Saturday, February 9, 2013

Dow Theory special issue: Dow Theory’s performance during the secular 1966-1981 bear market

How often does the Dow Theory outperform buy and hold? Part II

In my post “How often does the Dow Theory outperform buy and hold?, which you can find here, I started a series of articles dedicated to examining the classical/Rhea Dow Theory “flavor” under all market environments and across time.

In that post, we made some interesting findings.

We found out that the Dow Theory outperformed buy and hold. Both in raw terms (average returns) and risk-adjusted returns (much lower standard deviation of returns).

However, it was also ascertained that 41.2% of the time the Dow Theory severely underperformed buy and hold. Only 29.4% of the time managed the Dow Theory to outperform buy and hold. Therefore, the overall Dow Theory outperformance was made in relatively few, but critical, years. I encourage you to read thatpost and absorb all its details.
Whilst in such post, I made clear that the Dow Theory tended to outperform buy and hold during bear markets, I didn’t provide the readers of this blog with specific figures relating to secular bear markets. This is what we are going to do in this post.

We are going to focus our attention on the 1966-1981 bear market. How did the Dow Theory fare?

Well, as you can imagine, the answer is:

The Dow Theory did indeed fare very well during such secular bear market and trounced buy and hold.

Let’s look now at the fine print.

All figures that follow are exclusive of dividends.

During these 16 years, the Dow Theory outperformed buy and hold (the Industrials) six years or 37.5% of the time.

Three years or 18.75% of the time, the Dow Theory matched buy and hold (it was fully invested all year long).

Seven years or 43.75% of the time, the Dow Theory underperformed buy and hold.

So, during this secular bear market, the figures for out and under performance closely resemble those for the whole +115 years.

The average annual performance for the Dow Theory was 2.97%. Buy and hold only managed to scratch 0.77%. Please mind that the ca. 2% publicized Dow Theory outperformance for its +115 years track record also holds true during this secular bear market. Such “outperformance stability” is worthy of praise and is to be studied more in depth in a future post in this Dow Theory blog.

The standard deviation of annual returns clearly favored the Dow Theory. Buy and hold experienced a standard deviation of 17.43% whereas the Dow Theory had a more modest 10.99%.  Once again, the Dow Theory excelled by reducing significantly risk.

Buy and hold had seven losing years. The Dow Theory only six. However, the comparison between losing years gets more interesting when we look at the average loss in each losing year. Buy and hold lost -15.42% on average, whereas the Dow Theory significantly contained losses by losing only -7.56% on average. Hence, in bad years, the Dow Theory outperformed on average buy and hold by 7.85%.

True to its underperformance in good years, the Dow Theory managed to make only 9.28% in winning years, whereas buy and hold made 13.65%.%. Hence, in good years, the Dow Theory underperformed buy and hold by -4.08%. However, we shouldn’t get greedy. When the market is behaving nicely, there is no need to squeeze 13.65%. I’d rather prefer to make 9.28% in good years and containing my losses to only -7.85% (instead of -15.42% for buy and hold) in bad years. The investor’s long-term survival demands fewer stellar years and fewer horrible years. We don’t want a roller coaster; we just like a gentle smooth ride. Furthermore, it should be born in mind that the Dow Theory managed to outperform buy and hold by more than 2% when the whole period is considered (1966-1981).

But averages are misleading. Let’s take a look at the deepest drawdown suffered by the buy and hold investor during that secular bear market. Measured on a year-end  basis between 1973 and 1974 buy and hold lost -44.16%.

Do you want to know how much did the Dow Theory lose in 1973-1974? Make your guess….

The Dow Theory only lost -5.89% because it managed to keep the investor in cash (out of the market) during the great bulk of the devastating 1973-1974 bear market.
In real life, very few investors could survive such -44.16% devastation. Especially those nearing retirement. In my humble opinion, such draw down is an indictment of buy and hold.

By contrast, the Dow Theory worst draw down during the secular bear market amounted to only -15.26% in 1975.

Thus, we can notice that the Dow Theory is very dependable. The figures you are reading right now are very close to the statistics I posted here.

All the statistics I have just given deserve your careful attention if you are really serious about protecting your capital. Please mind my insistence in protecting capital. Take care of your equity and returns will take care of themselves. What you have in front of your eyes is the closest thing to a free lunch. Of course, it does not come for free. To believe in the Dow Theory takes work, hard work. At the risk of repeating myself, I always say that the Dow Theory looks deceptively simple. It is not so simple or at least not simple enough so that investors stick to it during the inevitable and frequent underperformance spells. Furthermore, and this is the subject for a future post in this Dow Theory blog, being a market timer takes an emotional toll on most investors. Not because of the stress of trading in and out of positions, since, as you can see from frequently reading this blog, the Dow Theory signals occur very sparsely, but because psychologically not being “buy and hold” has social and mental repercussions which not everyone is apt or willing to bear. Everything in life has a price, and the Dow Theory’s free lunch may not be so free after all. This is why I am pretty convinced that technical analysis and more especially the Dow Theory will not self destruct due to mass following. It spite of its simplicity (or because of it), it becomes psychologically intractable for most folks.

Have a wonderful weekend.

The Dow Theorist

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