Dow Theory Investment

Thursday, May 7, 2020

Dow Theory Special Issue: The Rule of Seven: A vital tool to determine profit objectives

Do Dow Theorists need to establish profit objectives?

Rhea wrote that the Dow Theory could not forecast the extent of a rally or decline. In other words, the Dow Theory determines likely direction, and we take what the market offers us. However, Schannep long time ago incorporated into his arsenal a tool that allows him to establish price objectives.

That tool is named “the Rule of Seven,” and while not created by Schannep, as far as I am aware of, it has been Schannep the investor who has put it most to use, and with documented success.

I know “purists” will be screaming “heresy,” as one of the tenets of the Dow Theory is that neither the time nor the extent of a primary movement can be determined in advance. However, I’d like to point out the following:

1) Rhea availed himself of loose price objectives based on market action. Yes. In actual trading, Rhea was often trading around secondary reactions. That is buying when he felt that a secondary reaction had run its course (which is a price objective based on retracements), and, more importantly, selling when he thought that there was an impending secondary reaction. A future post will further explain all this, and why we should not attempt to emulate Rhea’s trading when using Schannep’s Dow Theory. The takeaway for this post is that Rhea, in many instances, “sensed” that the bull swing was overdue for a correction (i.e., because the swing has lasted or advanced more than the average swing) and ran for the exits before an actual Dow Theory sell signal was given.

In his Dow Theory Comment number 30 of July 24th, 1933, Rhea advised existing at almost the very top (07/18 and 07/14/1933 for the Industrials and Transports respectively) of an overextended bull swing (which had been running from February 27th, 1933). I quote Rhea (with the express permission of the editor “Alanpuri Trading,” Los Angeles, 2012”):

“It is hoped that no readers of these letters got caught in the crash. It so, it is not the fault of this writer or of Dow’s Theory. In Mailing 29, July 19 (Ind. 103.58, Rls. 54.01) we stated: “The nearby trend is downward”

“The Ind. made a new high – the Rls. Refused to confirm- then both averages broke down through the preceding minor lows. No believer of Dow’s theory, as interpreted in these letters, should have been caught in the recent panic decline. The warning and the picture were there for all to read”.

Note: Ind. means Industrials, and Rls. means “Rails, that is Transports”.

The funny thing, though, is that Rhea recommended cashing out just one day after the market top of the Industrials (07/18/1933 top). If one reads Rhea’s letters in the weeks leading up to the top, Rhea clearly thought that the market was more than overextended. Hence, at the very first sign of weakness (a minor non-confirmation and the breakdown of a very minor low) Rhea decided to sell out.

2) Rhea wrote that higher confirmed highs carry less importance the older the bull swing gets. Eventually, there will be a turning of the trend. Or as legendary trend follower, Ed Seykota said, “the trend is your friend except at the end when it bends”. So while remaining trend followers, there are instances when cashing out may be in order. For this very reason, Schannep uses Capitulation which is just betting for a reversal to the mean. We want to make money in the markets, not to be zealots of one sect called trend following. We know, though, that 90% of the time, we will be in a pure trend following mode simply because it works. However, there will be some occasions when we are buying extreme weakness (capitulation) and selling strength (Rule of Seven, profit objective). The art, which Schannep has fine-tuned to almost perfection, is to know which exceptional weakness should be bought and which strength should be sold.

3) Even for those reluctant to using price objectives and willing to wait until finally stopped out, sensible price objectives serve to know when to tight stops. I give you an example from my actual practice: When dealing with non-US stock markets, I am forced to use “Rhea’s Dow Theory”, as I don’t have the privilege of having three indices. Readers know that under the classical Dow Theory, unlike Schannep’s, there are no hard and fast rules for determining a secondary reaction, so there is ample room for interpretation, and this is why I insist that outside of the realm of Schannep’s Dow Theory, one is well advised to accept alternative appraisals of secondary reactions to split the risk. This is why Rhea wrote that “no two students would agree on any rule for selecting” secondary reactions. In other words, depending on each one’s interpretation secondary reactions may vary in length and extent, which translates into tighter or looser stops. And here comes the beauty of having price objectives: When I know that prices are in the profit objective zone, I demand fewer days and, normally, less extent to declare the existence of a secondary reaction. Additionally, I pay more attention to non-confirmations at higher highs, and, I even take a look at volume. The result is a “tighter” stop based on a secondary reaction that has been appraised with less time and extent than usual. My next post will surprise you as Rhea went as low as just 7 days (and sometimes he even did away with confirmation) to declare a secondary reaction. However, Rhea was no fool, and he knew when it was time to be satisfied with just 7 days and when it was time to require more time.

For the three reasons given above, I feel the use of good price objectives (as usual “good” is the word, as not all rules to calculate profit objectives do work in actual trading) is a valuable addition to one’s trading arsenal.

It is worth remembering that Schannep nailed it down in his February 1^st, 2020 letter to Subscribers. In real-time, based on the price objective established by the application of the “Rule of 7”, Schannep alerted his Subscribers and wrote “I am doing some lightening up in my other accounts.” Please mind: That sentence was written on February 1^st, 2020 just days before the market top

If you are really serious about making (or at least not losing) money in the stock market, do yourself a favor: Read at least three times the followed linked Letter (February 1st, 2020) to Subscribers. It’s free.

https://thedowtheory.com/our-story/dow-theory-newsletter/sample-newsletter/

All in all, the Rule of Seven is a valuable tool to determine price objectives that may be successfully applied in our actual trading decisions. This post does not deal with the entrails of the “Rule of Seven” which are explained with great detail and real trading examples on the Subscribers area of Schannep’s website “thedowtheory.com”. You can get access to the Rule of Seven report by becoming a free Subscriber. Continue reading.

As I announced here, I joined Schannep’s “thedowtheory.com” as a contributing editor.

As an expression of gratitude to the followers of this blog, and as an invitation to follow me on my new home “thedowtheory.com”, I will be offering for the next few weeks a free two months subscription. For a FREE Trial, send an email with your name

TO: Editor@TheDowTheory.com

SUBJECT: Free Trial

and you will receive a username and password to access thedowtheory.com Newsletter.

That's it!

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

4) Our definition of a Bull market was met earlier last month confirming this up market

5) We have once again determined the upcoming Rule of Seven target for the new bullish swing.

While my blog is instructive and remains a valuable tool to dig deep into vital aspects of the Dow Theory, those truly intent on getting actionable and real-time advice with a proven and disclosed record should use “thedowtheory.com” as a companion to this blog.

Sincerely,

One Dow Theorist

Wednesday, April 29, 2020

SPECIAL ANNOUNCEMENT: I join Schannep's “thedowtheory.com”

And about the future of this Dow Theory blog

I am proud to announce that I joined Schannep’s letter “thedowtheory.com” as a contributing editor. From this blog, I can only express gratitude to Schannep and his wonderful family for inviting me to join them. I also want to thank them for their gentlemanly. More than a negotiation between two parties, it was like drinking coffee with some good friends.

I’m genuinely excited about this new undertaking. I express from this blog thanks to all the people who have been following me (many of them subscribers to “thedowtheory.com”) for all these years. I also thank Schannep’s subscribers who sent kind and encouraging words of support.

My first contribution to the Schannep’s Monthly Letter to Subscribers was posted on “thedowtheory.com” website last April 1st. The next contribution will be published on May 1st. Currently, both the Schannep’s team and I are fully immersed in the drafting of such a letter. I would have never thought than writing a 7-page letter entailed so much dedication. Going from draft to finished product is a fascinating process of brainstorming. As Schannep wrote to me some days ago, “words have meaning”, and thus, even the slightest nuance of a word is being discussed. I am amazed at the sharp focus and youthfulness that oozes Jack Schannep.

I also realize that it is not the same to write in this Dow Theory blog, which I consider my “home,” and I can walk around with slippers than to write on a professional basis where certain expectations must be met. Here I write what I please and when I please. Writing for a base of Subscribers who expect to get first quality and timely information is quite a different thing. One must remain much disciplined. This is not to say that the “quality” of this blog was defective (it is up to the readers to judge). Still, it is an entirely different beast to pen musings about finance than to be addressing a public who expects specific advice just on time. It is the transition from the theoretical (albeit I put to use many insights of my blog) to the practical. I give you one example of what I mean: Some days ago, I wrote the first draft of my assessment of the current trends under both Schannep’s Dow Theory (more accurately “21st Century Dow Theory” and the “Rhea/classical” one). In a similar vein to that of this blog, I started to almost lecture about the intricacies of the current market situation (i.e., further decline following the signal, specific details as to the weighting of positions following capitulation, etc.). The result was a loss of focus. I am learning to differentiate between what constitutes “lecturing” or “researching” from giving accurate and punctual advice about trends where the less verbiage, the better so that the message doesn’t get clouded by words. This doesn’t mean that I cannot get philosophical and continue carrying out research. However, it means that there is a space where one needs to deliberately go to the point and leave study and deep thinking for other areas.

Currently, “thedowtheory.com” only covers US stock indices. We have agreed that in the coming future (let’s say around 6 months), we’ll probably start covering US interest rates (of course, under the Dow Theory). After all, the US bond markets greatly exceed that of stocks in capitalization, and my take is that bonds lend themselves very well to being analyzed under the Dow Theory. I hope that the broadening of topics will make most of Schannep's Subscribers happy. If I can cope with the additional workload, and as I continue the process of adapting myself to the new environment, Schannep and I will probably include more markets such as precious metals (and energy??, and currencies??, who knows!). From here, only the sky is the limit since readers of this blog know that I have many Dow Theory related projects in my pipeline. However, I insist, writing professionally is not the same as blogging, so I feel that I have to take baby steps. My joining "thedowtheory.com" is a long term endeavor.

And what about the future of this Dow Theory blog? Well, the blog will continue.

The blog will remain to be the place for digressions, musings, and deep cogitations (although some of them may be exclusive to“thedowtheory.com”). Perhaps some pieces of cumbersome and time-intensive research (i.e., the last chapter of the capitulation saga which is full of vital information enriched with the developments of February/March 2020) are going to be exclusively made available under “thedowtheory.com” which I think is fair to its Subscribers. However, I plan to keep the blog alive and with good content. The only thing that is going to change partially will be providing information about the change of trends on the very same day they occur. I have just written “partially” because, most of the time, I never gave information about changes in trends in real-time. So there is no significant change. Maybe the delay will be a little bit longer. Two or three days? Such delays also occurred occasionally in the past.

Furthermore, it wouldn’t surprise me that even the quality of this blog gets heightened thanks to my contributing to “thedowtheory.com”. My being committed to providing extra quality service there will spill over to this blog. I hope to improve the quality of my charts, the spreadsheets I use, etc. Since to whom a good tree draws near good shade shelters, I know that my joining efforts with whom I consider my mentor, Jack Schannep, will further contribute to my mastering the Dow Theory, and in general, the analysis of the markets. What now follows is no empty flattering since long time readers of this blog know that I praised Jack Schannep’s wit from its very inception (when I not even remotely thought that one day we would be working together). Although this blog is full of posts demonstrating Schannep’s accomplishments (i.e., here), I’d like to stress the following about Jack Schannep:

· He’s a man of character, a gentleman. He’s always been willing to lend me a hand, even when I was a rookie blogger. Ever patient (particularly these days of hard work in common), always gentle, always good-spirited.

· His rendering of the Dow Theory is a true accomplishment that, as time passes, will be more and more recognized. Why am I so sure? Because of:

1. He has made the Dow Theory tradable for the layman. A common (and justified) criticism against the “classical” Dow Theory is its subjectivity. No two Dow Theorists seem able to reach a common ground. Schannep has provided clear-cut rules with very little room for interpretation. And such rules work!

2. Such clear-cut rules result in outperformance (ca. 2% p.a. more than “Rhea’s/classical” Dow Theory) and a marked reduction of drawdowns. In technical jargon, a much better risk-adjusted profile.

3. By generating a slightly higher amount of good quality trades than the classical Dow Theory (due to capitulation and somewhat shorter duration of trades, due to a shorter definition of secondary reaction) drawdowns are comparatively smaller than those of the “classical” Dow Theory.

4. The timing indicator provides us with an additional source of excellent quality trades and portfolio diversification (capital is supposed to be committed 50% to Schannep’s Dow Theory and 50% to the timing indicator). By the way, in the past, I couldn’t write about trades following Schannep’s timing indicator because it is proprietary. Now from "thedowtheory.com” my research will be made available together with this great indicator. As I wrote here, Schannep’s timing indicator has outperformed buy and hold for the last 60 and odd years by ca. 4% p.a. The last 20 years have witnessed an outperformance of 4.19% p.a.(CAGR of 9.40% versus 5.21% for buy and hold).

5. Schannep is one of the few newsletter writers that fully discloses all his trades since the ninety fifties, and, more importantly, their performance. One thing that irks me is seeing most investment “gurus” giving their investment recommendations in a way that results almost impossible to track. Furthermore, their newsletters don’t provide their readers with an accurate rendering of the outcome of the trades recommended in the past. They are masters in vagueness, and in hedging their words. No wonder that 90% of investment letters fail to beat their stated benchmarks, as explained by Investopedia. This is not the case with Schannep, who belongs to the selected 10%. In my opinion, investors should be very reluctant to follow investment recommendations not sufficiently backed up by a track record. Furthermore, Jack Schannep eats his own cooking and invests his own money based on his trading recommendations posting on his Letters the actual performance of his portfolio. He delivers.

So readers of this blog are encouraged to continue visiting me. The blog will continue to exist full of content.

There is one thing that most likely could change soon: The wording. Jack Schannep and I are currently discussing the wording to depict each market situation. For instance, what I call “primary bull/bear market” could change into a “preliminary bull/bear market” so that we distinguish this movement from the real “bear/bull” defined by the confirmed -16%/+19% movement. So some minor terminology aspects might slightly change.

As an expression of gratitude to the followers of this blog, and as an invitation to follow me on my new home “thedowtheory.com”, I offer you a free two months subscription. For a FREE Trial, send an email with your name