Saturday, June 13, 2020

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

What about the extent requirement?

Reminder: All this talk about secondary reactions is under Rhea's Dow Theory. Under Schannep's Dow Theory the appraisal of secondary reactions leaves no room for interpretation (which is a great advantage). However, as Hamilton wrote, the Dow Theory may be applied to non-US-Stock markets, as I do in this blog with precious metals and interest rates. When being outside of the realm of US Stocks, I am forced to use "Rhea's Dow Theory", as I don't have the privilege of having three indexes. Hence, the usefulness of mastering the intricacies of Rhea's Dow Theory.

In the last two posts, I debunked the idea that under “Rhea’s” Dow Theory a secondary reaction must last at least three weeks.

I wrote that many “classical” Dow Theorists fail to spot the turns of the market because they are too slow in appraising secondary reactions. One of the factors is being fixated with demanding 3 weeks on a confirmed basis. This factor was dealt with in-depth in the preceding post of this saga (here)

However, another mistake repeatedly made is being obsessed with demanding at least 1/3 retracement of the previous bull/bear swing on a confirmed basis.

As I will show, Rhea was more than flexible when it came to applying the “extent” requirement. I’d dare to say that Rhea, in actual trading, was very close to Schannep (which does away with the retracement requirement and just demand a minimum movement of 3%).

I don’t want to boast, but readers need to be given the plain truth: Before I set on writing this bold post, I must say that I have read more than thirty issues of Rhea’s “Dow Theory Comment” as well as his less-known book “The Story of the Averages” (and of course at least 10 times Rhea’s “The Dow Theory”). You can get both gems from Alanpuri trading. So what I am writing is the result of actually studying what Rhea did, not what others say what Rhea did.

So let’s get started.

Rhea in his book “The Dow Theory” (pages 64-66) tabulated all the secondary reactions (bullish and bearish) he could discern from 1897 to 1931. However, Rhea did not include in his book either the percentage retracement of the previous swing or the absolute percentage move of such secondary reactions.

So I performed the tedious task of calculating both retracements and absolute percentage moves of the movements that according to Rhea qualified as secondary reactions.

Since purists say that a secondary reaction must last more than three weeks on a confirmed basis, I tabulated all movements which actually lasted 15 days or less. Please mind that in Rhea’s time there was trading on Saturdays. 


So what conclusions can be drawn from the table above?

Firstly, as I already mentioned in my last post, there were 10 instances where we had a secondary reaction not exceeding 3 weeks.

Secondly, there were 5 instances when the retracement of the previous swing did not reach 1/3. Two of them did not even reach 30%. So much for the at least 1/3 retracement on a confirmed basis rule.

Thirdly, while not shown on the table, Rhea did not always require that the extent requirement (namely the retracement or percentage of the correction) should be always confirmed. Within this context, Rhea makes this astonishing statement:

“It is not necessary for the Rails and Industrials to confirm each other in extent of movement, nor is it required that they confirm in duration; nevertheless, while we may disregard the extent of a rally (or decline), and while we may ignore, to a degree, the time required for a movement, it is necessary for these formations to confirm each other, both in direction and in the penetration of the critical high or low points, before the movements can be taken as having any authority of forecast” (italics in original, bold font supplied)

Source: “The Story of the Averages”, 1934, page 16, Alanpuri Trading Edition, Los Angeles, 2013.

So Rhea is telling us in plain sight that we should not get obsessed (as many Dow Theorists do) with strictly demanding more than three weeks basis or at least 1/3 retracement on a confirmed basis. It is beyond my comprehension how Rhea has been misread by many Dow Theorists. Furthermore, Rhea is telling us that we need confirmation in direction and that relevant high or low points (i.e. lows of last completed secondary reaction, last bull market highs, etc.) should be jointly broken. Rhea’s deep experience should not go unheeded.

It is not easy to encapsulate Rhea into fixed rules, as he was more than flexible in actual trading (the “Art” part). This is why proclaiming, as most Dow Theorists do that the “right” application of the Dow Theory requires more than 3 weeks and at least a 1/3 retracement of the previous swing on a confirmed basis is plainly wrong. I insist: Go to the original source. Don’t go to second-hand references.

Furthermore, after having read many issues of Rhea’s Dow Theory Comment I can confidently conclude that, in some instances, one cannot in real-time declare the existence of a secondary reaction. I’ll explain myself with a real-life example.

In July 1933 the Industrials declined 18.63% in just four days. The Transports (Rails, at that time) had been declining for 15 days for a 21.6% decline. The Industrials retraced 34.6% of the bull swing and the Transports 36.9% (Dow Theory Comment, Issue 31, August 2, 1933). Confronted with the big decline, and in real-time, Rhea wrote that maybe that movement was a secondary reaction and that we had seen its final lows or maybe not (Issue 32, August 9, 1933). So he withheld judgment until he saw further action. Furthermore, Rhea paid lot’s attention to volume at critical points (i.e. at the alleged secondary reaction lows, at the rally that followed). So from judging the action that followed the alleged secondary reaction highs or lows he was able to declare whether he considered the existence of a secondary reaction. Of course, some cases are clear-cut, but the market does not always oblige.

Fast forward to the present: Let’s imagine a big decline that just took 8 days on the Industrials and 16 days on the Transports. The Industrials declined by 13% and the Transports by 15%. Furthermore, the retracement amounts to just 24% of the previous bull swing for the Industrials and 34% for the Transports. Should we immediately declare the existence of a secondary reaction? Well, it depends, we should exert some judgment. In this specific case, I’d be tempted to say that we have a secondary reaction as the time and extent requirement has been met by the Transports and the Industrials have confirmed in direction. The tipping point for me would be the absolute percentage decline: 13% and 15% is a significant decline. But the action of volume may give us additional clues. However, it is not the goal of this post to study the slippery role of volume. One day in the distant future, I’ll do it.

So from studying Rhea (see Table above) we can tentatively conclude the following:

1.      For considering the existence of a secondary reaction, Rhea always alluded to an “important move”. What is important? From my study “important” is any movement that either retraces at least 1/3 of the previous movement (not necessarily confirmed in extent, just in direction). Once we get 1/3 retracement of the previous swing and around one week of time, we may be declaring the existence of a secondary reaction.

2.      If the movement falls short of the 1/3 retracement, but its extent percentage-wise exceeds 4%, we may be declaring the existence of a secondary reaction. The more days the move took, the less stringent we will be with the percentage required. Thus, we see that in 1898 we had almost 15 days (13 days) and Rhea, with just a decline of -4.67% considered the existence of a secondary reaction.

Please mind that Rhea, by accepting secondary reactions which didn’t retrace 1/3 of the previous swing, and by accepting modest percentage-wise moves (i.e. -4.03% and -4.67%) was coming very close to Schannep’s Dow Theory. As readers of this blog know, Schannep did away with the 1/3 retracement and just demands that the minimum movement of 3% be satisfied. Such simplification of the extent requirement for a secondary reaction has not resulted in diminished performance (just the contrary) as it was shown here.

To tell you the truth, I have never felt comfortable with the 1/3 retracement. If the previous swing has been of big proportions (i.e. an uncorrected advance of 50% something which has occurred in the past), demanding 1/3 retracement implies being willing to sacrifice almost 17% from the top. In my opinion, this is a too ample stop, a stop difficult to digest. In actual trading, Rhea would never allow this to happen. When he sensed that the market was due for a secondary reaction, he was more than comfortable running for the exits at the first sign of weakness, as I explained with an example here.

A future post will deal with another common misconception concerning Rhea and what is called the “classical” Dow Theory: The use of primary bull and bear market signals to buy and sell. When one examines Rhea’s actual decisions under fire, one sees that we tried to exit before the onset of a secondary reaction (i.e. guided by volume, divergence, unconfirmed higher highs/lows, etc.) while his entries were relatively near the primary bear market lows or the bottom of secondary reactions. Of course, trading à la Rhea is not easy. However, one should never attempt to trade Schannep’s Dow Theory this way, as we are dealing with two different beasts (different ways to appraise secondary reactions, and, equally importantly, different tools in one’s arsenal of entry and exit rules)

Well, this post is coming to its end. I hope that now readers can understand that the appraisal of secondary reaction does not necessarily require more than 3 weeks and at least 1/3 retracement of the previous swing on a confirmed basis. Rhea was flexible in all aspects: Time, extent, and confirmation. Having said this, it is true that by their very own nature, most secondary reactions will end up having more than 3 weeks and will retrace 1/3 or more of the preceding swing. However, we should not confuse cause and effect. When appraising secondary reactions outside of the realm of Schannep’s Dow Theory (with its clear-cut and time-tested rules), we should not allow ourselves to be put into a straitjacket consisting of at least 3 weeks and 1/3 retracement both of them on a confirmed basis. We should be more nimble, as Rhea was.

This study of Rhea’s appraisal of secondary reactions has confirmed my rule of thumb: The more time of the reaction, the less extent I should demand and vice versa.

The Dow Theorist

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