Dow Theory special issue: How often does the Dow Theory outperform buy and hold?

 Evaluating performance on a year-end  basis.

It is no secret that I am deeply influenced by Schannep’s Dow Theory flavor. To learn more about Schannep’s flavor, I suggest you go here, or if you plan to buy his excellent book here.

For reasons that go beyond my comprehension (maybe because he’s the best-performing Dow Theorist) his „flavor“ meets frequent criticism from the Dow Theory fraternity. One such common criticism has been recently made here and answered here.

 

I quote:

“To proffer Jack Schannep or E. George Schaefer’s theory for your method of interpreting the markets is great, especially when it works.”

Implicit in the criticism is that Schannep’s interpretation of the Dow Theory doesn’t always work, and hence it is not as dependable as the “classic” Dow Theory. Those interested in finding a short and good explanation of the basic tenets of the “classic” Dow Theory (as explained by Rhea) can go here.

For the purposes of this post, it suffices to say that Schannep’s Dow Theory flavor unambiguously outperforms the “classic” Dow Theory. And this is quite a feat because it improves something that is close to perfect as it is the “classic” Dow Theory. I leave for future posts in this Dow Theory blog a more in-depth dissection of Schannep’s out performance, because I feel that, before dealing with Schannep, we should fully squeeze all the juice out of the “classic” Dow Theory orange. IMHO Schannep can only be analyzed by comparing him to the “classic” Dow Theory. Hence, it is vital that we first become fully acquainted with all the intricacies pertaining to the “basic” Dow Theory, or if you want to call it this way “Dow Theory 1.0."

To this end, I will dedicate a series of special issues devoted to analyzing the “classic” Dow Theory. I will focus on aspects such as, longest draw down, deepest draw down, average winning trade, average losing trade, percentage of winning trades, performance under secular bull markets, performance under secular bear markets, average trade duration and a long etc.

Once we know inside out what to expect from the “classical” Dow Theory, we will be in a better position to evaluate Schannep’s Dow Theory flavor. Furthermore, we will do ourselves a great favor, as we will better understand the “classic” Dow Theory which, I insist, is in itself good enough.

Today, we will begin by addressing the first criticism branded against Schannep, namely that it looks great….when it works.

The best way to address such criticism is by looking under the magnifier the “classic” Dow Theory. Since it is alleged that Schannep’s “flavor” is not so dependable, we should look at how the classic Dow Theory fares in this respect.

Our question is: How often does the classic Dow Theory outperform buy and hold?

Does it outperform more often than not buy and hold? Does it lag behind a significant period of time?

Personally, I would never have the courage to invest with the Dow Theory (of any “flavor” whatsoever) if I couldn’t give an answer to these questions (and more questions that will come in future posts). The key to success as an investor is discipline, to stick to your system. Discipline comes in two ways. Either you go a psychologist and work hard with your subconscious, or you know your investment strategy inside out. Of course, the best way is to both know your subconscious and know your strategy inside out.

Well, now I will give my readers a surprise.

I have the Dow Theory versus buy and hold (of the Industrials) record from 1896 to 2011. So we can compare on a year-to-year basis (year-end end figures) how buy and hold fared versus the Dow Theory. Thus, in a given year, buy and hold may have delivered +10% whereas the Dow Theory merely returned +3% and vice versa. We take as our reference for a buy and hold investor the Dow Jones Industrials.

Out of these +115 years, do you know dear readers how many years the “classic'” Dow Theory outperformed “buy and hold”?

Do you expect the Dow Theory to outperform every single year?

Do you expect, at the very least, the Dow Theory to outperform 60% of the time? Seventy percent of the time, perhaps?

Make your guesses…...

…..

…..

I want you to think it over…...

Well, here is the answer:

29.4% of the years the Dow Theory equaled “buy and hold” in performance. These are years when the Dow Theory was invested throughout the year (thus overlapping with buy and hold). The average annual performance in these years was 16.89% for both the Dow Theory and buy and hold.

29.4% of the years (I checked for a typo or math error and there is none) the Dow Theory outperformed buy and hold. The average annual out performance is 15.77%. The Dow Theory returned -0.95% whereas buy and hold returned -16.72%.

However, 41.2% of the years the Dow Theory underperformed buy and hold by 8.54%. In these years, the Dow Theory returned 6.35% whereas buy and hold returned 14.89%.

I am indebted to one reader of this Dow Theory blog for inputting the Dow Theory classic record into a spreadsheet on a yearly basis in parallel with the annual closing price of the Industrials thereby allowing me to filter out the resulting figures and elaborate these statistics. Thus, we can draw the following conclusions:

1.      The “classical'” Dow Theory underperformed “buy and hold” most of the time. So the criticism that Schannep is “great," especially when it works, is misleading. All timing systems, and all Dow Theory “flavors” undergo rough patches. Under performance spells also affect the canonized “classical” Dow Theory.

2.      However, in spite of such underperformance most of the time, over the long term the classical Dow Theory achieves greater returns with a much lower risk.

3.      Interestingly, the Dow Theory underperforms when there is no danger out there. In good years for the stock market, the Dow Theory, while remaining solidly positive, returns less than buy and hold.

4.      The Dow Theory outperforms buy and hold when it is most needed: When stocks go down. The average annual performance of the Dow Theory when it is outperforming is -0.95%. However, buy and hold returned in those years a dismal -16.72% on average.

The reader may be puzzled to learn that the Dow Theory underperforms when the stock market is in a “good” year (namely when it goes up solidly). However, this has an easy explanation. As with any market-timing  system, the Dow Theory never gets us “aboard” in real time. At the risk of oversimplifying we can say that ca. 10% of any new bull market is always lost as the bull market signal comes some time after the inception of the new bull market. When the market goes up in an almost straight line, by definition the Dow Theory will lag in returns. Furthermore, if you do the math you can see that the Dow Theory under performance in “good” years for the stock market was ca. 8%. In other words, 8% of market action was lost to the Dow Theory as it was “late” in getting in.

However, what results in under performance in “good” times, is out performance in “bad” times. When the market heads south and buy and hold gives away all the unrealized gains, the Dow Theory does an excellent job in getting the investor out of the market close enough to the top.

Of course, the best environment for the Dow Theory is a long and sustained bull market where the primary bull market swing lasts more than one year uninterrupted. These are the years when the Dow Theory gets aligned with buy and hold as it remains fully invested along the never ending primary trend. However, such blissful environment (for both Dow Theorists and buy and hold investors) occurred only 29.4% of the time. Furthermore, if markets were always in such a perfect bullish mood, there would be no need for the Dow Theory or any other market timing system for this matter. Investing would be a piece of cake.

As the market tends to have more “good'” year than “bad" years, it is not surprising the Dow Theory under performs most of the time. However, its value lies in out performing when it is most needed: When the going gets tough.

Conclusions:

1.      The Dow Theory smoothes out performance. It tends to deliver less than buy and hold in “good” years, but delivers much more in “bad” years. All this is accomplished with a higher average annual return. Such smoothed performance implies less risk for the investor and in technical jargon, we would say it has a higher Sharpe Ratio.

2.      Such smoothed performance is the closest thing to a free lunch. I am sure most seasoned investors would settle willingly with 2% less annual performance (i.e. 8% instead 10%) in exchange for reducing volatility, and draw downs. This is why bonds are successful in the first place. Or to put it differently, if there was an insurance that covers draw downs most investors would be willing to pay a premium of, say, 2% in order to protect themselves against the unexpected. This is why “puts” and derivatives are successful too. The Dow Theory provides us with ca. 2% annual average out performance while reducing dramatically volatility. It is like the insurance company paying us to buy its insurance. Not bad at all.

3.      Investors get blinded by performance. However, in real life, the investor is killed by draw downs. A 15% average performance is worth nothing if, somewhere along the road, there is going to be a draw down of -50%. Buy and hold is nice in theory, and it may work provided the investor has deep pockets (staying power) and psychological fortitude. However, in real life, very few investors possess both attributes at the same time. Thus, the publicized return figures of many investing strategies are not attainable in real life because the investor cannot endure the draw downs. If the average retiree needs to draw 4% off his capital annually (and this is a very realistic and even modest assumption), a draw down of 50% in any given year, will force him to draw 8% if he wants to keep his expenditures intact. Of course, he can cut with expenses, but as we well know, this is not an easy feat. Even if the retiree manages to reduce expenditures by 25%, this implies a withdrawal of 6% while being in the midst of the draw down. As a result total equity would be reduced by 50%+6%, thereby remaining only 44% of his original capital. A draw down of such magnitude is akin to a black hole. It is very difficult to escape from it. In most instances, the retiree will finish by eating up all of his capital. Game over for him!

4.      Therefore, the Dow Theory by strictly limiting losses in the “bad” years (remember in “bad” years the Dow Theory lost -0.95% versus -16.72 for buy and hold) clearly helps the normal investor lacking unlimited funds and/or mental fortitude. Furthermore, average returns don’t give the exact picture. Buy and hold lost on a year-end  basis more than 30% six years, whereas this never happened with the Dow Theory.

Have a wonderful weekend.

The Dow Theorist.