|Every bull market trend is composed of small rallies followed by small declines where each rally makes a higher high than the rally before, and each decline makes a higher low than the previous one. Each of these small rallies normally takes less than three weeks to complete and each small decline lasts from two to three days. The Dow theory considers these small rallies and declines as part of normal market action and does not pay any attention to them. |
However, these small rallies and declines when combined over time forms larger patterns to which the Dow theory does pay attention. The main larger patterns that the Dow theory pays particular attention to are secondary reactions, lines (horizontal trading ranges), double bottoms, and head & shoulders tops. In this article we consider secondary reactions. All references to secondary reactions here are referred to bull market trends, but by considering the opposite situations they also pertain to bear market trends.
Proper identification of secondary reactions is paramount in being able to determine when a new bull or bear market trend begins and ends. This is because the beginning of a bull or bear market looks much like a secondary reaction and it is only when the secondary reaction breaks its identifying characteristics that it can be considered a new bull or bear market. Therefore, before considering bull or bear market trends, it is important first to know and understand how to identify these secondary reactions.
There are three basic identifying characteristics of secondary reactions. The first is that secondary reactions normally last from three weeks to three months. Second, secondary reactions typically retrace from 33% to 66% of the primary upward movement that has occurred since the previous secondary reaction. And third, secondary reactions normally occur in three movements: a downward movement, followed by a one- or two-day upward movement, followed by a third downward movement.
Dow theory warns that trying to put exact limits on secondary reactions can lead to failure. Thus, these identifying characteristics should be considered to be guidelines and not unbreakable rules. There is one rule that cannot be broken according to Dow theory, and that is that secondary reactions cannot retrace more than 100% of the primary movement since the last secondary reaction or a new trend in the opposite direction will have been signaled, and also knowing that price normally retraces from 33% to 66% of its primary movement, since the previous secondary reaction infers that every bull market trend is made up of at least two secondary reactions. Thus, we can use this information to determine when a bull or bear market should terminate.
Having identified these three basic characteristics of a secondary reaction, you can appreciate that secondary reactions can only be identified late in their formation. In fact, Dow theory states that secondary reactions in a bull market are hard to guess and even their indications are sometimes deceptive. What the theory is saying is that it is difficult at best to determine ahead of time when a secondary reaction is about to take place. There are some indications, however, that Dow theory identifies what can be used to determine when secondary reactions are starting to take place, but the theory says even these can be deceptive.
|Figure 1 shows an upward rally that lasted from March 2009 until May 2010 and has been highlighted with green daily trading bars. Note also the two secondary reactions highlighted with red trading bars. Let's look at the identifying characteristics of these two secondary reactions. Note the first secondary reaction lasted almost four weeks, satisfying the first characteristic of a secondary reaction, that a secondary reaction lasts from three weeks to three months. Note also this first secondary reaction retraced 30% of the primary upward movement from March 2009. Not quite the 33% that Dow theory gave as a characteristic of a secondary reaction, but Charles Dow also said not to put exact limits on these identifying characteristics, or failure could result. This retracement therefore satisfies the second identifying characteristic of a secondary reaction. And finally, this first secondary reaction was formed in three movement parts: downward, upward, and a final downward. Thus, this secondary reaction satisfies all the identifying characteristics of a true secondary reaction.|
|FIGURE 1: S&P 500, DAILY. This chart shows the two secondary reactions that developed during the March 2009 rally.|
|Graphic provided by: MetaStock.|
|Looking at the second secondary reaction, note that it lasted almost three weeks but came up short by approximately two trading sessions. Again, Dow theory warned not to put limits on these identifying characteristics. Note also that this second secondary reaction retraced 38% of the primary upward movement since the previous secondary reaction. Finally, this secondary reaction moved downward in three parts. This second secondary reaction also meets all the identifying characteristics of a valid secondary reaction.|
Now that we have identified two valid secondary reactions in the upward rally off the March 2009 low, we should start to look for a third secondary reaction and the end of the upward rally. If a third secondary reaction can be verified, then the market can continue to move significantly higher. However, if a third possible secondary reaction breaks any of the three identifying characteristics, then it is not a secondary reaction, but the first downward leg of a new downward rally. Now, I call your attention to the downward price movement following the April 2010 peak. Does it look like a third secondary reaction or the resumption of the bear market trend?
|In conclusion, we have been given the three identifying characteristics of a secondary reaction according to the Dow theory. By properly identifying these secondary reactions, it is possible to determine if the market should continue in the direction of the primary price movement that occurred just prior to the secondary reaction or if the primary price movement has reversed direction. Note that I have purposely avoided the use of the term "bull market trend" in identifying the rally from the March 2009 low, as it has not met the identifying characteristics of a new bull market trend.|
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