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.

http://www.dowtheoryinvestment.com/2020/05/dow-theory-special-issue-did-rhea.html

http://www.dowtheoryinvestment.com/2020/04/dow-theory-update-for-april-4th-did.html

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

Dow Theory Update for June 3: US stocks in a primary bull market under all Dow Theory flavors

Bullishness in precious metals and US interest rates unabated

US STOCKS

Schannep’s Dow Theory (more properly: The Dow Theory for the 21^st Century)

 

 

At 06/1/2020, the primary trend was bullish since April 6th, 2020, as was explained here

The April 6^th, 2020 Buy signal (caused by a Bull market definition) was not an easy one to act upon, as it was given at ca. 19% (for the S&P 500) off the bear market bottom. Fear that the market was already overextended and fear of a big loss should the market decline revisiting the 03/23/2020 bear market lows resulted in some investors expressing concern. An in-depth study about the viability of the Buy signal of April 6^th, 2020 is available in our June 1st, 2020 Letter to Subscribers of thedowtheory.com. I know many followers of this blog have become Subscribers, so read carefully the June 2020 Letter. For those still sitting on the sidelines, I encourage you to take advantage of the free trial I offer at the end of this post.  

Now let’s focus on the secondary trend. The last recorded highs were made on April 29th, 2020, and the last recorded lows were made on May 13th, 2020, which amounts to 10 trading days for each index and hence an average of 10 trading days. Furthermore, at least two indexes should have declined for two calendar weeks, which was accomplished as well. So, the time requirement for a secondary reaction was met. As to the extent requirement all three indexes declined more than 3% and, thus, the extent requirement was also met. Therefore, on May 13^th, 2020 a secondary reaction was signaled.

Off the May 13^th 2020 secondary reaction lows all indexes rallied. The S&P 500 broke up its 4/29/2020 unconfirmed. Finally, on 5/26/2020 the Industrials and Transports confirmed (we only needed confirmation by one index) and the secondary reaction was ended and the primary bull market reconfirmed. All in all, the secondary trend is also bullish.

Here you have an updated chart showing the price action since the bear market bottom of 3/23/2020 to date. 

“Rhea’s /classical" Dow Theory

The primary trend is bullish since 4/29/2020 as explained here.  This primary bull market signal was determined by just demanding 13 and 18 trading days for the appraisal of the secondary reaction that led to the primary bull market signal.
 
As of this writing, I see no secondary (bearish) reaction against the primary bull market.

Here you have the charts displaying the price action since the 03/23/2020 bear market lows to date.

Primary bull market signaled on 4/29/2020 if we appraise a secondary reaction with just 13 days for the Transports

However, if we strictly demanded, like purists do (please mind that Rhea was not a purist, as explained here) a confirmed rally of at least 3 weeks, then we would have to wait until April 29^th, 2020 to declare the existence of a secondary reaction. From that date, the Industrials declined -5.6% and the Transports -10.05% until their lows of 5/13/2020 and 5/15/2020 respectively, so the setup for a primary bull market was completed. From such pullback lows, there was a rally which broke up the April 29^th secondary reaction highs on a confirmed basis on 05/26/2020 and hence a primary bull market was signaled on that date.

So, no matter how we appraise the secondary reaction, the primary trend is bullish according to the classical Dow Theory.

Here you have an updated chart:

If we demanded 3 weeks for a secondary reaction, the primary bull market would have been signaled on 5/26/2020

Readers can see that by using two legitimate secondary reactions, we can derive two alternative entry levels, which is a good way to split one’s capital. If one lacks the conviction to bet the whole farm on a given signal, it may not be a bad idea to cut the available trading capital into two halves. At the risk of insisting too much on this aspect: The more “good quality” trades (that is trades derived from a sensibly appraised secondary reaction) we have, the more likely our drawdowns will be reduced in time and depth.

GOLD AND SILVER

The primary was signaled as bullish on 02/19/2020, as explained here.

Following a sharp decline, SLV penetrated its last recorded primary bear market lows on 3/12/2020. GLD declined but on a much more muted basis and did not confirm. Hence, no primary bear market signal. Rhea (page 77 of his book, Fraser Edition 1993) recognized as a valid exit point the closing lows of the last primary bear market (red horizontal lines on the charts below).

One could consider the decline as a secondary reaction. An in-depth explanation about it here.

 

On 4/9/2020 GLD bettered its last recorded primary bull market highs unconfirmed by SLV, so the primary bull market has not yet been reconfirmed. Thus, the secondary trend remains bearish.

Here you have an updated chart:

GOLD AND SILVER MINERS ETFs

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

For those wishing to adhere to a more strict interpretation of a secondary reaction, 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. 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.

So, anyway we cut it, the primary trend is bullish for SIL and GDX. 

The recent price action of SIL and GDX epitomizes the need for being flexible (and “sensible”) when appraising secondary reactions (which lead to the final buy or sell signal). In this specific instance, following the bear market lows 3/13/2020 SIL and GDX staged such a powerful rally without any meaningful confirmed pullback, which resulted in no setup for a “typical” buy signal. Thus, the primary bull market signal had to wait until the last recorded primary bull market highs were jointly broken up. 

As I explained here given the sheer magnitude of the rally that followed the 3/13/2020 primary bear market lows, it was legitimate and even “orthodox” (Rhea would have done so) to shorten the time requirement for a secondary reaction, and following the pullback, derive the setup for a primary bull market. 

Here you have the updated charts:

Two alternative entries, depending on the way one appraises secondary reactions

 

US INTEREST RATES

Depending on the way one appraises the secondary reaction that led to the setup that resulted in the primary bull market signal, the primary bull market was signaled either on 11/19/2018 or 12/18/2018. From Rhea's deeds and writings, we can see that the definition of secondary reaction is not carved in stone. The signal of 11/19/2018 was obtained by being satisfied with just 14 trading days for TLT and 15 days for IEF. 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. It’s up to each investor to decide what to do (i.e. to commit to each signal 50% of one’s equity or go fully invested with just one signal). 

From the 03/09/2020 closing highs, both ETFs declined until a bottom was made on 3/18/2020. Hence, there has been just 7 days of decline, and, thus, the time requirement for a secondary reaction against the strong bullish trend has not been met. However, given the magnitude of the shake-up, retracement of the last bull market swing, and the total percentage of the declines, I’d be inclined to shorten the time requirement so that the 03/18/2020 closing lows become the lows of a secondary reaction of just 7 trading days. One sensible trader might proceed as follows: Consider the 7 days decline as a secondary reaction, and, hence, as the basis for determining the setup for a primary bear market signal. At the same time, be more conservative and insist on demanding at the very least 10 days or even 3 weeks. Once we have two alternative setups, which may lead to actual sell signals, split the capital into two. 

All in all: both the primary trend remains bullish, and the secondary trend continues bullish if we stick with a 3 weeks’ time requirement for a secondary reaction.  However, if we consider the last pullback as a secondary reaction, the secondary trend would be bearish. Up to you to decide! Both alternatives set the basis for good trading and are not mutually exclusive.

On 04/01/2020 IEF bettered its last primary bull market closing highs of 03/09/2020 unconfirmed by TLT. On 4/21/2020 TLT equaled its last recorded primary bull market high of 03/09/2020 but could not better it. One tenet of the Dow Theory is that we need penetration, just one decimal or cent suffices. Hence, absent by a hair confirmation by TLT, the primary bull market has not been reconfirmed and, if we consider the last pullback as a secondary reaction, the secondary reaction has not been canceled. 

Here you have an updated chart. The grey rectangles display the “dubious” secondary reaction of just 7 days but associated with big declines both in terms of retracement of the preceding bull market swing  (ca. 75% for TLT retraced and ca. 50% for IEF) and the total percentage of the pullback (huge volatility, so a big movement percentage-wise). In my opinion, the charts are screaming at us “please shorten the time requirement for a secondary reaction; at least for half of your capital. Don’t ignore Rhea’s flexibility”. 

The primary bull market continues

ANNOUNCEMENT

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As a reminder Subscribers to “thedowtheory.com” Letter get real-time information when action is required, something one cannot get in this blog. Furthermore, “thedowtheory.com” really helped Subscribers navigate through the recent turbulent waters as:

1)     The Rule of Seven nailed the February highs at 29,316 (see February SAMPLE Letter).

2)     Our definition of a Bear market beat all others to the punch in March

3)     Capitulation (the time to start buying) was signaled throughout two weeks in March

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Sincerely,

One Dow Theorist