Is the Dow Theory Misunderstood? The Truth Behind the Dow Transportation Weakness

 Secondary Reaction Highs (Lows): The Key to Market Confirmation

Recent weakness in the Dow Jones Transportation Average relative to the Dow Jones Industrial Average has prompted many “experts” to proclaim a bear market signal. They argue that new all-time highs by the Dow Industrials, unconfirmed by the Dow Transports, spell doom for the overall stock market.

Understanding the Dow Theory

Let’s clarify the concepts. Lack of confirmation means that one index makes a higher high (or lower low), and the other fails to break out. However, there is a common misconception about the Dow Theory. It’s often believed that if one index makes an all-time high, the other must also make an all-time high to confirm. This is not the case.

The Dow Theory, a cornerstone of stock market analysis, is based on the concept of secondary reactions. The top (or bottom) of a secondary reaction, which need not be an all-time high, is the relevant price level to be taken out. Thus, it can well happen that one index, like the Dow Industrials, makes an all-time high while the other takes out a minor high (a secondary reaction high). This counts as confirmation.

The Importance of Relevant Highs

Fixating on both indexes surpassing their all-time highs is not the right way to apply the Dow Theory. Most signals would be terribly late if we demanded “all-time highs” confirmation. Jack Schannep explains it beautifully on pages 39-41 of his book.

This post also gives a recent example of the relevant highs to focus on in seeking confirmation. While significant weakness in the Dow Transports when both the S&P 500 and Dow Industrials are making higher highs may be a yellow flag (as it was in October 2007 and December 1999), requiring all-time highs confirmation to enter the market leads to poor performance.

Thus, the lack of confirmation of a relevant high (not “all-time highs”) merely serves as a yellow light that may question the persistence of the current trend. It is NOT, as many purport, a signal showing a change in the trend.

Bullish Implications of Non-Confirmation

Furthermore, I will boldly assert that the Dow Transports’ lack of confirmation of an all-time high by the Dow Industrials is bullish. This is not just a claim, but a viewpoint supported by two studies.

The first study by Mark Hulbert  shows that the stock market performs better when the Dow Transports are lagging.

 The second study by Seth Golden shows that while the S&P 500 made a new 12-month high in the first half of the year unconfirmed by Dow Transports, it was notably higher in the second half of the year. The study confirms that “all-time” or “12-month highs” confirmations are not the proper highs to focus on when looking for confirmation.

 

Key Takeaways

Confirmation is essential when correctly applied: Focus on the highs (or lows) of secondary reactions, which in many instances are not the all-time highs. Lack of confirmation of such relative highs is a yellow flag (not a red one) with trading implications as they help avoid a sucker rally or a bear trap, as you can see in the following examples HERE and HERE, and a couple of weeks ago with Bitcoin whose breakup was not confirmed by Ethereum (a post on this non-confirmation that once again saved my skin will follow soon).

Conclusions

• When applying the principle of confirmation, identify the right highs (or lows) to be jointly taken out.
• All-time highs are not the right highs in many instances.
• Secondary reaction highs (or lows) are the right highs (or lows) to focus on in most cases.
• Lack of confirmation of a relevant high (or low) is not a Sell (or Buy) signal; it is simply a yellow flag.
• Lack of confirmation by the Dow Transports of an all-time high or even a 12-month high is actually bullish for the stock market.

Sincerely,

Manuel Blay

Editor of thedowtheory.com

 

SLV and GLD: Evaluating the Secondary Reaction and the Setup for a Potential Primary Bear Market

 

The primary trend remains bullish 

Overview: SLV and GLD (silver and gold) are in a secondary reaction, and on 6/20/24, the setup for a potential primary bear market has been completed.

The gold and silver miners ETFs (GDX and SIL) are also in a secondary reaction, but no setup for a potential primary bear market has been completed. In a future post, I will deal with the miners.

General Remarks:

In this post, I extensively elaborate on the rationale behind employing two alternative definitions to evaluate secondary reactions.

GLD refers to the SPDR® Gold Shares (NYSEArca: GLD®). More information about GLD can be found HERE.

SLV refers to the iShares Silver Trust (NYSEArca: SLV®). More information about SLV can be found HERE 

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

I explained in this post that the primary trend was signaled as bullish on 4/2/24.

Following the 5/20/24 (GLD) and 5/21/24 (SLV) highs, there was a pullback until 6/7/24 (GLD) and 6/13/24 (SLV), which met the time and extent requirement for a secondary reaction. Following, the secondary reaction lows, a rally ensued until 6/20/24 that completed the setup for a potential primary bear market signal.

The table below shows the relevant data:

So, now there are two possible outcomes:

1) A primary bear market would be signaled if GLD and SLV head south and jointly break below their pullback closing lows (Step #2 in the table above).

2) If GLD and SLV extend the present rally and jointly surpass their most recent highs (Step #1), the current primary bull market would be confirmed, and the secondary reaction and the setup would be canceled.

The chart below shows the secondary reaction (Step #2, brown rectangles) and the rally starting off the 6/7/24 (GLD) and 6/13/24 (SLV) lows (Step #3, blue rectangles). The blue horizontal lines highlight the most recent highs (Step #1), whose breakup reaffirmed the primary bull market, and the red lines show the pullback lows (Step #2), whose violation would entail a new primary bull market. 

Therefore, the primary trend is bullish, and the secondary one is bearish.

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

I explained in this post that the primary trend was signaled as bullish on 4/2/24.

The most recent pullback did not last at least 15 trading days, so it did not qualify as a secondary reaction.

So, now the primary and secondary trends are bullish.

Sincerely,

Manuel Blay

Editor of thedowtheory.com

 

 

TheDowTheory.com and our recent recession alert featured by Mark Hulbert (MarketWatch)

 Understanding the Schannep Recession Indicator and Its Impact on Market Timing

 

We’re honored to have our Schannep Recession Indicator (SRI) featured in MarketWatch by Mark Hulbert on 6/14/24. We wrote a must-read article with the evocative title: “The latest unemployment report has triggered this spot-on recession indicator”

Below is the link to the MarketWatch article (likely behind a paywall):

https://www.marketwatch.com/story/the-latest-unemployment-report-has-triggered-this-spot-on-recession-indicator-08f2785d

and below is the link to a version not behind a paywall:

https://www.morningstar.com/news/marketwatch/20240614271/the-latest-unemployment-report-has-triggered-this-spot-on-recession-indicator

Below are the key highlights of Mark’s article:

1. Schannep Recession Indicator (SRI) Accuracy

The Schannep Recession Indicator has accurately identified all 12 U.S. recessions since 1946, demonstrating its reliability in predicting economic downturns.

2. Recent Recession Signal

The latest signal from the SRI was triggered on June 7, 2024, when the U.S. unemployment rate report for May showed an increase to 4.0%. This rise brought the three-month moving average to 3.9%, surpassing the threshold by 0.4 percentage points and suggesting that a recession is either underway or imminent.

3. Timeliness of SRI Signals

The SRI provides recession signals much closer to real-time compared to the National Bureau of Economic Research (NBER). Historically, the average lag between the onset of a recession and the SRI signal is just 1.58 months, offering a timely tool for economic forecasting and market decisions.

Finally, I want to remind our esteemed readers of the SRI’s Stock Market Timing Utility. Beyond predicting recessions, the Schannep Recession Indicator is another valuable tool for timing the stock market. By providing early warnings of economic downturns, investors can make more informed decisions about the right time to sell. Our Subscribers already have a plan to trade the stock market according to the new economic conditions. Do you?

Sincerely,

Manuel Blay

Editor of thedowtheory.com

 

Unlocking the Power of Trend Following and Relative Strength: A Century of Outperformance

 Reducing Drawdowns and Maximizing Returns

Trend following and relative strength works. The latest research by Gary Antonacci and Carlo Zarattini, delving into almost 100 years of data, proves conclusively that when done correctly, market timing results in significant outperformance and, more importantly, drawdown reduction. Most investors get blinded by the “outperformance” and forget that the best offense is a good defense, namely, cutting your losses short.

Below is the executive summary provided by one of its authors on LinkedIn, Gary Antonacci (emphasis added by me):

“This study delves into the profitability of a simple, low-frequency trend-following model applied to US industries using a comprehensive database of all US stocks traded between 1926 and 2024.

Over the past century, the Timing Industry portfolio achieved an average annual return of 18.5% with an annual volatility of 12.1%, resulting in a Sharpe Ratio of 1.46. This starkly contrasts the US equity market’s 9.7% return, 17.1% volatility, and 0.63 Sharpe Ratio.

In the paper’s final section, we introduce 31 sector ETFs by State Street Global Advisors and backtest the same trading methodology over the past 20 years. The ETFs successfully replicate the model’s exposure and returns.

We also assess the impact of commissions and slippage, demonstrating that the active timing strategy remains largely profitable even with high trading costs.”

Here is the link to the research article, which is worth your time:

https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4857230

Sincerely,

Manuel Blay

Editor of thedowtheory.com

Dow Theory Signals Bull Market for Bonds on 6/4/24: Recession or Soft Landing?

 US Bonds Turn Bullish: What’s Next for the Economy?

Overview: When appraised by the more reactive application of the Dow Theory, the trend of US bonds turned bullish on 6/4/24. The question is: Is the bond market discounting a recession or merely a soft landing resulting in lower inflation?  The unemployment rate for May, to be published on 6/7/24, will probably give us more clues, as well as oil, if it maintains its bearish trend.

General Remarks:

In this post, I extensively elaborate on the rationale behind employing two alternative definitions to evaluate secondary reactions.

TLT refers to the iShares 20+ Year Treasury Bond ETF. You can find more information about it here

IEF refers to the iShares 7-10 Year Treasury Bond ETF. You can find more information about it here.

TLT tracks longer-term US bonds, while IEF tracks intermediate-term US bonds. A bull market in bonds signifies lower interest rates, whereas a bear market in bonds indicates higher interest rates.

A) Market situation if one appraises secondary reactions not bound by the three weeks and 1/3 retracement dogma 

The primary trend shifted to bullish on 6/4/24 when TLT and IEF jointly surpassed their 5/15/24 closing highs.

You may read more about the setup that preceded the new primary bull market signal in my 6/3/24 post.

The table below displays the price action that led to the new bull market signal.

So, now the primary and secondary trends are bullish.

The charts below depict the current market situation. The grey rectangles on the left show a rally that occurred in March that did not qualify as a secondary reaction. The blue rectangles (Step #2) highlight the current secondary (bearish) reaction against the primary bear market. The brown rectangles show the most recent pullback that set up both ETFs for a potential primary bull market signal. The blue horizontal lines highlight the bounce highs (step #2), whose breakup signaled the new bull market. The red horizontal lines highlight the primary bear market lows whose breakdown would signal a new primary bear market.

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

As detailed in this post, the primary trend was signaled as bearish on 2/13/24.

TLT and IEF drifted downward until 4/25/24 (Step #1 in the table below). From these lows, a bounce lasting 28 trading days followed until 6/5/24 (Step #2). The table below shows that the rally met the time and extent requirements for a secondary (bullish) reaction against the primary bearish trend. Now, we wait for a >=3% pullback to complete the setup for a potential primary bull market signal.

The charts below depict the current situation. The blue rectangles highlight the present secondary (bullish) reaction against the primary bear market.

Therefore, the primary trend is bearish and the second one is bullish.

Sincerely,

Manuel Blay

Editor of thedowtheory.com

 

 

Dow Theory Alert: The trend for US bonds could change from bearish to bullish soon. Learn the critical price levels to watch

From Bearish Trends to Potential Bull Markets: TLT and IEF Insights

Overview: TLT and IEF remain in a primary bear market, but this could change soon. If TLT and IEF jointly surpass their 5/15/24 closing highs, the trend will shift from bearish to bullish. More details are provided below.

General Remarks:

In this post, I extensively elaborate on the rationale behind employing two alternative definitions to evaluate secondary reactions.

TLT refers to the iShares 20+ Year Treasury Bond ETF. You can find more information about it here

IEF refers to the iShares 7-10 Year Treasury Bond ETF. You can find more information about it here.

TLT tracks longer-term US bonds, while IEF tracks intermediate-term US bonds. A bull market in bonds signifies lower interest rates, whereas a bear market in bonds indicates higher interest rates.

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

As I explained in this post, the primary trend for TLT and IEF was signaled as bearish on 2/13/24.

TLT and IEF drifted downward until 4/25/24. From these lows, a bounce lasting 14 trading days followed until 5/15/24. The table below shows that the rally met the time and extent requirements for a secondary (bullish) reaction against the primary bearish trend. After the 5/15/24 bounce highs, there was a pullback until 5/29/24, completing the setup for a potential primary bull market signal.

 

Now, we have two alternatives:

a) If TLT and IEF jointly surpass their 5/15/24 closing highs (Step #2 bounce), a primary bull market will be signaled.

b) If TLT and IEF jointly violate their 4/25/24 closing lows (Step #1), the primary bear market would be reconfirmed.

The charts below depict the current market situation. The grey rectangles on the left show a rally that occurred in March that did not qualify as a secondary reaction. The blue rectangles (Step #2) highlight the current secondary (bearish) reaction against the primary bear market. The brown rectangles show the most recent pullback that set up both ETFs for a potential primary bull market signal. The blue horizontal lines highlight the bounce highs (step #2). The red horizontal lines highlight the primary bear market lows whose breakdown would reaffirm the primary bear market. 

 

Thus, the primary is bearish, and the secondary one is bullish.

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

As detailed in this post, the primary trend was signaled as bearish on 2/13/24.

The most recent bounce, not reaching the >=15 days threshold, does not qualify as a secondary reaction, and accordingly, no setup for a potential primary bull market signal has been completed.

Therefore, the primary and secondary trends are bearish.

Sincerely,

Manuel Blay

Editor of thedowtheory.com