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.
Sincerely,
The Dow Theorist
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