Dow Theory Update for October 19: Revisiting the Oct. 19th 1987 crash (35 years)

Did the Dow Theory help? YES

 

Today, October 19^th, is the 35^th anniversary of the 1987 stock market crash. So, it is timely to revisit two posts a penned in the past. Today, I reproduce and update one post I wrote exactly 10 years ago. Tomorrow, I will repost the second one.

How fared those that followed the Dow Theory? Were they spared?

 

The answer is clear: YES. They were spared.

 

I will use “classical” Dow Theory with just the Industrials and Transports in this study. I do this because in 1987 Schannep’s improvement, which includes the S&P, was not known yet (or at least was not known to the majority of the public since his seminal book was not published yet). More on Schannep’s book here:

 

However, even “classical” Dow Theory was responsive enough to keep us on the safe side of the market during the market crash. 

 

Look at the chart below, which displays the period surrounding the crash.

 

October 1987 crash: The Dow Theory kept investors protected

 

We can see that the Dow Industrials made its highest high on 08/25/1987 at 2722.42. The Dow Transportation made its highest high on 08/14/1987 at 1101.16.

 

From such highs, a secondary reaction developed. The lows of the secondary reaction were jointly made on 09/21/1987. The Industrials’ low was 2492.82, and the Transports’ low was 1005.80. Hence, percentage-wise the Industrials declined by 9.21% and the Transports by 9.48%. The secondary reaction lasted 18 trading days (from 08/25 to 09/21), thus fulfilling the time requirement for a secondary reaction (even for those Dow Theorists who require at least 3 weeks).

 

A rally ensued that exceeded 3% in both indices. After that, the markets headed south. On 10/09/2012, the Industrials violated the preceding secondary reaction lows of 09/21/1987. However, the Transports didn’t confirm. So, no primary bear market signal was displayed. 

 

On 10/15/1987, the Transports violated its secondary reaction lows giving a Dow Theory primary bear signal. At the close of that day, the Transports stood at 980.24 and the Industrials at 2355.09.

 

Those nifty investors could have exited at the close. Those less reactive investors should have sold at the open on 10/16/2012 (Friday). Under Dow Theory, there is no excuse for getting out later.

 

So, how much “lost” Dow Theory investors from the highest high of the Industrials to the exit point at 2355.09? Let’s do the math: (2355.09/2722.42)-1 =

 

-13.49% Loss for followers of the Dow Theory.

 

How much was to lose the market from the 2722.42 high to the 1738.74 low? Let’s do the math again: (1738.74 / 2722.42)-1 =

 

-36.13 % Potential loss for ordinary investors.

 

No need to use more letters or words. The facts speak for themselves.

 

And what would have been the numbers if we had used the Schannep version of the Dow Theory? The answer: Even better. According to his book, the loss would have been further reduced by 2.4% (page 114). 

 

This is my Dow Theory way to celebrate the 35th anniversary of Black Monday. 

 

Tomorrow, we'll compare 1987 to the 2020 crash. While both showed similar suddenness and declines, technically were very different.

 

Sincerely,

Manuel Blay

Editor of thedowtheory.com

 

Dow Theory Update for October 13: Even "normal" trend following works if you are patient.

Trend following works BUT most people cannot digest the spells of underperformance and/or drawdowns that inevitably occur. You must be patient and control your fears. The chart below is taken from the October monthly report of a very successful trend-following fund with a track record starting in April 99. The red lines show all the 5 drawdowns that would have led many investors to think, "is the system broken?". As you can see, all drawdowns have been followed by higher equity highs, and it beat the pants off to Buy & Hold (S&P500 total return, orange line). My question is: How many investors have stayed the course through thick and thin? Very few, I suspect.

 

 

Sincerely,

Manuel Blay

Editor of thedowtheory.com

Dow Theory Update for October 12: Heretical interpretations of the Dow Theory

 Not everything promoted as "Dow Theory" is the correct Dow Theory

 

Three years ago, I wrote a saga of three posts explaining what I consider “divergent” interpretations of the Dow Theory, namely interpretations that do not fully reflect what true Dow Theorists like Robert Rhea did, and are likely to result in underperformance. More information here, here, and here.

Today, I will refer again to what I consider not only a “divergent” but a plain “heretical” application of the Dow Theory, rendering it useless.

I will not give names, as learning how to properly apply the Dow Theory is what matters.

So what is what I consider to be “heretical” (or “plain wrong”)?

Lower lows by the Dow Industrials and Transportation in September prompted several market observers and journalists to proclaim that “The Dow Theory signals a Sell” because on 9/16/22, the Dow Transportation closed below its June low, and the Dow Industrials on 9/23/22 confirmed.

Those analysts confuse confirmation of an already existing sell signal with a new signal. The differences for investors are enormous.

The “classical” Dow Theory triggered a SELL on 2/22/22, as I explained here.

As the bear market progresses, both Indexes make lower lows. However, the breakdown of prior lows merely confirms the 2/22/22 SELL; it is not a new Sell signal. The longer the bear market lasts and continues making lower lows, the more likely that we are near the end. Of course, we don’t know when it will end, but we do know that the odds for lower prices were much higher on 2/22/22 than on 9/23/22. In other words, acting on a SELL on 9/23/22 implies a realized loss of almost -20% for the Dow Industrials (from the 1/4/22 closing highs), whereas selling at the correct date, 2/22/22 entailed exiting at just of ca. -7.5% off the bull market highs (and locking a realized gain from the previous BUY on 5/26/20 of 34.41%. Timing is everything and getting late to the party may turn a profitable trading system into a money- churning one.

The charts below show the right (and wrong) interpretation of the “classical” Dow Theory

 

So don’t be misled: The Dow Theory, when properly applied, only triggers one Buy and one Sell. Successive higher highs or lows simply confirm the existing trend (and the last Buy or Sell signal). Of course, writing that the Dow Theory gave a Sell signal on 9/23/22 makes catchier headlines than writing that the bear market or 2/22/22 Sell has been reconfirmed.

And what about the trend when appraised by the Dow Theory for the 21st Century (aka. Schannep’s Dow Theory)? It is also bearish. Schannep’s Dow Theory, since 1953, outperformed Buy and Hold by 3.21% p.a., with a marked reduction of both the depth and time in drawdown. Schannep’s Dow Theory achieved such an outperformance by investing only in the major indexes, which is quite a feat.

Still not enough? We are now targeting 5% p.a. outperformance with our just launched Dow Theory-based ETF trading system, as explained here.

Do you want to know more? Become a Subscriber, and you’ll get access to a wealth of information (i.e., access to our Letters since 1962 and their concomitant trade recommendations, the power of the consumer confidence report as a timing device, the special report about the yield curve, how to calculate profit objectives that work, and much more). More importantly, you’ll be punctually updated through our email service of any change in trends and the specific ETFs making up our Dow Theory on steroids portfolio. Not accidentally, our Newsletter has consistently been ranked among the top investments Letters.

Sincerely,

Manuel Blay

Editor of thedowtheory.com

Dow Theory Update for September 22: Primary bear market for bonds signaled on 9/20/22

 No secondary reaction on the horizon

 

General Remarks:

In this post, I provided a thorough explanation concerning the rationale behind my use of two alternative definitions to appraise secondary reactions.

TLT is the iShares 20 years + Treasury bond ETF. More about it here

IEF is the iShares 7-10 years Treasury bond ETF. More about it here.

Thus, TLT tracks longer-term US bonds, whereas IEF tracks middle-term US bonds. A bull market in bonds entails lower interest rates. A bear market in bonds represents higher interest rates.

A) Market situation if one appraises secondary reactions not bound by the three weeks and 1/3 retracement dogma.

As I explained here, the primary trend was signaled as bullish on 7/22/22.

In my 8/26/22 post, I explained the development of a secondary (bearish) reaction against the primary bull market.

On 9/6/22, TLT broke down below its 6/14/22 primary bear market lows unconfirmed by IEF. On 9/20/22, IEF broke down below its 6/14/22 primary bear market lows confirming TLT, signaling a primary bear market. So, the primary and secondary trend is bearish now.

 

The charts below display the current situation. The brown rectangles highlight the pullback (secondary reaction) that developed against the then-existing bullish trend. The red horizontal lines show the primary bear market lows which have been jointly broken down. The small grey rectangles highlight a mini-rally that did not meet the requirements to set up both ETFs for a primary bear market signal (we need at least two confirmed days, and some "extent"). Please remember that under the Dow Theory, we have alternative ways to signal the trend change, which enables us to always have a “backup” plan in all market environments. Please read this post to know more. You need to know more. One thing is the “casual” application of the Dow Theory (which is doomed to fail).  Another thing is to dig deeper into its understanding to master one of the best trend-following methods.

 

 

B) Market situation if one sticks to the traditional interpretation demanding more than three weeks and 1/3 confirmed retracement to declare a secondary reaction.

 

The primary trend was signaled as bearish on 9/28/21. A more aggressive and legitimate interpretation would have signaled the bear market on 9/24/21. The explanations here.

I explained in my 8/26/22 post the development of a secondary (bullish) reaction against the primary bear market and the setup for a potential primary bull market signal.

On 9/6/22, TLT broke down below its 6/14/22 bear market lows, unconfirmed by IEF. On 9/20/22, IEF broke downside its 6/14/22 bear market lows and confirmed. Such a confirmation entails three consequences:

 

a)      The primary bear market has been reconfirmed.

b)     The secondary (bullish) reaction against the primary bear market has been canceled

c)      The setup for a potential primary bull market signal has been canceled too.

 

      So now, both the longer and short-term oriented renderings of the Dow Theory are in gear. Both are bearish.

     Below you have the updated charts displaying the most recent price action. The blue rectangles show the secondary (bullish and now aborted) secondary reaction against the primary bear market. The brown rectangles highlight the pullback that set up TLT and IEF for a potential (please mind the word) primary bull market signal, which was canceled by the confirmed lower lows. The red horizontal lines display the 6/14/22 primary bear market lows,  which have been jointly broken down. 

 

General remark:

As with any long-term trading system that seldom triggers signals, performance should be evaluated by taking a sufficiently long observation period (I'd say at least 5-6 years for a portfolio and 10 years if dealing with one asset class alone). The link below offers you an evaluation of the outperformance and drawdown reduction operated by the Dow Theory when appraising the trend with TLT and IEF:

http://www.dowtheoryinvestment.com/2022/03/dow-theory-update-does-dow-theory-work_22.html

Sincerely,

Manuel Blay

Editor of thedowtheory.com