Wednesday, December 5, 2012

Why I like timing? Why I love the Dow Theory as a capital protector?

When the stock market runs smoothly as it did in the 80s and 90s there seems to be little need for any timing device. Be it the Dow Theory or a moving average. 

However, when the cake is shrinking or not growing, or, simply, the market decides that it is time for lower multiples and lower prices, buy and hold is a recipe for disaster. Market timers (even those using a modest 200-day  MA) tend to be on the right side of the market and protect capital much better. So when the going gets tough, market timers lose less or even post modest gains.

If the cake is growing and stocks undergo a secular bullish trend, market timing will have a tough time to outperform buy and hold. The lower the draw downs, the swallower the swings, the more difficult it will be for any market-timing  device to outperform. However, even if results are alike or even modestly lower, I’m very happy to achieve slightly more modest gains in a secular bull market in exchange for protecting my capital when a vicious bear market sets in. I’d rather make 10% when the markets are making 12% with the almost assurance of making only -5% when the markets are down by -15%.

We know that the basic “flavor” of the Dow Theory (with only two indices) has outperformed historically the Industrials by ca. 2% annually. But averages are misleading. We can safely assume that this average can be broken down as follows:

a)     Outperformance in bear markets: +11.5% (duration of bear markets ca. 30% of the time).
b)     Underperformance in bull markets: -2% (duration of bull markets ca. 70% of the time).

Total weighted outperformance:

( 11.5 x 0.3) – (2 x 0.7) = 3.45-1.4= ca. 2%

Thus, as you can see, the Dow Theory delivers outperformance when it is most needed: In tough times. It is not the same to make a  “mere” 10% when buy and hold makes +12% than making -5% when buy and hold is losing -16.5%.

If these figures are difficult to believe, I suggest you read my post “Revisiting the 1987 crash” which you can read here.
As you can read in the post, on that fateful day, the Dow Theory, by ushering investors into cash some days before the crash, outperformed the markets by almost 23%. These are cold facts.

In technical jargon, I could say that the Dow Theory has a much better risk-adjusted profile than merely buy and hold. In other words, the plus 2% outperformance is obtained with fewer equity swings. So, overall, a portfolio following the Dow Theory is a much better one (both in terms of raw performance and risked-adjusted performance) than mere buy and hope, sorry, hold.  It doesn’t take a genius to understand that the lesser the oscillation of one’s equity, the lower the risk. The investor should never underestimate the destructive power of drawdowns. Both financially and psychologically. It is quite different to see in hindsight a drawdown of 50% (as it happened in 2008-2009) than to live it in real time. Drawdowns can decimate the investor’s capital and also destroy his psychological ability to stay in the markets and force him to throw the towel at the worst possible time. Don’t forget that a drawdown of 50% requires a further gain of 100% to just break even.

And what about the retiree who withdraws 5% of his capital annually? How would such a 50% drawdown affect him? The answer is painful. If a drawdown of -50% hits, the retiree, having now only ½ of his capital left, is forced to withdraw 10% if he wants to maintain his lifestyle. Even if he makes ends meet and merely withdraws a half of it, that is 5%, he will be in the hole by 55% (50% drawdown + 5% annual withdrawal). So drawdowns are the mortal enemy of retirees. Not all investors have the privilege of being able to average down or make monthly contributions to his retirement fund. There is a reaping season which cannot bear deep drawdowns.

I hope readers get my message. We follow the Dow Theory not to get filthy rich but just not to go to the almshouse. Curiously, by mitigating devastating drawdowns and achieving ca. 2% (Schannep’s flavor ca. 4%) outperformance we have a distinct possibility of becoming people of means over the long run (i.e. 20 years of diligent Dow Theory practice and investment).


The Dow Theorist.

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