Dow Theory Update for June 10: Nuances concerning the appraisal of secondary reactions.

Trends remain unchanged.

We know that the appraisal of secondary reactions is not an easy feat. Accordingly, Rhea wrote that “probably no two students would agree on any rule for selecting and tabulating important secondary reactions” (Rhea’s “The Dow Theory”, Fraser Edition, page 61).

Thus, recent price action, and my particular divergence from Schannep’s Dow Theory, as far as “in the clear” signals are concerned (which set the stage for the development of a new secondary reaction), prompted one reader of this blog to email me. Basically, he was asking (on June 4) whether, as per my reading of the Dow Theory, a secondary reaction had been signaled given the Transports long and ample decline.

Here comes the edited version of my email, which I hope may serve to hone your skills when it comes to gauging the existence of a secondary reaction:

Hi XXXX,

I answer you with the technical makeup of June 4 (date of your email). A red dotted vertical line on the right side of the chart marks that date.

Please find below an updated chart. The blue round arrows on the right of the chart display the last recorded closing highs. The SPY and the INDU bettered the last recorded primary bull market highs, whereas the TRAN failed to do so. As per my interpretation of the Dow Theory, I consider the primary bull market reconfirmed and from this higher point, I set the “clock” to zero in order to appraise the start of the next secondary reaction.

No secondary reaction for stocks, yet or never

 

Since the TRAN did not better the last recorded primary bull market highs, I take the last minor high (which must be close in time to the INDU and SPY’s highs) as the relevant high from which to count the start of a new secondary reaction.  Thus, I don’t count days for the TRAN starting from the last primary bull market high. I just take the minor high in the vicinity of the highest highs made by the SPY and INDU.

So now we can count the total number of days elapsed between the last recorded high (prim bull market high for SPY and INDU and relative high for TRAN), and the last recorded closing lows:

INDU: 12  days down.

SPY: 10 days down.

TRAN: 9 days down (13 days down, but last closing low was only 9 days after the last closing high).

 

So please mind that in order to assess the total number of down days for the Transports, I only consider the time passed between the last high and the last low.

Average of down days (making lower lows) = 10.33 days, which fulfills the time requirement for a secondary reaction as per Schannep.

However, on June 4, the extent requirement was not met. Neither the SPY nor the INDU declined  more than 3% from the last recorded primary bull market highs.

 

Furthermore, on June 9 (date of the last lows hitherto seen), neither the INDU nor the SPY reached  the 3% benchmark. As of this writing, this situation has not changed. 

All in all, when two indices better the last recorded primary bull market highs, and one fails to do so, I reset to zero the counting of days for a new secondary reaction for all indices. This implies that the relevant highs to be considered for the index that failed to better its primary bull market highs must be a minor high.

Please bear in mind that my “variation” when it comes to applying Schannep’s Dow Theory, is neither “better'” not “worse" than the original. It merely reflects my personal preferences. I am aware that by:

a) Using Rhea’s page 77 stop (lows of the last preceding completed secondary reaction) (more here: http://www.dowtheoryinvestment.com/2015/02/dow-theory-special-issue-schannep-and-i.html )

b) and defining secondary reactions earlier as I just require two indices to reconfirm a primary movement,

I tend to have narrower stops, which not may be ideal for people with a greater drawdown tolerance.

//

I am writing on June 11, before the close, as far as I see, it is highly unlikely that a secondary reaction for stocks will be signaled today.

P.S.: Primary and secondary trends remain unchanged for stocks, GLD, SLV and their miners ETFs GDX and SIL. Here you find the last in-depth explanation as to the current state of trends:

http://www.dowtheoryinvestment.com/2015/05/dow-theory-update-for-may-18-primary.html

As to US debt, a primary bear market signal was signaled on June 3rd, 2015, and the primary trend for the EUR remains bullish which tends to confirm the bearishness of US debt. Here you have the details:

 http://www.dowtheoryinvestment.com/2015/06/dow-theory-special-issue-us-bonds.html

Sincerely,

The Dow Theorist

Dow Theory Special Issue: On the deceptiveness of trying to gauge value versus cold hard technical action

Now it could be that stocks are not so overvalued after all.

This article on Ritholz blog “The Big Picture” seems to suggest that if we adjust for current inflation valuations are not expensive at all. So, all the chatter of overvaluation notwithstanding, it could be that there is not so much secular headwind for stocks after all.

What’s my take on this? I don’t know. I just wanted to show you that determining values is not an easy feat. It is highly elusive, and hence, as I have repeatedly written on this Dow Theory blog, I rather prefer to focus on spotting primary trends (1—2 years duration) and completely ignore valuation issues. I prefer to let supply and demand, as interpreted by the Dow Theory, to guide me.

This brings me to another interesting article posted in “thereformedbroker.com”, entitled "2 Things you don't know about the Dow Theory"

The article says that based on the (classical) Dow Theory, the benefit of the doubt belongs to the bulls, since the primary bull market signal remains in force and, in spite of recent weakness of the Transports, the Industrials have refused to violate their last recorded lows. So, as you can see no guessing, just cold hard facts. By the way, the articles also makes some interesting remarks concerning the elusive predictive value of the Transports.

This is why I am very skeptical as to trying to time the market based on valuation. To begin with, my yardstick to appraise value may be defective, or, at best non stationary, and hence all predictions are worth nothing. More about the unreliability of trying to appraise values, here. 

P.S.: Primary and secondary trends remain unchanged for stocks, GLD, SLV and their miners ETFs GDX and SIL. Here you find the last in-depth explanation as to the current state of trends:

http://www.dowtheoryinvestment.com/2015/05/dow-theory-update-for-may-18-primary.html

As to US debt, the primary a primary bear market signal was signaled on June 3rd, 2015, and the primary trend for the EUR remains bullish which tends to confirm the bearishness of US debt. Here you have the details:

 http://www.dowtheoryinvestment.com/2015/06/dow-theory-special-issue-us-bonds.html

Sincerely,

The Dow Theorist

Dow Theory Special Issue: US bonds flashing primary bear market signal

We have to wait to today’s close to be sure.

Some days ago, I alerted that US debt was flirting with a primary bear market signal.

Furthermore, I made clear that a new primary bull market had been signaled for the Euro and CHF.

I am writing before the close, so my conclusions are not final. However, as you can see in the chart below  IEF (ishares 7-10 Yr Treasury bond ETF) has just violated its last secondary reaction lows and, hence, it is confirming the bearish action of its peer TLT (ishares 20+ Yr Treasury Bond ETF). The blue ellipse on the right side of the chart highlights today's action. As per the Dow Theory a confirmed violation of the last recorded secondary reaction lows flashes a primary bear market signal.

This is a textbook Dow Theory pattern. If today’s IEF close remains below the red horizontal line (which highlights the secondary reaction lows –red rectangle-) then a primary bear market will be signaled.

Couple this with the primary bull market in the EUR and CHF, which was also signaled here, and while we are talking about odds and not certainties, it seems that weakness for USD bonds and the USD is a more likely event in the days and weeks ahead. By the way, the primary bull market in EUR/CHF has not been hitherto challenged by a secondary reaction (no decline has lasted at least 8 days), and hence our Dow Theory stops remains fixed at the last primary bear market lows (highlighted by a red horizontal line at the bottom of each chart).

So let’s wait to today’s close.

Here you have the two vital charts you have to monitor:

First the TLT/IEF chart (US long term/medium term debt).

Anatomy of the end of a primary bull market.

 

And the EUR/CHF chart, which shows us how the antidollar (the EUR) is faring (in a bull market)

 

A new bull market has been born for the EUR and CHF...The antidollar is in good health now

Sincerely,

The Dow Theorist

Dow Theory Special Issue: Dual Momentum versus Dow Theory

Trends remain unchanged

I have compared in the past the Dow Theory versus moving averages. Let's compare now the Dow Theory and Dual Momentum.

This post is the edited correspondence with one follower of this Dow Theory blog.

He, like I, has read the book "Dual Momentum Investing", by Gary Antonacci. 

By the way, I wrote a laudatory review of his book here.

 I was asked whether dual momentum, as expounded by Antonacci was even better than the Dow Theory, since Dual Momentum boasts an annual return of 17.43%.

What follows is my answer with some more "meat" I have added during the writing of this post.

Antonacci’s dual momentum seems to have a máximum drawdown of -22.72% (page 102) (with a lookback period from 1974).

Schannep’s Dow Theory has had a lower drawdown (I don’t have here the exact figure) (with a lookback period from 1956). I suggest you go back to this page, in order to fully understand why Schannep’s drawdowns are well contained and likely not to get out of hand in the future.

 

The longer the lookback period, the more realistic the maximum drawdown. However, always bearing in mind that the worst drawdown in our career lies ahead. Thus, I find more credible Schannep's drawdowns (due to a longer lookback period) than those of Dual Momentum. I am not implying that dual momentum is a bad strategy, since I have written in the past that if I forgot all I know about the Dow Theory, I would immediatly make dual momentum my investing strategy of choice.

The average “loss from entry point” (be it actual –losing trade- or potential) with Schannep tends to be around 4-8%, which is quite narrow. If we had 3-4 losing trades in a row we could match Antonnaci’s drawdown. This has not happened yet, but it can certainly happen when looking forward. But such a bad luck (string of losing trades, or death by a thousand cuts), could also afflict Antonnaci, as it affects all who don't stick to "buy and hold". However, Schannep’s Dow Theory has a quirk (to be explained in the future, if I find time and focus) which makes such scenario a very unlikely event.

There is another thing that makes me more comfortable with just the Dow Theory. It has nothing to do with technical analysis. In my blog I have writtten several times that, even though, I am a technical guy, I have eyes to see and a brain to thing. Personally, and I can be “fundamentally” wrong, I distrust bonds, t-bills (yes, what if one day the USD goes under or there is a reset; look what happened to the EUR/CHF some days ago). So, on the eve of a big reset, stocks could show less momentum than bonds (first deflation, then, suddenly, high inflation), and following Antonacci, one should be in bonds. All in all, I don’t like debt, I like equity, and, as an insurance with optionality, physical gold. While all this is “fundamental”, I feel more comfortable “trading technically” with a system (Dow Theory) focused on equities and avoid debt instruments.

During Weimar (Germany) hyperinflation, debt was destroyed. Equities hold some ground (even though they lost real value), and gold and USD made real purchasing power gains.

So, under the current economic environment I distrust all kinds of debt (be it USD, EUR o JPY denominated).  If I don’t want to touch debt, then Antonacci’s system becomes somewhat maimed.

As to physical gold, this is a very personal decision.

As to equities, I feel comfortable with the Dow Theory. Having said this, if I didn't know the Dow Theory, I'd find Antonacci's Dual Momentum the best technical strategy to follow (for trades with a time horizon of ca. 1 year). So, I find Antonacci's strategy very sound. 

Furthermore, there are some ways to increase the basic performance of the Dow Theory and aim for dual momentum returns. Instead of buying the indices, if you just buy high relative strength stocks when a primary bull market is signaled and sell them when a primary bear market is signaled, you tend to make much more than by merely buying the SPY. However, you get more of a roller coaster. Of couse, this strategy can be improved (and has been improved) but even the basic version works well. 

Another way to try to add an additional 3-4% annual performance to the Dow Theory would be buying stocks with positive insider buying ratings. I am in the early stages of this research but preliminary I think that coupling stocks with good insider buying when a primary bull market signal is flashed and selling them when a primary bear market is signaled is a sensible way to aim for greater returns with a very limited risk (as such stocks tend to have lower draw downs unlike high relative strength stocks). The best book I have read, which contains in-depth research, concerning insider buying is "Investment Strategy for Insider Trading". Read the book and start exploring coupling such stocks with a Dow Theory filter, and relax.

Sincerely,


The Dow  Theorist