Tuesday, May 26, 2020

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 25th, 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 19th, 1897 to November 9th, 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. 

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
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. 
One Dow Theorist

No comments:

Post a Comment