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Dow Theory Update For January 31: Capitulation And Secondary Reactions Under Schannep's Dow Theory

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

Precious metals and their miners remain in primary bull market.

Stocks remain in primary bear market.

US STOCKS

The primary trend as per Schannep’s Dow Theory is bearish, as explained here. The secondary trend (secondary reaction against the primary bear market) is bullish, as explained here.

Under the “Rhea/Classical” Dow Theory stocks are under a primary bear market, as explained here.

The secondary trend as per the “Rhea/classical” Dow Theory is bullish as explained here.

Here you have an updated chart:

Powerful secondary reaction within primary bear market

Neither Schannep’s (3 indices) nor the Classical Dow Theory (2 indices) underwent a pullback of 2 or more days exceeding 3%. As the chart belows shows (tiny orange rectangles at the right side of the charts), there was a 1 day pullback that exceeded 3% on the S&P 500 and the Transports. However, as per Schannep's Rules, the pullback must last at least two trading days. Hence, not setup for a primary bull market has been completed. Absent such a pullback, we have to keep an eye on the last recorded primary bull market closing highs. (10/03/2018, for the Industrials, 11570.84 for the Transports and 9/28/2018 for the S&P 500). Should they be bettered, we would also get a primary bull market signal.

Thus, in spite of the torrid action we have witnessed since the market lows of 12/24/2018, the primary trend remains bearish.

By the way, and as an aside: Astute readers perusing the charts might object: "Hey you Dow Theorist, after just seven trading days of advancing prices, you were looking for a 2 days pullback. This is too soon, as Schannep's Dow Theory requires a minimum time average of 8 trading days for a secondary reaction to exist before we begin to look for the minimum two days pullback."

Well, actually I began to monitor the development of a pullback even sooner than that. I considered the existence of a secondary reaction as soon as 4 trading days of confirmed rallies following the 12/24/2018 bear market lows had elapsed.

The astute reader might retort: "What!!! A secondary reaction after just four trading days?!"

And I'd anwser: Yes, a shortened time requirement for a secondary reaction is possible under Schannep's rules only if there had been a previous capitulation.

Now please, follow me.

As I have written in the past, Schannep has more weapons in his “timing” arsenal. The Dow Theory is the most important, but not the only one. Hence, when the market is severely oversold, he avails himself of his proprietary “capitulation indicator” (basically an oscillator), which has had an excellent track record in the past. On 12/24/2018, the very day of the primary bear market low, his “capitulation” indicator flashed a “buy”, which implied a recommended buy between 25% (for those not using the so called “composite” indicator) or 50% (for those using the “composite”) indicator. This blog focuses on just the Dow Theory. However, readers are well advised to acquaint themselves fully with all the tools that Schannep has devised over the years. One future post, will explain why the use of the additional tools, while modestly boosting performance, are important in order to smooth out performance, and hence, reduce drawdowns. Anything that contributes to reducing drawdowns deserves consideration, as drawdowns tests our patience and many investors throw in the towel at the worst possible time. In real life very few investors can put up with drawdowns. While we await this future post, please read chapter 8 (pages 79 to 95) of Schannep’s book The Dow Theory for the 21st Century

More about “capitulation” here.

All in all, those using the full “arsenal” devised by Schannep have made a handsome profit by buying 25% or 50% at the absolute (hitherto made) primary bear market lows. Of course, we are talking of unrealized profits and, depending on further price action, such profits could vanish but are unlikely to end up in losses.

Well, going back to capitulation and secondary reactions, when capitulation has occurred Schannep shortens the time requirement for a secondary reaction to exist. Please read page 103 of his book and his vital newsletter for subscribers of November 1st, 2008 (which is accessible to new subscribers in Schannep's archives) and you will see that the time requirement for a secondary reaction is shortened (somewhere between 4 trading days -half the ordinary time- and one calendar week) for a secondary reaction to exist. Schannep's rule makes sense. The Dow Theory is pure trend following. No mean reversal. Therefore, it makes sense to be less stringent as to the time requirement when we know that in all likelihood the market has probably made some important lows. We still require evidence of a change of trend (rally, following the lows) but we are less demanding when it comes to the time requirement. As I have explained above, those brave of heart, are even encouraged to buy at capitulation's day (which is no trend following, but mere mean reversion, something which requires a very good stomach as one is catching the proverbial "falling knives"). Thus, it is up to each investor to decide to remain 100% trend follower (hence, no buying at capitulation, and waiting for a real Dow Theory signal showing that the trend has changed) or being more pragmatic and making a small commitment at capitulation (mean reversion) and waiting for a real Dow Theory signal to come later to go to a full invested position. However, for those Dow Theorists that deem heretical to buy at bottoms without having been signaled a primary bull market signal, it is good to remember that both Charles Dow and Rhea knew when to be less unbending and bet for a mean reversion.

I quote from Schannep's website:

“[a] word [capitulation] Charles Dow never uttered but he clearly alluded to with his discussion of the final phase of bear markets when he described “distress selling of sound securities, regardless of their value…..” Robert Rhea described it asa semi-panic collapse (AND) it is wise to cover short position and even perhaps make commitments for long account” (emphasis in original).

Hence, we can draw two conclusions:

a) Occasionally, i.e. at capitulation, when markets are severely oversold (please mind that “capitulation” levels are not reached often, many years pass by without any) it may be wise to make a small commitment.

b) Even for those refusing to fade trends, it looks sensible (and the empirical track record attest to its soundness) to shorten the time period for a secondary reaction to exist after capitulation has occurred. Please mind that Rhea himself wrote that the time requirement (and so the extent requirement) for secondary reactions are not carved in stone. I quote from Rhea’s book “The Dow Theory (Fraser Publishing Company 1993, page 61):

“Probably no two students would agree on any rule for selecting and tabulating the important secondary reactions which have occurred (…). This writer has attempted secondary classifications in a great many ways (…) but no method produced entirely satisfactory result. One test eliminated all reactions as negligible which did not extent more than 15 days, with the result that many really many important movements were eliminated and insignificant ones were retained. Then the time element was disregarded, with all reactions resulting in a movement of less than 5 per cent of the price of the averages eliminated (emphasis supplied)….”

All in all, depending on conditions, it may be wise to shorten the extent requirement for a secondary reaction to be declared. One of such conditions is following capitulation when the odds favor a subsequent rally of good magnitude.

This is precicely what Schannep did in his Dow Theory “flavor”, which, as you can read from the quotes above, is no heretical proposition at all.

GOLD AND SILVER

The primary and secondary trend is bullish as explained here. No changes. The small pullback we can see on the charts below did not qualify as a secondary reaction.

As of this writing GLD, SLV continue making higher confirmed highs, which is normally a good sign. The higher they go, the most likely to lock in profits even if there is a reversal.

Here is an updated chart that shows the last secondary bullish reaction against the now defunct primary bear market (blue rectangles), the pullback that set up for a primary bull market signal (orange rectangles), the breakup (primary bull market signal, vertical line, light blue arrow, and subsequent price action:

SLV and GLD are rallying beautifully...Primary bull market

GOLD AND SILVER MINERS ETFs

The primary and secondary trend is bullish as explained here. No changes. The pullback we can see on the charts below did not qualify as a secondary reaction.

As of this writing GLD, SLV continue making higher confirmed highs, which is normally a good sign.

Here is an updated chart that shows the last secondary bullish reaction against the now defunct primary bear market (blue rectangles), the pullback that set up for a primary bull market signal (orange rectangles), the breakup (primary bull market signal, vertical line, light blue arrow, and subsequent price action:

SIL and GDX in a nice bull market too...

Sincerely,

The Dow Theorist