Dow Theory Special Issue: Lessons learned from the Chinese stock market crash (II)

How to exit when the Dow Theory refuses to setup “orderly” primary bear market signals.

Recently, I wrote about the primary bear market signal for Chinese stocks.

As you well know this primary bear market signal came much too late, if we are to judge from the percentage decline from the top to the exit point.

Some days before the primary bear market signal for Chinese stocks, I raised a thorny issue: What to do on the rare occasions (not yet seen in US stocks in +115 years) when the setup for a primary bear market signal (that is secondary bearish reaction followed by a rally and subsequent violation of the secondary reaction lows  “type 1 signal” or outright violation of the lows of the last competed secondary reaction “type 2 signal”) fails to materialize at safe levels? By “safe," I mean an exit point (lows of the secondary reaction to be violated) close enough to the last recorded top, which helps us exit in an orderly manner. More specifically: A good exit level is, i.e. a loss/decline of ca. 5-10% from the top. A bad exit level is a loss/decline of -30% from the top as we have recently seen with Chinese stocks. You are encouraged to read my first post on this issue. 

Below is a rough depiction of what I am talking about:

This is what the Chinese stock market recent did: A very rare occurence from which we can learn

I said that Chinese markets, unlike US markets (crashes of 1929, 1987 and 2008, included, which allowed for "good" exits) had been most unruly and unbecoming. Why the Dow Theory which hitherto has always allowed eschewing monster declines on this specific occasion failed to deliver a “safe” exit level with Chinese stocks. It is of little comfort to me to say, “Ok, US markets are different, they are more orderly and less volatile and if the past is a guide to the future we should expect the Dow Theory will continue to keep us safe."

I am very frank to you all: The pattern we saw with Chinese stocks is highly unusual. However, we would be ruined if two such “unusual” events happened in a row.

So, personally, what I have seen with Chinese stocks has been a wake-up call. I have not lost my faith in the Dow Theory, as I steadfastly continue to believe it is the best timing method by a long shot. However, we should be prepared for highly unusual scenarios.

This is why, as a reminder, it is very important to let Rhea’s page 77 book soak in (more about it here). Even though 90% of the primary bull/bear market signals are so-called “type 1” signals (secondary reaction, subsequent rally and violation of secondary reaction lows), occasionally the market starts to decline and refuses to stage even on one index a +3% rally. Here is when the “type 2” exit (the lows of the last completed, the previous one, secondary reaction) let us off the hook.

Thus, the “type 2” exit will offer us a technically sound (Dow Theory-based) exit point when the ordinary “type 1” exit fails to set up.

Furthermore, for those who think that the Chinese situation is not repeatable in US stocks, I’d like to make two observations:

Firstly, the Dow Theory is basically long term oriented. This results in few signals. Hence, we can say that for the last +115 year less than 80 signals have occurred (much less with the classical Dow Theory). While such a successful sample is reassuring because it spanned +115 years under very different economic conditions), it is far from being an exhaustive sample. I’d feel more comfortable if we had a +500 years sample with 400 signals. Therefore, albeit I remain committed to the Dow Theory, I am aware that more extreme scenarios are not to be ruled out. As traders say: “your worst drawdown is always ahead”.  Furthermore, please keep in mind that the US stock market has been very lenient with investors, as for over one century the US has been the economic leader of the world. Thus, our "sample" could be not so representative of extreme situations. There is a trick, though,  to suddenly expand your sample of trades by a factor of, at least x 26, which would be tantamount to ca. 2990 years. It is beyond the scope of this post to explain it, and, furthermore, I want to further research this issue. However, my preliminary results with such an expanded sample helped me to further cement my faith in the Dow Theory. All in all, if we manage to live 200 years, it is very likely that we will be confronted with more difficult price setups; however, the Dow Theory is very likely to fare well even under price structures not hitherto seen.  

Secondly, even with a +500 years track record, we are dealing with emotions, the economy and many variables we cannot control. Hence, a pattern (such as the one seen with Chinese stocks) that hitherto has not occurred with US stocks, could materialize in the future. Prices are free to set up as they please free of our intellectual constraints.

All in all, while I believe that the Dow Theory is great (and specially Schannep’s), I do also believe that we have to be armed with alternative exits when in the future we are confronted with a Chinese situation. The issue is how to get more premature exits when the price pattern, as interpreted by the Dow Theory, refuses to give us a “safe” exit.

What follows is the result of some days of instrospection. This is the roadmap as to "what to do" when the Dow Theory refuses to offer us an exit at decent levels:

a) Add third and even fourth index, in order to try to derive a Schannep DT signal. US stocks have the distinct advantage of having many indices. Please mind that we were dealing with just two indices when we were analyzing the Chinese stock market. Thus, if we see that we are approaching the “danger zone” (i.e. a loss exceeding 10-12%) and the indices we use refuse to set up for a primary bear market signal, we should start looking for greener pastures (i.e. including the NYSE, Nadaq, etc.) until we find a decent primary bear market setup. Please mind that this is very exceptional. Schannep is no friend of using the Nasdaq (pages 48-49 of his book "The Dow Theory for the 21st century"), and so am I. However, under exceptional circumstances (that is when by using the SP500, Industrials and Transports, we fail to get a decent primary bear market set up) we should try using other indices. With Chinese stocks you could be thinking in adding the CSI 300 Index (ETFs:  ASHR, PEK). By the way, this is one of the reasons why Schannep's Dow Theory is likely to continue outperforming (and cutting losses) better than the classical Dow Theory. With three indices is more unlikely that "Chinese" situations develop.

If no signal is derived with 3 or even 4 indices, then:

b) Look at what distance lies the 200 days moving average (if it lies 20% below current prices, then it is not a good alternative stop. However, if prices have been consolidating and the MA is at a reasonable distance (i.e. 12%), then this could be our alternative (which we accept reluctantly) stop. Readers of this blog know that I am no friend of moving averages as timing indicators, as the Dow Theory is beyond one shade of doubt clearly superior, as explained here.

However, we are now dealing with exceptional measures, and, hence, on the extremely rare occasions when the Dow Theory fails to facilitate an exit at a reasonable level, we have to look for alternatives. The 200-day  MA is an alternative.

In addition (or in lieu of) to the MA stop, we should start accepting alternative technical stops as those three listed below under letters “c”, “d” and “e”.

c) Minor lows that did not qualify for a secondary reaction (due to lack of time and/or extent), apparent on the chart, which are within a reasonable distance (i.e. no too near, at, i.e. -4% below the peak, but not too far away at -20%). After all, according to Rhea, the violation of any low is certainly not bullish.

d) Is the violation of a significant trend line at a reasonable level (i.e. -10% below the top) and not too near (i.e. -4% below the top).

e) Is there a head and shoulders pattern, which allows for an exit at a reasonable level?

f) Honor a percentage fixed (i.e. -16%) stop. Bear in mind though that what has worked for the US stock market (and there is no guarantee that an empirically-based stop will continue working in the future even for US stocks) may not necessarily work for the Chinese stock market which tends to be more volatile, and hence might require a more ample stop. 

To further cement your confidence in the alternative exits listed above, pay special attention to non-confirmation or divergences as well. The current break down of Chinse stocks was preceded by a non-confirmation, and I alerted my readers here. If there was a non-confirmed top, the odds for a break would be higher. Under such a scenario, and when no “normal” Dow Theory stop is at a reasonable distance, then be willing to use less orthodox ways of exiting.

Of course, it’s up to each one to decide what to do. I can only provide a small blueprint.

Sincerely,

The Dow Theorist

Dow Theory special issue: Why the Dow Theory uses daily bars, not weekly and for good reason

Primary and secondary trends for stocks, gold and silver and their ETFs miners unchanged.

Travis, one reader of this blog, recently posted a comment whereby he asked why I use daily bars instead of weekly bars to determine what allegedly is the long-term trend. What follows is my answer, which deserves a post of its own.

The primary bull (bear) market signals hinge on the properly gauging the lows (highs) of secondary reaction (not just “any” low, though significant it may look on the charts, as I have recently written here as many mistakenly believe). We also know that the time requirement for a secondary reaction to exist is at least 8-10 days (bars, when daily bars). However, since for a secondary reaction to exist we also need the extent requirement (at least a confirmed +/- 3% rally/decline), and the subsequent rally (pullback), most secondary reactions span a much longer time far exceeding 8-10 days.

The actual signal that follows the breakout of the secondary reaction highs (lows) may actually take several months. The last primary bear market signal of late August 2015 is a clear example of what I am meaning. In other words, the Dow Theory when working with daily bars is perfectly calibrated: Signals are sparse, and it is a far shot from following the short or even medium trend. It is wonderful to see how the Dow Theory by using “dailies," we actually determine the longer-term  trend. Furthermore, by using dailies and its associated “extent” requirement of 3%, we are able, while avoiding the short and medium trend, to exit at relatively “save” levels (that is near from the top) in most instances (at least this holds true for US Stocks, including the latest primary bear market signal). Of course, the non-parametric nature of the Dow Theory, plays a part in the usefulness of "dailies" in determining the long-term trend, since the absence of a parameter (i.e. we don't give a damn whether the lows of the secondary reaction to be broken are 10 days lows or 100 days lows, since we demand additional requirements), helps us get rid of non-qualifying lows. A simple example which, I hope, will clarify what I mean: it is not the same a breakout system (turtles-like) with just an n-days breakout requirement traded with daily bars, that the same system with an additional extent requirement which filters out many "n-days" breakouts. This is the issue that plagues "breakout" systems: in order to avoid too many signals, you have to either use "weekly" bars, or, with "dailies," you have to use a very high breakout number (i.e. 55 days breakout), which, nonetheless, continues to be very prone to whipsaws due to the absence of a filtering out of non-relevant highs (lows), which under the Dow Theory are filtered out thanks to the extent requirement, which serves to declare as the only valid lows (highs) those that qualify as secondary reaction lows (highs). Readers, now it's up to you to cogitate all this. For me, after years of mulling it over, this is as clear as day, but now you have to take your time until all this soaks in.

If we were dealing with weekly bars, then we should also adjust the minimum extent requirement. A weekly equals five trading days. According to Brownian motion (more here on Wikipedia: https://en.wikipedia.org/wiki/Brownian_motion ), we should calculate the square root of 5 (5 days/ 1 day) in order to ascertain our minimum movement multiplier. In other words, if when working with “dailies” we require a minimum movement of 3%, when working with “weeklies” we should require 3 x 2.23 = 6.7% minimum movement for a movement to be meaningful. Furthermore, patterns are fractal, so the minimum time requirement would continue to be 8-10 bars (formerly, “days”). All in all, our new “secondary reactions” determined by weekly bars, would be too long term oriented. Our primary bull/bear market signals would be flashed too far away from the top/bottom. Thus, the 1987 crash would not have been avoided when using weekly bars, as a way to gauge the primary trend.

However, “weeklies” may be useful as a technical means to determine the secular trend. Let’s make a thought exercise. If when using “dailies” a Dow Theory primary bull/bear market signal is signaled ca. every 1-2 years, when using weeklies, we can expect signals to be signaled every 5-10 years, which is well attuned to the secular trend (multiplier of 5). I have some research (which will remain private for the time being), and the longer the time frame (by using, i.e. weeklies) the less noise, and hence the less signals. In other words, when being in a x 5 greater time frame, signals will not necessarily be signaled x 5 slower, but rather, you may expect even them to be signaled more than x 5 slower. Readers of this Dow Theory blog know that I am highly skeptical as to the usefulness for the average investor of the secular trend (more about his here and here). Having said this, if I had to rely on a method to gauge the secular trend, it would be technical (as with Dow Theory with “weeklies”), and certainly not, value/fundamentally based.

The use of weeklies as a way to establishing the secular trend may be useful for certain investors in order to avoid whipsaws when trading along the primary trend as determined by “dailies." In other words, one could wait for the secular trend to turn bullish (as determined by “weeklies”) in order to buy pursuant a primary bull market signal (as determined by the “dailies”). However, be advised, that by doing so you would have missed the monster primary bull market signal of mid-2009. If you wait to honor primary bull market signals (as determined by “dailies”) until the secular trend (as per “weeklies”) has turned bullish, you may avoid a few whipsaws, but you’ll miss a big piece of the action. 

By the way, if we gauge the current trend with weeklies, we have to conclude that the secular trend remains bullish. The current decline would qualify as a secondary reaction whose Friday, September 4^th lows have not being violated yet.  Furthermore, no setup for a primary bear market signal has occurred yet, and hence, we cannot say that the final lows of the secondary reaction have been put yet. Nonetheless, I would not trust my fortunes (and timing) to a bullish secular reading, albeit such secular readings may be useful to some very long term oriented investors. Here you have a weekly chart of the Industrials, Transports and SPY (bottom), and the ongoing secondary reaction is highlighted by orange rectangles.

Dow Theory applied to weeklies: Just a secondary reaction against the secular bull market

Of course, the opposite holds true when applying the Dow Theory in shorter time frames. I also have some preliminary research that seems to prove that the Dow Theory can also be applied to lower time frame bars (i.e. 130 minutes bars). As with “weeklies," you have to adjust the minimum movement (which will be lower than 3%) in order to account for the lower time frame. Theoretically, signals should be given (when working with 130’ bars) 3 times for often than with “dailies” (as 130' x 3 = 390’=one trading day=1 daily bar), which would be ca. 1.5-3 signals per year (0.5-1 signal per year with dailies x 3). However, given that noise tends to increase with lower times frames, you should expect more signals, and hence more whipsaws, as the lower the time frame, the higher the noise and non-trendiness (Nassim Taleb, in his book “Dynamic Hedging," makes some interesting remarks concerning mean reversion, trend and time frames).

Conclusions:

1) Daily bars are the ideal vehicle for gauging the long term trend under the Dow Theory, and to avoid crashes like the one of 1987 or to get aboard early as in mid-2009 and not miss a new bull market. 

2) Weekly bars are useful in order to gauge the secular trend (on a pure technical basis). However, they are not the “best” timing indicator, as it tends to be late at crucial market turnings.

3) The current “secular” trend remains bullish (a mere secondary reaction against the bullish secular trend) when gauged on a pure technical basis (with the Dow Theory), which may be of little consolation for those experiencing deep losses.

4) The Dow Theory seems to work at lower time frames (i.e. with 130' bars). However, noise increases and, while still profitable, key measures like profit factor, percentage win, etc. seem to deteriorate.  Further research should be conducted.

Sincerely,

The Dow Theorist