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Dow Theory Update For August 19: Lessons Learned From The Chinese Stock Market Crash (I)

|Includes: DIA, GDX, IYT, SPDR S&P 500 Trust ETF (SPY)

Trends unchanged.

This post was overdue, but time was scarce.

While I am an ardent believer in the Dow Theory (of any persuasion whatsoever), I try not to be a fool. The Dow Theory is, in my opinion, the best mean to extract out performance and diminish drawdowns, provided the market obliges.

By an "obliging" market, I do not mean a market that always goes up. It can go down, and it is healthy that markets go down, as the new bull market that follows a bear market offers good entry points.

Hence, when it comes to US stocks, the Dow Theory has done remarkably well, in cutting losses when stocks go down, and making money when stocks go up.

However, an "obliging" market is one whose price movements and price structure have some degree of "smoothness." Thus, we know that a primary bear market signal will be flashed if:

a) after the signaling of a secondary reaction, a rally on at least one index of +3% (lasting at least 2 days) must follow. Thereafter, a decline follows that jointly violates the secondary reaction lows.

OR

b) If setup "a" does not materialize, the lows of the last completed secondary reaction (Rhea's book page 77), when jointly violated. This vital alternative exit was dealt with in depth in a saga of five posts. Here below you have the link of the fifth post, which contains the links to the complete saga.

http://www.dowtheoryinvestment.com/2015/02/dow-theory-special-issue-schannep-and-i.html

OR

c) The empirically deducted -16% Schannep's stop is jointly violated. More about this stop here:

http://www.dowtheoryinvestment.com/2013/05/dow-theory-special-issue-introducing.html

If we have an "obliging" market, we can be pretty sure that one of the three alternative stops will "quick in," and hence we will be out with moderate losses.

However, there is no assurance that the market will "oblige" and we will have type "a" or "b" Dow Theory stops at a reasonable level. As to the -16% stop, I have written that:

"The -16% stop is an empirically deducted stop which seems to do well with US indices which normally have lower volatility than Chinese ones. Hence, I'd be very careful to extrapolate the -16% stop to Chinese indices or for that matter, to silver, gold or GDX or SIL"

In other words, when dealing "outside" US stock indices, the -16% stop more than doubtful since:

a) Volatility may not be similar to that of US stock indices, and hence -16% may be too loose or too tight.

b) We lack the empirical record (and even empirical records when existing are certainly no guarantee when looking forward. The past need not necessarily repeat itself.

Therefore, when dealing with Chinese stocks, I feel we only have stops "a" (the classical Dow Theory pattern) and "b" (Rhea, page 77, lows of the last completed secondary reaction).

The issue is: what if the market does not "oblige" and stop "a" fails to materialize (which means that stocks begin to go down and no rally of at least 3% occurs on at least one index)? What if the alternative stop "b" lies too far from the last recorded highs? Are we willing to accept -26% losses? (-26.10% was the loss for FXI, iShs China large-cap ETF from top to bottom).

Even worse: what if at the -26% level, the violation of the lows of the last completed secondary reaction (stop "b") are not confirmed? Do we stick with the trade and refuse to sell?

This is precisely what has happened to Chinese stocks.

They were in a primary bull market (which was signaled here)

A secondary reaction was signaled by mid June 2015.

So, it seems that Chinese stocks were nicely setting up for a primary bear market signal. However, the +3% (or whatever value in volatility-adjusted terms) did not materialize. Furthermore, no Chinese index managed to stage a two days rally (which is the minimum time requirement for the subsequent rally to complete the primary bear market setup). No sooner the secondary reaction was signaled by the Dow Theory, there was just a one-day rally of negligible proportions, to be followed by a precipitous decline. Hence Dow Theory stop "a" (the normal one) did not materialize for Chinese stocks.

And what about, the alternative stop, the lows of the last completed secondary reaction (Rhea's book page 77)? Well, I have more bad news:

To begin with, the lows of the last completed secondary reaction were -28.93% below the last recorded highs for FXI and -29.06% for HAO (China small cap ETF). Not a very appealing stop, which for practical matters, is tantamount to no stop, as theoretical losses close to 1/3 are not acceptable.

Furthermore, to add insult to injury, the violation of the last completed secondary reaction lows (orange rectangles on the left side of the chart) was not confirmed. Thus, only HAO did briefly violate the lows of 10/1/2014, whereas FXI did not violate its 10/1/2014 closing lows.

What would we do if the US Stock market behaved like this?

In strict application of the Dow Theory, lack of confirmation would mean that we could not declare the primary bull market as death, and no primary bear market signal would have been signaled.

So what to do if the US market behaves so unbecomingly? I will try to address this thorny issue in my next post. However, I would like to raise an equally interesting point. Are investors in US stocks technically and mentally prepared to deal with such an unruly market? What would we, Dow Theorists, have done if suddenly the US stock market went Chinese? Are we armed with the proper technical tools? Would we be frozen and do nothing? Or we would run for the exits? But if we run for the exits, when? Well, at least with US stocks we have the -16% uncle point. But, what if, in the future, US stocks have a volatility resembling that of Chinese stocks? Would be applied without hesitation the -16% stop? Would still be valid under greater volatility?

And when it comes with Chinese stocks, being deprived of the -16% stop, what would have you done, had you been invested in FXI or HAO or both? Would you have applied the -16% stop? Or -16% adjusted by volatility (which might be, depending on the way you compute volatility in the vicinity of -25%)? Or just ignore such a stop, and sit tight in spite of losses that might reach almost 1/3, since as of this writing no primary bear market has been signaled?

We tend to feel comfortable with US Stocks (and by implication with the Dow Theory) because US Stocks have certainly behaved properly in the past, allowing Dow Theorists for orderly exits when the tide was down (primary bear markets), what if we don't have the privilege of such "obliging" markets in the future? Thus, the Dow Theory managed to have investors out of the market before the crashes of 1929 and 1987 materialized, as explained here.

Of course, I am not despising the Dow Theory, the fate that awaits buy and holders may be even worse, but I am trying to take a very realistic view at the risks, we investors, are confronted when looking forward.

In my next post, I'll try to offer some "solutions" to the thorny issue of when to get out, when stocks set up in such a manner that both Dow Theory stops lie at very distant levels from the top.

Sincerely,

The Dow Theorist