Dow Theory Special Issue: Did Rhea really tell that secondary reactions had to last three weeks? (II)

Demolishing the 3 weeks time requirement dogma

In the first post of this saga, which you can find here, I made the bold statement that Schannep’s Dow Theory by shortening the time requirement for a secondary reaction and by doing away with the 1/3 retracement of the previous bull/bear swing was actually closer to Rhea than most other Dow Theorists. So let’s submit the evidence.

Our starting point is page 43 of his book (“The Dow Theory”, Chapter VIII “Primary bear markets”) where Rhea wrote:

“The student of the averages who can pick the bottom within 10% of the low price is indeed fortunate, but before the price has advanced 20%, the indications of a trend change should be obvious to anyone accustomed to using the Dow Theory”

This apparently innocuous statement contains some clues regarding secondary reactions, which should be heeded by all Dow Theorists.

First of all, Rhea is telling us that before we reach a 20% movement, a trend change should be obvious. However, we know that the trend has changed when the lows/highs of a secondary reaction (the current or the previous one) have been broken down or up. Thus, Rhea is telling us that a secondary reaction should not exceed 20% (low to high or vice versa). If we appraise a secondary reaction and the result is, i.e., a pullback of -30%, something might be wrong in the way we apply the Dow Theory. By the same token, if markets have rallied or declined by more than 20% and the Dow Theorist still has not found a valid breakdown/up point something is wrong (at least generally). This is precisely the situation that befuddled a well-known investment writer in March 2020, as explained in my post “Back to Divergent Interpretations of the “classical” Dow Theory”. US stock indices were falling, and the analyst was unable to find a secondary reaction upon which a primary bear market signal could be given.

Secondly, the above quote tells us that in most instances the market will not let us appraise a secondary reaction until at least a movement of ca. 10% has been in place. No trend following method can call the absolute top or bottom. However, Schannep's Dow Theory detects trend changes at a slightly lower level than 10% (around 7.5% on average), as explained in this post.

 

So why so many Dow Theorists are late in calling the market turns (that is in timely identifying secondary reactions whose breaching signals a buy or sell)? There are four reasons.

The first one explained ad nauseam in this blog, is the failure to appreciate the lows (highs) of the previously last completed secondary reaction as a valid entry/exit point. Most Dow Theorists get fixated on the current, ongoing, secondary reaction. However, the previously completed one is also a valid point to enter and exit when we don't get the "typical" sell signal (secondary reaction, rally and breakdown of the current secondary reaction lows). A still fresh example of the usefulness of using the lows of the previously completed secondary reaction as a valid exit point was the sell signal given on February 25^th, 2020 (more about it here).

 

The second one is the obsession with requiring at least 15 trading days (3 weeks) for the existence of a secondary reaction. This ties many Dow Theorists into a straitjacket. Once again, the declines of late February-March 2020 are a vivid example. The first leg (swing) of this primary bear market had been completed before three weeks from the last top had elapsed. On many occasions, secondary reactions last three weeks or more. However, it sometimes happens much faster. The famous “three weeks’ time requirement” should be viewed as a common but not invariable trait of secondary reactions rather than a pre-requirement for their existence. In other words, once we have pinpointed a secondary reaction through other means (i.e., a significant decline), we observe that the majority of secondary reactions have lasted more than 3 weeks. We should distinguish between cause and effect. 

Furthermore, Rhea wrote that secondary reactions "usually" last from three weeks to as many months (page 52, Fraser Edition 1993). He didn't write "always".

The third one is the defective interpretation of the extent requirement; especially the obsession of requiring 1/3 retracement without qualifications. The extent requirement, which is tricky, will be dealt with in the next post of this saga. 

The fourth one, which I hope to further deepen in the future, is to put excessive emphasis on "confirmation" in order to declare the existence of a secondary reaction. While my position on this point is not final yet, it seems that Rhea was kind of flexible with demanding confirmation in order to appraise a secondary reaction, as I explained in this post. Furthermore, if one goes back to the charts of yesteryear, I've found that Rhea tabulated as a secondary reaction a movement that was not confirmed by the other index (confirmation was in direction but neither in time nor extent).

The issue of time is vital. Go to chapter 10 of Rhea’s book, and you’ll see that Rhea is very cautious with making a fixed rule of the time requirement. On page 61 (Fraser Edition 1993) he states:

“One test eliminated all reactions as negligible which did not extend more than 15 days, with the result that many really important movements were eliminated and insignificant ones were retained” (emphasis supplied)

Rhea is telling us in plain sight that we should not rule out the existence of a secondary reaction because the magical number “3 weeks” has not been reached. Hence, the 3 weeks’ time requirement “dogma” should be reconsidered.

In the quote above Rhea is giving us a clue as to when to classify a movement spanning just a few days as a secondary reaction. He writes “important movements”. Hence, even if we don’t have enough time, if the rally or pullback is “important”, we should not discard the movement. What was “important” for Rhea? Well, I went to pages 64-66 of his excellent book. There he tabulated all the primary swings and secondary reactions (as appraised by him with no preconceived dogmas) from April 19^th, 1897 to November 9^th, 1931.

Out of a total 71, ten movements lasting 15 days or less were labeled as secondary reactions. In other words, 14% of all the movements classified as valid secondary reactions lasted 15 or fewer days. Furthermore, Rhea went as low as 7 trading days for a movement to be classified as a secondary reaction. On three occasions, he accepted 8 days as sufficient time for a secondary reaction to exist. On all these occasions, there was a noticeable extent requirement, which will be studied in the next post of this saga.

Jack Schannep, of “thedowtheory.com” less prone to verbiage than this blogger truly yours was right when he decided (see his Letters to Subscribers) and his book to shorten the time requirement of a secondary reaction by just requiring 8 days as the average of the three indices he uses. 

Another not so well-known Dow Theorist, Charles B. Stansbury, should be given credit too for having written that a secondary reaction may last "for a short period as a week" (" The Dow Theory Explained", Barrons Publishing Company 1938, page 40). It rests to be seen whether Stansbury meant one calendar week (which equates to five trading days) or he meant 7 trading days. Schannep goes as low as 5 trading days following Capitulation (more about Capitulation here).

On the other hand, Rhea made clear that we cannot do completely away with the time requirement. In this vein, Rhea wrote (page 61 of my 1993 Fraser Edition):

“Then the time element was disregarded, with all reactions resulting in a movement of less than 5 per cent of the price of the averages eliminated. Then the percentage was raised to 7 and 1/2 and again to 10, but each of these methods always resulted in the eliminating of really important movements although many insignificant minor movements remained”

From the quote above, we can deduct:

a)     A big percentage decline (i.e. 10% or even more) not coupled with a minimum of days is to be disregarded. This brings me flash crashes. If the thing is real, it should last at least some few days (seven?) for the decline to be labeled as a secondary reaction. Please mind that if this big decline penetrates the lows of the previously completed secondary reaction we should get out without waiting for the new secondary reaction to develop.

b)     On the other hand, a small decline which has developed over many days, is not to be neglected. This brings to my mind the issue of “lines”. By definition, lines span a relatively short period (10 days or more) and percentagewise are small (5% or less). However, the breaking of a line is to be treated as a secondary reaction (page 80, second paragraph).

Of course, not all movements spanning 15 days or less were labeled by Rhea as secondary reactions. This is why Rhea wrote “important” movements. 

From all the preceding we can deduct that in many instances Dow Theorists confuse cause and effect. While it is true that most (not all) secondary reactions last more than 15 days, it is not true that we have to wait at least 15 days for a secondary reaction to be declared. The time needed for a secondary reaction to be declared depends on the extent of the rally/decline.

  

However, there is a warning. We should not shorten the time requirement just for the sake of improving our timing or getting more signals. Thus, when using the secondary reaction lows (highs) in order to signal a primary bear (bull) market, Rhea wrote (page 76, Fraser Edition 1993):

"[m]any traders try to apply this rule to minor reactions forgetting that a normal secondary reaction last from three to twelve weeks and retraces from one-third to two-thirds of the primary movements since the last important secondary reaction"

Rhea uses the word "normal", not "always" allowing for exceptions. From examining Rhea's appraisal of secondary reactions I can see that the time requirement was shortened when one could spot on the charts a significant decline (or rally). What is "significant" will be explained in the next post of this saga. Furthermore, Rhea was always very mindful of volume. Hence, judgment should be always exerted when deciding to shorten the time requirement. 


Rhea basically confirms my rule of thumb: the less time, the more extent (decline/advance) we must require, and vice versa, the more time available, the less extent we have to request. However, the “extent” aspect is tricky, since two factors simultaneously interact, as we will see in our next post of this saga.

Until then, meditate this post. It took me years of introspection to be able to write it. 

ANNOUNCEMENT

 

As I announced here, I joined Schannep’s “thedowtheory.com” as a contributing editor.

As an expression of gratitude to the followers of this blog, and as an invitation to follow me on my new home “thedowtheory.com”, I will be offering for the next few weeks a free two months subscription. For a FREE Trial, send an email with your name

 

TO: Editor@TheDowTheory.com

 

SUBJECT: Free Trial

 

and you will receive a username and password to access thedowtheory.com Newsletter. 

 

That's it!

 

As a reminder Subscribers to “thedowtheory.com” Letter get real-time information when action is required, something one cannot get in this blog. Furthermore, “thedowtheory.com” really helped Subscribers navigate through the recent turbulent waters as:

 

1)     The Rule of Seven nailed the February highs at 29,316 (see February SAMPLE Letter). 

 

2)     Our definition of a Bear market beat all others to the punch in March

 

3)     Capitulation (the time to start buying) was signaled throughout two weeks in March

 

4)     Our definition of a Bull market was met earlier last month confirming this up market

 

5)     We have once again determined the upcoming Rule of Seven target for the new bullish swing.

 

While my blog is instructive and remains a valuable tool to dig deep into vital aspects of the Dow Theory, those truly intent on getting actionable and real-time advice with a proven and disclosed record should use “thedowtheory.com” as a companion to this blog. 

 

Sincerely,

One Dow Theorist

Dow Theory Update for May 15th: Bullishness in Precious Metals

Any way we measure secondary reactions both precious metals and their miners ETFs are in a primary bull market

US STOCKS

Schannep’s Dow Theory (more properly: The Dow Theory for the 21^st Century)

At 05/12/2020, the primary and secondary trend was bullish since April 6th, 2020 (bull market definition), as was explained in-depth here

“Rhea’s /classical" Dow Theory

Readers of this blog know that I am making a habit of not being wedded to just one definition of a secondary reaction when the charts scream at me that there may be an alternative one. Sometimes charts will tell us that only one definition makes sense. On other occasions, we may get two alternative definitions, both being technically sound.

I feel that in our specific juncture, it made full sense to declare the existence of a secondary reaction with just a rally of 13 trading days for the Transports and 18 days for the Industrials. Please read this link carefully in order to know the 7 reasons that advocate for accepting a secondary reaction in spite of just 13 days rally for the Transports.

The Industrials made its secondary reaction highs on 4/17/2020, from that date it declined for two trading days. The Transports made its secondary reaction highs on 4/09/2020, and from that date it declined for eight trading days. Both indexes declined more than 3%, and hence the setup for a primary bull market was completed.

On 4/27/2020 the Transports bettered its 4/09/2020 secondary reaction highs. The Industrials did so on 04/29/2020, and hence on 4/29/2020, a primary bull market was signaled.

As of this writing, I see no secondary (bearish) reaction against the primary bull market.

Here you have the charts displaying the price action since the 03/23/2020 bear market lows to date.

However, if we strictly demanded, like purists do (please mind that Rhea was not a purist) a confirmed rally of at least 3 weeks, then we would have to wait until April 29^th, 2020 to declare the existence of a secondary reaction. From that date, the Industrials declined -3.8% and the Transports -10.05%, so the setup for a primary bull market has been completed. So now for purists, we have the following alternatives:

a)     Either the April 29^th, 2020 closing highs get jointly broken up in which case a primary bull market would have been signaled.

b)     Or the primary bear market lows of 3/23/2020 are jointly violated in which case the primary bear market would be reconfirmed. Please mind that under the strict definition of a secondary reaction, we are still under a primary bear market.

Here you have the updated charts:

Readers can see that by using two legitimate secondary reactions, we can derive two alternative entry levels, which is a good way to split one’s capital. If one lacks the conviction to bet the whole farm on a given signal, it may not be a bad idea to cut the available trading capital into two halves. At the risk of insisting too much on this aspect: The more “good quality” trades (that is trades derived from a sensibly appraised secondary reaction) we have, the more likely our drawdowns will be reduced in time and depth.

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).

One could consider the decline as a secondary reaction. An in-depth explanation about it here.

 

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. Thus, the secondary trend remains bearish.

Here you have an updated chart:

GOLD AND SILVER MINERS ETFs

One legitimate interpretation of the Dow Theory would let us conclude that the primary trend turned bullish on April 9th, 2020 as explained here.

For those wishing to adhere to a more strict interpretation of a secondary reaction, the primary trend would have remained bearish (bearish signal given on March 11th, 2020) until 05/15/2020, as explained here. On 05/15/2020 SIL finally broke up its last recorded primary bull market closing highs of 12/26/2019. GDX had done so on 4/22/2020. Thus, even under the most restrictive interpretation of the Dow Theory, the primary trend was signaled as bullish on 05/15/2020.

The recent price action of SIL and GDX epitomizes the need for being flexible (and “sensible”) when appraising secondary reactions (which lead to the final buy or sell signal). In this specific instance, following the bear market lows 3/13/2020 SIL and GDX staged such a powerful rally without any meaningful confirmed pullback, which resulted in no setup for a “typical” buy signal. Thus, the primary bull market signal had to wait until the last recorded primary bull market highs were jointly broken up. 

As I explained here given the sheer magnitude of the rally that followed the 3/13/2020 primary bear market lows, it was legitimate and even “orthodox” (Rhea would have done so, as I will explain in a soon-to-be-published post) to shorten the time requirement for a secondary reaction, and following the pullback, derive the setup for a primary bull market.

 

I am reading Rhea’s Dow Theory Comment (available from Alanpuri Trading), and I can tell you that Rhea was nimble. He knew very well when to shorten the time requirement and even to exit near a top. His agility was sometimes difficult to digest for his subscribers. No wonder some disgruntled subscribers considered him heretical in his time and a bad follower of Dow’s teachings (even though now many label Rhea as orthodox, go figure!). The takeaway from reading how Rhea traded stocks in real-time is that he was intelligently flexible.

Here you have an updated chart:

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. On 4/21/2020 TLT equaled its last recorded primary bull market high of 03/09/2020 but could not better it. One tenet of the Dow Theory is that we need penetration, just one decimal or cent suffices. Hence, absent by a hair confirmation by TLT, 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”. 

 

ANNOUNCEMENT

As I announced here, I joined Schannep’s “thedowtheory.com” as a contributing editor.

As an expression of gratitude to the followers of this blog, and as an invitation to follow me on my new home “thedowtheory.com”, I will be offering for the next few weeks a free two months subscription. For a FREE Trial, send an email with your name

TO: Editor@TheDowTheory.com

SUBJECT: Free Trial

and you will receive a username and password to access thedowtheory.com Newsletter. 

That's it!

As a reminder Subscribers to “thedowtheory.com” Letter get real-time information when action is required, something one cannot get in this blog. Furthermore, “thedowtheory.com” really helped Subscribers navigate through the recent turbulent waters as:

1)     The Rule of Seven nailed the February highs at 29,316 (see February SAMPLE Letter).

2)     Our definition of a Bear market beat all others to the punch in March

3)     Capitulation (the time to start buying) was signaled throughout two weeks in March

4)     Our definition of a Bull market was met earlier last month confirming this up market

5)     We have once again determined the upcoming Rule of Seven target for the new bullish swing.

While my blog is instructive and remains a valuable tool to dig deep into vital aspects of the Dow Theory, those truly intent on getting actionable and real-time advice with a proven and disclosed record should use “thedowtheory.com” as a companion to this blog.

Sincerely,

One Dow Theorist