to a large stop-loss. Our worst-case stop-loss lies at -16% (bear market definition), and the most likely outcome (ca. 9 signals out of 10) is that a “typical “sell signal will be set up with its resulting tighter stop-loss. Go to this post to convince yourself that the average exit lies at ca. -7.7% below the highest point attained in the bull market.

I always insist that the outperformance of the Dow Theory, or any other trend following method, is derived from the declines that follow a sell signal. Nobody can beat buy and hold when declines are absent (or muted). We need the occasional big decline for trend following to recover its luster. For this reason, Schannep (see his book page 108) and I keep an eye on the further decline that follows a sell signal.

 

As I wrote in this post, it was legitimate to discern (and act) upon two different sell signals. One was given on 02/25/2020 with the S&P 500 at 3128.21. The other one was given on 03/09/2020 with the S&P 500 at 2746.56. The subsequent decline until the final bottom of 03/23/2020 (S&P 500 at 2237.4) amounted to a whopping -28.48% for the first exit and a respectable -18.54% for the second one.

Here you have a chart showing the most recent action.

From bear market bottom to new bull market definition

 Under the "classical" Dow Theory

The primary and secondary trend turned bearish on March 9^th (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, we have to wait for a change of trend until:

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

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

GOLD AND SILVER

The primary and secondary trend 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. 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). GLD remains at a safe distance, and hence no primary bear market was signaled. More about the alternative entry and exit signals under the Dow Theory here.

GLD has declined for just 9 trading days. SLV (from last highs to bottom) for 17 trading days. Hence, the decline does not meet the time requirement for a secondary reaction. Since we just have two indices, I’m inclined to go quite “classical” as far as the time requirement is concerned (requiring 3 confirmed weeks). However, being “classical” may entail some degree of flexibility shortening the time requirement for a secondary reaction when circumstances warrant so. The very same Rhea did occasionally require much less time for a secondary reaction to be declared (as I will prove in a post I am currently penning). Readers of this blog stay tuned.

Some readers may wonder why my sudden interest in deepening Rhea, as I have always been a steadfast follower of Schannep’s Dow Theory. The answer is twofold:

• To the best of my knowledge, Schannep himself is the Dow Theorist closest to Rhea, and I know that Schannep is a devout follower of Rhea. 

• Schannep’s Dow Theory uses three indices and has been fully backtested (and traded with real money) for more than 60 years with stock indexes. However, when it comes to applying the Dow Theory to other markets, I don’t have the privilege of having three indices and a proven method. And I am very interested in applying the Dow Theory to other markets as a way of generating more good quality trades. Hence, the better we know all the intricacies of Rhea, the better.

Here you have an updated chart. The hypothetical secondary reaction against the primary bull market is displayed with grey rectangles. Readers of this blog know that bearish reactions (against primary bull markets) are shown in orange. However, since this is a dubious reaction, I use the color grey, to show hesitancy. If we accepted the grey rectangles as a valid reaction, then the subsequent rally (to this day) should be considered as enough to set up both precious metals for a primary bear market (horizontal orange lines). In any instance, we have already an exit area: The lows of the previous primary bear market which were already penetrated by SLV whereas GLD did not confirm by a hair. Hence, if we accept the last pullback as a secondary reaction, its lows would serve as an alternative exit signal.  In other words, we would have two scenarios:

a) If GLD broke down its last primary bear market lows (long horizontal red line at the very bottom), a primary bear market would be signaled.

b) If both SLV and GLD penetrated the shorter orange horizontal lines (secondary reaction lows), a primary bear market would be signaled. 

SLV retraced more than 100% of the previous swing. GLD almost did so. Hence, I feel one could relax the time requirement. Rhea in all likelihood would have done so

GOLD AND SILVER MINERS ETFs

The primary trend was signaled as bearish on March 11th, 2020, as explained here.

Following the turmoil which afflicted markets in late February and March, SIL violated on 02/28/2020 the lows of the last completed secondary reaction, which also constitutes a valid exit signal (especially under the Classical Dow Theory), unconfirmed by GDX. On March 11th, 2020 GDX confirmed, and, thus, we got a primary bear market signal. 

On 03/13/2020 both ETFs made their hitherto last primary bear market lows. From that date, they have rallied (from bottom to last top) for 8 trading years (SIL) and 16 trading days (GDX), which falls short from 3 confirmed weeks. So no secondary reaction in sight, unless we relax either the confirmation principle (something that Rhea occasionally did when dealing with secondary reactions) or the time requirement (which he also did as explained above) or both. In this specific instance, the rally that followed SIL and GDX 03/13/202 lows have retraced slightly more than 50% of the previous bear market swing for SIL and ca. 61% for GLD. Which is quite acceptable. Percentage-wise the rally of the bottom has been huge. So I feel that in this specific instance it might be sensible to consider the existence of a secondary reaction. One could, for instance, accept the current movement as a secondary reaction when both SIL and GDX had been rallying for 8 days (until 03/25/2020) and consider the pullback that followed (until 04/01/2020 for SIL and 03/31/2020 for GDX) as the pullback that set up both ETFs for a primary bull market. signal. 

Furthermore, one is not obliged to bet the whole ranch on any given interpretation (i.e. whether we have right now a secondary reaction or not). One could commit half of the trading funds usually allocated to SIL and GDX to a signal derived from a secondary reaction as described above, and the other half to a more conservative definition which staunchly demands three confirmed weeks. Trading is not black or white. There are nuances. On one specific trade the three weeks definition will emerge as a better option; on other trades, it will be the shortened version. We really don't care. If both secondary reactions have been sensibly appraised we'll do fine after several trades on both definitions. Short term traders when testing parameters for their strategies know that a parameter is dependable when good results are not particularly affected by just one value. If I test a breakout system, and just 15, 45 and 68 days yield profits whereas other values fail something is wrong with the parameter. On the other hand, if good results are uniformly present, then we can somewhat trust the system. The same applies to secondary reactions. Depending on market conditions sometimes a long time definition (i.e., minimum 15 days) will perform better than a shorter definition (i.e. 8 days). However, in the long run both should be profitable. Furthermore, if we shorten the time requirement because specific conditions are met, we are even more likely to be profitable.

Readers of this blog know that I favor multiple “good quality” (sensibly appraised) entries and exits as a way to diversify. The Dow Theory generates on average less than one trade per year. Hence, if one just trades one market, it can take a long time to recover from a string of losing trades (or even only one big losing trade). In traders’ jargon: It takes a long time for the expectancy of the system to be reasserted. I am a very short term trader with ca. 75% of my funds committed to a day trading system. Even though the Dow Theory serves me to adjust my parameters to the “big picture”, I relish the abundance of trades given by short term trading. I don’t care if I have four losing days in a row. I know that next day more new trades will come, and, hence, my drawdowns are likely to be short-lived. 

While the Dow Theory doesn’t lend itself so easily to become a profitable ultra-short-term trading system, we have two ways of generating more good quality trades (and hence lower the amount risked on each trade and the likely duration of drawdowns on a portfolio basis):

• The first one is using alternative definitions for a secondary reaction so that we can split our capital across several entries (with their concomitant exists). I am conducting such a test with TLT and IEF (US bonds ETFs), and the results look for the time being promising (I am currently in the year 2012).

• The second one is to use several markets; to construct a Dow Theory based portfolio.

By using these two sources of good quality trades, one could generate 10 trades a year (i.e., 5 markets with two alternative entries and exits in each per year). While not a day trading system, the depth and duration of drawdowns (and the percentage risk taken on every trade) would be lessened.

Here you have an updated chart:

Given the amount retraced (more than 50% and the strong rally that got started off the lows one might consider that we have a secondary reaction. Not carved in stone but a valid option.

US INTEREST RATES

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.  

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”. 

This is the clearest example of the advisability of demanding fewer days to declare a secondary reaction

Sincerely,

One Dow Theorist