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Dow Theory Special Issue: More On The Chinese Primary Bull Market Signal

|Includes:Comfort Systems USA, Inc. (FIX), HAO, SPY

In this post, I explained that a primary bull market had been signaled in Chinese stocks. Let's look a bit deeper into it.

Let's start by showing an updated chart:



Anatomy of a primary bull market signal

I will focus on the FXI as it represents 25 big companies. It is the equivalent of focusing on the Industrials (NYSEARCA:DIA). So, even though, I also use the HAO (small cap ETF), the following considerations are based on the HAO.

The primary bear market lows were made on June 25th, 2013 at 31.7.

The primary bull market was signaled on September 10, 2013; the FXI closed at 38.79.

Thus, our initial Dow Theory trailing stop (more about such a stop here), is set at the primary bear market lows at 31.7, which amounts to 22.37% below 38.79.

A stop of 22.37% is a remarkably wide stop, which exposes the investor to a significant amount of risk should the market reverse its course and, with no intervening secondary reaction, violate the primary bear market lows at 31.7. Readers of this blog know that when dealing with the US stock market, the original Dow Theory stop tends to be narrower (between 5 and 10%), as explained here.

Why, then, such a larger Dow Theory stop? There are two reasons:

1) FXI's volatility more than doubles that of the SPY. Given FXI's larger volatility it is normal that the original Dow Theory stop is larger. The same happens when trading GDX or SIL. Such precious metals ETFs have a very high volatility and, accordingly, all price movements and patterns (including initial Dow Theory stops) reflect such higher volatility.

2) The setup leading to the primary bull market signal was of the variety which does not include a pullback, and which results in a lower entry price level. The only pullback that occurred (orange circle on the chart) didn't reach the minimum volatility threshold to be meaningful under the Dow Theory. Thus, we had an unusual, but fully orthodox, as explained here, primary bull market signal, which consists on the breaking up of the last recorded secondary reaction closing high against the primary bearish trend. This results in a somewhat delayed primary bull market signal and a concomitant larger original Dow Theory stop.

Of course, if I were to invest in the FXI, I wouldn't be willing to risk losing -22.37% if things go sour. My rule of thumb is that the initial risk should never exceed more than 10% in long term trades (being long term for me anything that on average may last 1 year). Thus, my "solution" would be to invest a lower amount of equity, so that the real amount of capital lost doesn't exceed 10%. In this specific case, this would imply investing ca. 44% of one's capital and letting the remainder in cash (or better yet, invested in some other trading opportunity with a maximum risk not exceeding 10%).

Issues of portfolio composition (that is how much money to allocate to each specific trade) are almost as important as proper timing the market.

Have a nice weekend.


The Dow Theorist

Stocks: FIX, HAO, SPY