Dow Theory Update for July 19: Two typical Dow Theory misconceptions (I)

And setting the record straight

Many badmouth the Dow Theory, and I must say for a good reason.

Yes, criticism aimed at the Dow Theory does not surprise me because it is casually studied and applied. It appalls me to read many “experts” getting things half right, which is tantamount when investing money to half or fully wrong. While it is true that neither Dow, nor Hamilton and even Rhea (although the latter came very close to it) did not produce a definite set of rules, and hence there is room for human interpretation, I feel that many confuse legitimate interpretation with outright misunderstanding (or merely lack of deep knowledge) of the Dow Theory.

I am just talking about the “classical” Dow Theory as applied by Hamilton, and, more importantly, Rhea.

I am going to address two frequent misconceptions.

Misconception 1: A primary bull (bear) market signal require the previous formation of a secondary reaction.

In other words, once we are in a primary bear (bull) market, for the trend to be changed it is necessary that a secondary bullish (bearish) reaction against the primary trend be formed. Once the secondary reaction has materialized, then we wait for the pullback (rally) and subsequent breakout of the secondary reaction highs (lows). Absent this sequence, we cannot declare a change of trend even though stocks may jointly be making higher closing highs (lows).

Go to this MarketWatch article and you will basically read what I have just described.

The article goes on to say that Schannep is one of the few Dow Theorists which, absent the development of a secondary reaction, would declare a change of primary trend, if the stocks indices break out the last recorded primary bull (bear) market highs (lows).

The article is correct when it comes to stating the dismal situation of the Dow Theory fraternity. However, the classical Dow Theory has the "alternative" bull market signal too, namely: The Industrials and the Transports, without the "normal" setup shoot up like a rocket (what we are seeing right now) and jointly better the closing highs of the last primary bull market. This signal is very often ignored or neglected but it pertains to the "classical" Dow Theory as well; not only Schannep's. Rhea makes this clear in his book (page 77 of my Fraser Edition).

Thus, it is not right to infer that Rhea did not mention the confirmed breaking out of the last recorded primary bull (bear) market closing highs (lows) as a valid primary bull (bear) market signal. In other words, if you read Rhea carefully (and any Dow Theorist worth his salt is supposed to having done so) you will find that Rhea clearly had in mind that sometimes the market does not oblige with a secondary reaction in order to setup stocks for a primary bull (bear) market signal.

Of course, not all “highs” and “lows” are born equal, and hence, not the breaking out of any “high” or “low” that stands out in a chart serves to declare a change of trend. This is a typical misunderstanding made by many casual Dow Theorists. There are only three types of closing highs and lows which are relevant in order to signal a change of the primary trend:

            The first one, is the typical sequence, which I have just explained: Secondary reaction against the primary trend, subsequent pullback (rally) and final breakout of the secondary reaction closing highs or lows.

            The second one, is the confirmed breaking out of the closing highs (lows) of the last recorded primary bull market highs/lows (in our juncture, the April 20^th closing highs)

            The third one, is the breaking out of the closing highs (lows) of the last   completed secondary reaction. This is a very tricky one, which should be used with lots of caution. I have written profusely about it in the past (here), and I plan to write even more in the future (giving hints as how to us it depending on market conditions). Here you have the graph depicting this often neglected Dow Theory signal (which I used, by the way, to signal the new primary bull market of gold and silver miners on March 3^rd.)

  

In my next post, I will address the second typical misunderstanding. No wonder that many people get their fingers burned when miss-applying the Dow Theory.

Well let’s have a look at the markets we monitor.

US STOCKS

The primary trend turned bearish on June 24^th, as was profusely explained here.

The secondary trend is bullish (secondary reaction against the primary trend), as all three indices (Industrials, Transports and SP 500) have been rallying for more than 8 trading days (average of the three indices) and each of them has rallied more than three percent. As of this writing we don’t know whether we can declare the end of the secondary reaction, as no index has pulled back more than 3%.

As I explained here, if the Transports were to break out above their April 20^th closing highs (primary bull market highs), a primary bull market would be signaled. The longer it takes for the Transports to confirm the SP 500 and Industrials higher highs, the more likely a decline is in the making.

GOLD AND SILVER

The primary trend is bullish (Dow Theory signal of March 17^th, 2016), as reported here and here.

The secondary trend is also bullish as explained here

GOLD AND SILVER MINERS ETFs

The primary and secondary trend is bullish as explained here, and more recently here

Sincerely,

The Dow Theorist

Dow Theory Update for July 9: We are nearing a primary bull market signal for US Stocks

I don’t have much time to write or to post charts.

Stocks closed strongly last Friday 8^th. The Industrials and the SPY (S&P 500) have bettered the last recorded primary bull market closing highs of April 20^th, 2016. The Industrials failed to do so.

One of the primary trend signals according to Schannep’s Dow Theory is three indices jointly bettering the last recorded primary bull market closing highs (what he calls to be “in the clear”).

Thus, if the Transports break above their April 20^th closing highs, a primary bull market would be signaled.

Without emotions, I’d honor such a signal. No arguments.

Sincerely,

The Dow Theorist

Dow Theory Special Issue: Does it make sense to short with the Dow Theory?

Primary and Secondary Trends unchanged

This post is my answer to Algyros, a faithful follower of this blog.

Basically, he asked about shorting with the Dow Theory. Does it make sense?

My first answer read as follows (link to it here):

I’d summarize my opinion concerning shorting as follows:

• Primary bear markets last less than primary bull markets.
• Primary bear markets decline percentage wise less than bull markets.
• Hence, the amount likely to be made is lower than in primary bull markets, whereas the potential loss is higher (market reversal).
• Furthermore, shorting costs money: dividends have to be paid, and most brokers charge expensive shorting fees, which grow higher the longer the trade (it is like paying interest on the amount shorted).
• Shorting forces you to use a margin account. This is not the most suitable account for a long-term investor concerned with safety because it also implies that, when being long, shares can be loaned out.
• Thus, I don’t favor a short position along the primary bear market.

For those who know very well what they do, short term shorting along a primary bear market (and even in a primary bull market at very sweet spots with selected equities) may be OK. However, such shorts:

• Try to exploit bearish secondary reactions (optimally within a primary bear market).
• Last a few days.
• Only short when an excellent risk reward ratio is present.

And don’t forget that the longer your time frame, the less likely your shorts are going to perform well.

Furthermore, given that we know that the average further decline following the primary bear market signal averages ca. -12.5% and given that we know that we lose on average ca. 7% getting in and out of a position (ca. 14-15% total), we can see that "on average" bear market swings lack enough magnitude to be profitable.

As a follow up to my answer, Algyros posted in Seeking Alpha an additional comment/question:

The answer, persuasive as it is, still leaves me wondering. If, indeed, on average, shorting the market during a Dow Theory sell signal, is not profitable, then, does it not follow that, on average, Dow Theory calls are no more profitable than a buy and hold strategy?

Of course, a strategy may be as profitable as another one, yet still be more desirable because it is subjected to smaller drawdowns. Is that, in your view, the advantage of Dow Theory?

As always, I am grateful for your generosity.

Well this post is an answer to Algyros hoping to dispel all doubts concerning shorting with the Dow Theory.

I am very roughly speaking but I hope my readers get the idea.

The US stock market has roughly gained (dividends excluded) ca. 8% p.a. since 1940 (here you can find annual returns):

http://www.moneychimp.com/features/market_cagr.htm

Eight per cent p.a. is a clear upward bias. When shorting you have to fight against prices rising on average 8% p.a.

Schannep’s Dow Theory has managed (on the long side) to add ca. 4% to the average 8% annual gain, while reducing dramatically drawdowns. This is the “improvement” of Schannep’s Dow Theory versus buy and hold.

Let’s flip sides and go to the sort side.

A “short and hold” shorting strategy would be losing ca. 8% p.a. (and please include dividends, commissions for shorting, etc.). Let’s assume that the Dow Theory, when using its signals to short, manages to also “create” 4% p.a. (as it does on the “long side”).

However, given that we are facing headwind (the 8% p.a. upward bias), we could expect to make when shorting:

-4% (from the Dow Theory shorting) + 8% (upward bias) = +4% p.a.

Please mind that a positive number when shorting means losing money. When shorting you are likely to lose on average 4% p.a. (plus dividends you have to pay, shorting fees, etc.), which may well represent a real loss of 6-7% p.a. (“short and hold” would be losing something in the vicinity of -10% if we take into account dividends too)

The Dow Theory adds value: ca. 4% outperformance and drastic drawdown reduction. However, 4% "added value" is not enough when shorting to outweigh an upward 8% p.a. bias.

Of course, nobody knows the future. If stocks were going to deliver ca. 8% p.a. in the future, then shorting would not be advisable. Even under conditions of modest growth (something which by the way is expected for the next 20 years) of just 4% p.a. shorting would at best break even. If stocks were to have zero growth for the next years, then it’d be likely (although not guaranteed) that shorting according to the Dow Theory could deliver modest, albeit positive results (depending on the dividend payout).

Armed with this knowledge, we can also guestimate what we can expect of the Dow Theory (long side) under negative market conditions. The Dow Theory does not float in a vacuum. It is sensitive to the vagaries of the stock market. If there is an upward bias, it will capitalize on it (by hopefully adding +4% p.a. on average and reducing drawdowns) to the average annual return. If markets remain flat, then we should expect to make just ca. 4% p.a. (and cash some dividends during the time we are invested). More about what to expect (on the long side) of the Dow Theory on the next 20 years here.

 If stocks were to decline -4% p.a. during the next decade or so, then the long side of the Dow Theory would be likely to just break even (-4% +4% outperformance = 0). In such a case, shorting with the Dow Theory might add some value (0 -4% outperformance short) = -4% (a negative number is a positive return when shorting). However, in real life, when we account for dividends, short fees, etc. real profits would be much smaller. 

Personally, I see shorting for short term trades under very specific circumstances and very specific stocks. Thus, I can short certain stocks as a very short term trade when the Dow Theory is bearish. However, my personal use of shorts, rather to add value to my trading merely serve to smooth performance. In other words, at best I just make marginal profits with my selected short term shorts. However, such shorts tend to do well when my longs fail to perform (i.e. under severe market declines) or when I have no longs because my filters tell me to eschew longs.

Sincerely,

The Dow Theorist