Dow Theory Update for October 17: Comparing the 1987 and 2020 stock market crashes.

 

Next Monday, October 19th, it'll be the 33^rd anniversary of the 1987 stock market crash. I wrote about it in the past and made clear that the Dow Theory (of any flavor whatsoever) could get investors out of stocks before the big decline set in.

 

The Dow Theory for the 21^st Century (what I affectionately call “Schannep’s Dow Theory) called the turn 3 days before the Classical Dow Theory did, as the Industrials broke down below their September 21^st, 1987 secondary reaction lows on October 9^th, whereas the S$P 500 did so on October 12^th. Since we need the S&P 500 plus one other index to declare a primary bear market, on October 12^th (S&P 500 at 309.39), Schannep’s Dow Theory proclaimed that the writing was on the wall. On the other hand, the “original” Dow Theory, which does not have the S&P 500, and needs the Transports to confirm, had to wait until October 15^th (S&P 500 at 298.08) when the Transports finally deigned to break down below their September 21^st lows. The S&P 500 made their closing highs on August 25^th, 1987, at 336.77. So the total loss for Schannep’s Dow Theory was a well-contained loss of -8.13% for those trading the S&P 500.

 

However, the goal of this post is not gloating about past successes. Since this year we have had a crash, too, I thought it might be interesting to compare the two.

 

Similarities:

·        Both bear markets dropped in a free fall.

 

·        While the 2020 “crash” recovery has been more quickly (roughly 6 months for the S&P to make new all-time highs), the 1987 crash managed to make higher highs in ca. 23 months. It was not like that in the 1929 crash. Soothsayers (I keep one notable name for myself) who predicted a prolonged bear market were proven wrong (both in 1987 and 2020).

 

·        The total loss from peak to trough has been similar for the two crashes. The S&P 500 declined from a high of 366.77 (August 25^th, 1987) to a low of 223.91 (December 14^th, 1987), for a total decline of -38.95%. In the most recent crash, the S&P 500 declined from a high of 3386.15 (February 19^th, 2020) to a low of 2,237.40 (March 23^rd, 2020), for a total decline of -33.92%.

 

However, there is a significant discrepancy between the two bear markets. The attentive analyst could see the 1987 crash (or at least a very severe correction) brewing, as there were many warnings both technical and, for those with this inclination, fundamental or value-based.

 

I’ll focus on one of my pet indicators, which has stood the test of time. The Advance/Decline line. For an accurate description of this line, go to investopedia. In essence, the advance decline line keeps a cumulative record of the difference between advancing and declining issues. A rally with a declining AD line implies poor following and tends to be a technical warning.  

As you can see in the chart below, the AD line gave several warnings at to the underlying weakness of the then existing primary bull market. 

 

Anatomy of the 1987 crash. The AD line gave ample warning

 

 However, the situation was different in the months leading to the February-March 2020 crash. While I will not clutter this post with charts, neither the 52 Weeks highs, nor the VIX, or any other indicators gave warning in advance as to the incoming bear market.

 

Here you have a chart of the S&P 500 and the AD line. As you can see, the AD line confirmed higher highs made by the S&P 500. So, nothing in the AD line was suggesting underlying weakness.

 

Anatomy of the February-March 2020. The AD line did not give any warnings

This is why it is essential to honor your Dow Theory-based stop-losses. While background information may be useful in some specific instances (i.e., in 2007 when weakness in the Transports advocated against being long), we cannot second-guess a primary bear market signal. As traders say: “The first loss, is the best loss”.

 

Sincerely,

The Dow Theorist

Dow Theory Update for October 8th: Dissecting the current secondary reaction in SIL and GDX (silver and gold miners ETFs)

 

 

General remarks:

Well, let’s try to write the promised post concerning the ongoing secondary reaction in SIL and GDX.

 

As I wrote here, the secondary trend for precious metals had changed on September 23^rd, 2020. Now it is bearish (secondary reaction against the primary bull market).

 

In this post, I provided a thorough explanation concerning the rationale behind my use of two alternative definitions in order to appraise secondary reactions.

 

Please mind that I am writing before the close of October 8th, 2020. So things might change after the close. Readers beware.

 

GOLD AND SILVER MINERS ETFs

 

A) Market situation if one is to appraise secondary reactions not bound by the 3 weeks dogma.

 

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

 

During July and the first days of August, both ETFs made higher highs so both the primary and secondary trend was bullish.

 

On August 5^th, 2020, both SIL and GDX made their last recorded highs. From that day, prices dropped for 34 trading daysuntil the final bottom made on September 23^rd, 2020. So the time requirement for a secondary reaction was fulfilled. Please mind that even though we are “flexible” under this heading and may appraise a secondary reaction lasting less than three weeks, I could not discern any secondary reaction until 09/23/2020. If you look at the charts, the first low that followed the highs of 08/05/2020 was made on 08/11/2020, which is equivalent to only 4 days of decline. Four days is too little time to declare a secondary reaction.

 

Now let’s take a look at the extent requirement that must also be met for a secondary reaction to exist. Let’s observe the spreadsheet below:

 

Percentage-wise SIL declined -20.01%. GDX -15.50%. When applying the Dow Theory to US stock indices, we require a minimum 3% movement for a swing to be taken into account. Swings not reaching 3% are to be discarded (too little movement). When we venture outside of the realm of US stock indices, I feel we should consider the different volatility of the financial assets concerned. This is why I perform a volatility adjustment. I compare the daily percentage change of the asset in question to that of the SPY. If, for example, SIL had a double daily average percentage change than the SPY, then the minimum volatility requirement for SLV would be 2 x 3% = 6%.

 

Since volatility changes, I performed 200 days and 1000 days average calculations. As you can see in the spreadsheet above, the pullback underwent by both SIL and GDX clearly exceeds the minimum volatility-adjusted movement (around 6.20% for SIL and 5.89% for GLD when one takes a 200 days moving average of daily price changes). Being influenced by Schannep’s Dow Theory, which does not use retracements but absolute percentage swings, I’d say that given the magnitude of the pullback, I’ll consider the extent requirement fulfilled.

 

The icing on the cake, which confirms beyond any shade of doubt that there is a secondary reaction is the existence of a confirmed retracement of the previous bull market swing (from the lows of the last secondary reaction -06/18/20- to the highs of 08/05/20) exceeding 1/3 on both ETF (55.55% for SIL and 57.02% for GDX).

 

By the way, based strictly on the Dow Theory, I alerted about the enhanced likelihood of a secondary reaction by the end of July 2020. Several warning signs piled up: Excessive volume and, more importantly, several divergences between gold and silver. You may read the full explanation here.).

 

Off the September 23^rd closing lows, SIL and GDX rallied for 8 trading days. SIL rallied 8.13%, which is more than the minimum volatility-adjusted movement (MVAM). GDX rallied 5.16% which lies slightly below its MVAM. Please mind that, as I have repeatedly written in the past, the final rally (pullback) that sets up the ETFs for a primary bear (bull) market signal need not be confirmed in extent, just in direction. However, confirmation never hurts. Rhea nuanced the issue of confirmation clearly in his book “The Story of the Averages”. The spreadsheet below gives you the relevant figures:

 

All in all, the current rally set up both ETFs for a primary bear market signal. If the September 23^rd closing lows were jointly broken (which is a distinct possibility) as we are currently flirting with such lows, a primary bear market would be signaled.

 

Here you have the updated charts, which display the previously completed secondary reaction (left side orange rectangles) and the current one (right side orange rectangles). The blue rectangles display the ongoing rally, which setup SIL and GDX for a primary bear market signal.

 The validity of the current primary bear market setup seems to be further strengthened because I discern a “line” (narrow range) on both the SIL and GDX chart. I saw a similar formation in US bonds (see here). Many similar patterns are being formed these days in several markets.

 

Rhea wrote that a “line” is made when both the Dow Industrials and Transports move within a range of approximately five percent for at least two weeks. Given that the daily volatility of SIL and GDX approximately doubles that of the SPY values close to 10% would be acceptable for them. The spreadsheet below gives you the details of the line:

 

 

Here you have the charts. The red oranges display the “line”. Please mind that on both charts, the line was broken downside with increasing volume. Not a very good omen (at least for the coming days). Furthermore, during the rally that followed the September 23^rd lows volume has been subdued. 

 

SIL formed a "line" (confirmed by GDX). The line was broken down on high volume

 

GDX formed a "line". The line was broken down on high volume too

 

I know there is a lot of bullishness concerning precious metals and miners. There is talk of inflation, of printing money to infinity, etc. However, we are technical traders. If the September 23^rd lows are jointly broken down, a primary bear market will be signaled, no questions asked.

 

As a reminder, this is the current state of the unrealized profits:

 

 

B) Market situation if one sticks to the traditional interpretation demanding more than three weeks of movement in order to declare a secondary reaction.

 

For those wishing to adhere to a more strict interpretation when determining secondary reactions, the primary trend would have remained bearish (bearish signal given on March 11th, 2020, as explained here) until 05/15/2020. On 05/15/2020 SIL finally broke up its last recorded primary bull market closing highs of 12/26/2019, and a primary bull market was signaled. 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.

 

No secondary reaction has been signaled since the primary bull market signal of 05/15/2020.

 

On August 5^th, 2020, both SIL and GDX made their last recorded highs. From that day, prices dropped until the final bottom made on September 23^rd, 2020, for 34 trading days. So the extent requirement for a secondary reaction was fulfilled.

 

As to the extent requirement the spreadsheet below tells you the whole story:

 

 

Percentage-wise, both ETFs have declined more than the minimum volatility adjusted movement. However, under the “strict” (and in my opinion somewhat misguided) interpretation of the Dow Theory, we need have a confirmed 1/3 retracement of the previous bull swing.

 

Our bull swing started at the 03/13/2020 bear market closing lows and ended at the 08/05/2020 closing highs. As you can see in the spreadsheet above, the amount retraced does not reach 1/3 (31.32% for SIL, and 27.03% for GDX).

 

So the extent requirement has not been met. If no secondary reaction has been declared, we are still far from completing a primary bear market signal setup.

 

Here you have an updated chart. The grey rectangles display the current pullback. Since it is not a secondary reaction (under this “strict” interpretation) is has not been given the orange color of secondary reactions.

 

Under a strict interpretation of the Dow Theory, the bull swing has not been retraced by a confirmed 1/3. No secondary reaction yet.

Sincerely,

One Dow Theorist

Dow Theory Update for October 6th: Primary bear market for US bonds signaled on October 5th

 

The primary trend remains bullish when one appraises the trend of US bonds with a somewhat longer time-frame.

 

I still owe the readers of this Dow Theory blog the promised in-depth explanation of the current secondary reaction in SIL and GDX (the gold and silver miners ETFs). However, Dow Theory’s relevant events pile up, and I allot my time as good as I can.

 

This post focused on the primary bear market signal that has been signaled today in US bonds.

 

US INTEREST RATES

General Remarks:

 

In this post, I provided a thorough explanation concerning the rationale behind my use of two alternative definitions in order to appraise secondary reactions.

 

TLT is the iShares 20 years + Treasury bond ETF. More about it here

IEF is the iShares 7-10 years Treasury bond ETF. More about it here.

Thus, TLT tracks longer-term US bonds, whereas TLT tracks middle term US bonds. A bull market in bonds entails lower interest rates. A bear market in bonds represents higher interest rates.

 

A) Market situation if one is to appraise secondary reactions not bound by the 3 weeks and 1/3 retracement dogma.

  

If one appraised the secondary reaction that led to the setup that resulted in the primary bull market signal, the primary bull market was signaled on 11/19/2018. The signal of 11/19/2018 was obtained by being satisfied with just 14 trading days for TLT and 15 days for IEF.

 

This primary bull market that got started on 11/19/2018 underwent three secondary reactions. It survived two of them (in the sense that confirmed higher highs terminated the secondary reaction and confirmed the bull market) and succumbed to the third one.

 

As it was explained in-depth here, the final lows were jointly made on 8/4/2020. TLT declined for 18 trading days and IEF for 17. The final secondary reaction lows were made on 8/28 and 8/27. From those dates, there was a rally that lasted 5 trading days until 9/3/2020 on both ETFs. TLT rallied 2.96% and IEF 0.8%. As you can see in the spreadsheet below, TLT rallied much more than the minimum volatility-adjusted movement, and IEF did the same too (when measured against the 1000 days moving average of volatility). Please mind that, as I have repeatedly written in the past, the final rally (pullback) that sets up the ETFs for a primary bear (bull) market signal need not be confirmed in extent, just in direction. However, confirmation never hurts. Rhea made this point clear in his book “The Story of the Averages”.

 

 

The breakdown has been on higher volume than the its 50 days average. So it was a relatively high volume day. However, it did not reach monster proportions. Notably, it remained below the 8/28/2020 lows for TLT (not so for IEF whose breakdown has been on higher volume). So volume seems to confirm the breakdown tentatively. However, volume readings are always to be taken with a pinch of salt. I’d say that price action provides 90% of actionable information, while volume may account for the remaining 10%. So, in my trading, volume is only a tie-breaker when price readings are not conclusive.

 

Finally, I see on the charts that the price action between 8/27/2020 and 10/2/2020 constitutes a “line” (narrow range in Dow Theory jargon). As a reminder, a “line” is a confirmed narrow range (5% between the upper and lower boundaries for US stocks), which spans at least 2 weeks. Today, that “line” has been broken down. Rhea wrote that:

 

“simultaneous advances above the limits of the “line”, indicate accumulation and predict higher prices; conversely, simultaneous declines bellow the “line” imply distribution and lower prices are sure to follow.”(emphasis supplied).

 

Source: “The Dow Theory”, original Barrons Edition 1932, Eleven Printing, page 79.

 

Thus, the breakdown of the “line” is another bearish factor pertaining to the Dow Theory, which I see on the charts.

 

So we can conclude that the secondary reaction closing lows of 8/28 and 8/27 were the decisive ones to be broken down for a primary bear signal. The break down occurred on October 5^th, 2020, and hence, a primary bear market has been signaled. Now both the primary and secondary trend is bearish.

 

So from the primary bull market signal to bear market signal, almost two years have elapsed. This is quite in line with what we can expect of Dow Theory trades.

 

The spreadsheet below shows the profits realized:

 

 

As a trader, I don't favor making a commitment to IEF due to its low volatility. IEF’s lower gain on this Dow Theory trade is entirely due to its swinging much less than TLT. As a reminder, TLT is based on +20 years bonds, whereas IEF is based on a much shorter term duration (7-10 years). While being necessary to derive Dow Theory signals (confirmation), IEF is not necessarily the best vehicle to invest in. However, those wanting to play very conservative might allocate some of their funds to IEF. Up to each trader.

 

As an aside, in my post of 11/9/2020, I alerted about the likelihood for a reversal. I quote:

 

“By the way, TLT’s confirmation of the higher highs made by IEF took quite a long time, namely more than 4 months. Belated confirmations tend to be a warning sign about the underlying health of the trend.”(Emphasis supplied).

 

While warning signs are on themselves not necessarily enough reason to act (i.e., to partially or totally sell), as we are trend-followers, they serve to validate further the signal we have got today. However, when such warning signs pile up (i.e., belated confirmation, divergences, ominous volume readings, price objectives reached, etc.), there would be nothing wrong with unloading “some” provided the trader has a definite re-entry plan. This is what we suggested in our September 1st, 2020 Letter to our Subscribers for US stock indexes. The pullback that followed attested to the wisdom of partially lightening up.

 

Here you have an updated chart. The orange rectangles display the secondary reaction. The blue rectangles show the rally that setup both ETFs for a primary bear signal. The purple rectangles show the line that formed between 8/27/2020 and 10/2/2020.

 

 

Perhaps I am wrong, but I see it constructive for US stocks that a decisive “down” day in US bonds has been met with a decisive “up” day in US stocks (albeit I’d be even happier if I had seen a somewhat higher volume). Are US stocks building up strength and no longer need the dope of extremely depressed interest rates? Just a thought.

 

B) Market situation if one sticks to the traditional interpretation demanding more than three weeks and 1/3 confirmed retracement in order to declare a secondary reaction.

 

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.

 

Since the pullback from 03/09/2020 to 03/18/2020 spanned just seven trading days, and despite its vast magnitude, we could not declare the existence of a secondary reaction if bound by the three weeks' time requirement dogma. Subsequent declines did not close below the 03/18/2020 closing lows, and hence no secondary reaction was signaled.

 

On 04/01/2020, IEF bettered its last primary bull market closing highs of 03/09/2020 unconfirmed by TLT. On 08/04/2020, TLT finally deigned to confirm and broke up its 3/9/2020 primary bull market highs, and, hence, the primary bull market was reconfirmed. An in-depth explanation here.

 

Despite the most recent pullback and today’s lower lows, the secondary trend remains bullish, as was explained here.  Notwithstanding today’s decline, the amount of the bull swing (from the bear market lows of 11/02/2018 for TLT and 10/05/2018 for IEF to the top of 08/04/2020) retraced does not reach 1/3. So, when one sticks to the Dow Theory’s mainstream interpretation, the extent requirement has not been fulfilled.

 

Here you have an updated chart. The grey rectangles display the successive pullbacks, which satisfied the time requirement for a secondary reaction, albeit the extent requirement has not been met. Until we get a secondary reaction, I’ll keep the grey color.

 

Sincerely,

One Dow Theorist