Secondary (bullish) reaction for US stocks under the Classical Dow Theory
I am polishing a relevant post concerning the appraisal of secondary reactions. As you know, the correct assessment of secondary reactions is vital as we derive the primary bull and bear market signals from them. The introductory post can be found here.
Please read all the sections of this post, as I have left scattered musings around it. This "Dow Theory Update" is a lengthy one. Take your time to fully digest it. No pain, no gain.
Schannep’s Dow Theory
The primary and secondary trend is bullish since April 6th, 2020, as was explained in-depth here
“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).
I’d be tempted to say that we already have the secondary (bullish) reaction against the primary bear market. Why? Because the Industrials have rallied for 18 trading days and the Transports for 13 trading days. Classical Dow Theory purists have it that we need at least a 3 weeks rally on a confirmed basis. Thus, if I try to remain a purist, I have to say that we don’t have a secondary reaction yet.
In my opinion, though, if we weighted in all the evidence, I feel we could safely say that even under a “classical” interpretation, the odds favor the existence of a secondary reaction:
1. Both indices have rallied more than 20% off the 03/23/2020 lows. So we are talking of a huge rally.
2. The Industrials have retraced more than 50% of the bear market swing (from the last top to bottom). The Transports have retraced ca. 33%. Purists would say that the transports by not having exactly retraced 33.33% (1/3) still falls short of confirming the extent requirement.
3. The Industrials have rallied for 18 days, the Transports “only” 13 days.
4. Rhea wrote (page 43 last paragraph of “The Dow Theory”, Original Barron’s Edition 1932) that “before the Price has advanced 20%, the indications of the trend change should be obvious to anyone accustomed to using the Dow Theory”. Thus, under the Classical Dow Theory, we are at a level of prices where further delaying the definition of a secondary reaction will result in a setup for a primary bull market signal at a too high level.
5. The Classical Dow Theory does not include Schannep’s +19% bull market definition (more about it here). Hence, we cannot be waiting forever until we get served a “text-book” secondary reaction. Rhea was flexible and knew how to put things into context (as he did in July 1932, bear market lows, when the Industrials rallied by 100% before developing a secondary reaction. Of course, Rhea did not wait until prices were up by 100% to buy)
6. As I will make clear in my next post, Rhea knew when to accept a secondary reaction even if the magic number of 15 days was not reached.
7. My rule of thumb is “the more extent, the less time should be required”. “Extent” has been huge, so we shouldn’t get so picky with the “time” requirement.
Therefore, and at risk of being scolded by purists, I feel that one could sensibly conclude that US stock indices are under a secondary reaction. In the end of the day, each investor (or trader) should do his own homework.
This is no math. Rhea was wont to say that the Dow Theory is also an art. Furthermore, alternative definitions of secondary reactions don’t exclude each other. It can be equally right (by “right” I mean winning trades over the long haul) to demand a secondary reaction with just 13 days on the Transports and, alternatively, strictly require 15 confirmed days. The current Dow Theory trade in US bonds attests to that (read below). In that specific instance, I decided that a sensible approach might be to have two alternative definitions of a secondary reaction, which led to two alternative (and hitherto successful) primary bull market signals.
In dubious (and even obvious) cases, by having two alternative definitions of a secondary reaction, you split your risk. I am convinced that over the long run (many trades) both alternative definitions will be profitable (some private tests clearly confirm my view), and, in the short-run (few trades) small divergences may occur (which is good, as it helps us diversify across “good quality” trades). Hence, it may be even a sound practice to make a habit of trying to define two alternative secondary reactions (provided the two of them are logical).
Here you have an updated chart. The blue rectangles display what I’d consider a secondary reaction. However, each trader must do his own homework.
|I consider the blue rectangles to be a secondary reaction against the primary bear market|
GOLD AND SILVER
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.
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 already have 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 accepted the last pullback as a secondary reaction, its lows would serve as an alternative exit signal, and somewhat tighter stop. 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.
On 04/09/2020 GLD bettered its last recorded primary bull market closing highs (03/09/2020) unconfirmed by SLV. Hence, the primary bull market has not been reconfirmed yet; and, if we accept the grey rectangles as a secondary reaction, it has not been canceled yet.
Please observe on the charts that we have had two non-confirmations. On 3/12/2020 SLV broke down its primary last primary bear market lows (unconfirmed by GLD), whereas on 4/09/2020 GLD broke up its primary bull market highs unconfirmed by SLV. If SLV confirmed, this would be very bullish, as, typically, a breakdown unconfirmed followed by a breakup confirmed denotes a whipsaw (weak hands are shaken out on the unconfirmed breakdown) and a reassertion of the bullish trend on the breakup.
GOLD AND SILVER MINERS ETFs
The primary trend was signaled as bearish on March 11th, 2020, as explained here.
However, some traders might consider that the trend turned bullish on April 9th, 2020 (read below). At least for some, April 9th, 2020 could have been the day of making a 50% commitment.
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.
In my last post, I wrote that one could consider the existence of a secondary reaction with 8 trading days for SIL and 16 for GDX. Well, since there was no pullback, and the rally continued, now we have a rally of 21 days for SIL and 20 for GDX. Thus, no doubt, the time requirement has been met.
As to the extent requirement, SIL has retraced about 70% of the bear market swing (from last top to bear market low) and GDX almost 100%. Hence no doubt as to the existence of a secondary reaction.
Here you have an updated chart:
Furthermore, the fact that we are witnessing so huge retracements (and a belated entry if we finally get a primary bull market signal as per this definition of secondary reaction) proves that I was not so misguided when in my post of April 8th, 2020 I even dared to consider a secondary reaction when both SIL and GDX had been rallying for only 8 days (until 03/25/2020) and considered 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.
Read the additional information I gave on that post concerning that alternative definition of a secondary reaction. I want to add that Rhea went as low as 7 days to consider a movement as a secondary reaction. I do not advocate to always shorten the time requirement. However, sometimes the pivots that form on the charts together with a sizeable retracement of the previous bear/bull swing are begging at us to shorten the time requirement.
The charts below display what could have been considered as a secondary reaction (light blue rectangle), the pullback (orange box) and the subsequent breakup (blue horizontal lines penetrated). The primary bull market signal (as per this alternative definition of secondary reaction) would have been given on 04/09/2020, which would have been at a relatively close level from our previous exit (in other words, not so many points lost, a quite good reentry).
|The light blue boxes show an alternative secondary reaction which would have resulted in a primary bull market on 4/9/2020|
I know things are getting complicated on this blog.
It is easier to keep things simple and to only demand 15 confirmed days and hope for the best. It is true that even the unsophisticated and mechanical application of the Dow Theory results in outperforming buy and hold (In future posts I will post the result of my buy and sell signals for precious metals and their ETF miners, and you’ll be convinced: Outperformance and dramatic drawdown reduction). However, why settle with something good when we can strive for the best? The more I mature, the more convinced I become that when specific circumstances so warrant, we should be more flexible when appraising secondary reactions. What we lose in certainty will be won in performance and additional drawdown reduction.
The more this blog evolves, the more I conclude that it is not a “timing” service. It is the place to explore, to brainstorm, and to improve our practical application of the Dow Theory. Once we get more proficient, each of us will decide upon the secondary reaction that fits him best. Some readers may stick to the 15 days dogma and will thrive for sure; others will shorten the time requirement in specific circumstances and will do well as well. Others will do both, and, as a result, will probably have a smoother equity curve (traders understand that).
I have three goals as a trader, and in this order:
- Firstly, to reduce time in drawdown.
- Secondly, to reduce the depth of drawdowns.
- Thirdly, to beat buy and hold.
To achieve my goals (which may not be those of other traders or longer-term investors), I need to create many “good quality” trades. To do this, I have to toy with alternative definitions of secondary reactions and make sure that all of them are “good”. However, if one recklessly shortens too much it can backfire, as mean reversion could set in.
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. 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”.
One Dow Theorist