Friday, February 22, 2013

Dow Theory special issue: Dow Theory’s performance during the secular 1982-1999 bull market

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

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.

At the risk of repeating me, it is worth remembering some interesting findings we made.

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 that post and absorb all its details.

I made clear too that the Dow Theory tended to underperform buy and hold during bull markets. However, I didn’t provide the readers of this blog with specific figures relating to secular bull markets. This is what we are going to do in this post. By the way, an in-depth study of what happened during the secular 1966-1981 bear market can be found here.

We are going to focus our attention on the 1982-1999 bull market. How did the Dow Theory fare?

It fared well, but its performance was slightly less stellar than that delivered by buy and hold. So, once again, it is confirmed that the Dow Theory comes really in handy when the going gets tough. There is no need for protection when the market is in a smooth ride. And as explained here and here, timing devices rarely outperform bull markets.

During these 18 years, those that bought and hold the Industrials made an average gain of 15.94% annual.

Those following the Dow Theory (in its classica/Rhea “flavor”) made an average gain of 14% annual.

So the Dow Theory underperformed buy and hold by 1.94% on an annual basis during the secular 1982-1999 bull market.

This is fully in line with the findings we made in the first post of this saga. The Dow Theory underperforms when markets go up. However, true to its “protector” function, the Dow Theory managed to make +24.21% in 1987 (the year of the crash) whereas buy and hold made a  meager +2.26% for the year.

Hence, in such fateful year, the Dow Theory managed to outperform buy and hold by almost 22%. Not bad, I think!

But yearend figures are  only part of the story. If you read mypost concerning the 1987 stocks market crash, you will learn that the loss experienced by Dow Theorists from the top amounted to only -13.49% whereas buy and hold endured a loss of -36.13% from top to bottom.

An image is worth more than thousand words, I encourage you to read the 1987 crash post and, more importantly, look at the chart. It says anything you need to know.

1990 was not a particular good year for the stock market. Buy and hold lost -4.34%. The Dow Theory made a somewhat modest loss of -4.28%.

Now let’s break down the out and underperformance of the Dow Theory versus buy and hold.

In only 2 years, the Dow Theory managed to outperform buy and hold. As you can guess such years were 1987 and 1990, namely when there is trouble in the air.

In 8 years the Dow Theory equaled buy and hold. Those were typical secular bull market years when the Dow Theory remained fully invested along the primary trend during all the year. Thus, the Dow Theory remained fully invested from 1993 to 1997, that is five consecutive years. This gives you a measure of the strength of the secular bull market.

In 8 years, the Dow Theory underperformed buy and hold.

Now let’s take a look at the standard deviation of returns. If you go back to my post “DowTheory’s performance during the secular 1966-1981 bear market," you’ll see that the standard deviation of annual returns for buy and hold during such a vicious bear market amounted to 17.43% (the Dow Theory had a much modest standard deviation of only 10.99%).

During the secular 1982-1999 bull market, things were different. It was such a bountiful period that the standard deviation of returns for buy and hold declined to only 11.45%, which was slightly lower than the standard deviation for the Dow Theory at 11.60%.  I do think that such secular bull market was the closest thing to nirvana for buy and hold investors, which perversely, resulted in blinding them as to the realities and hidden dangers of buy and hold when one doesn’t have the privilege of having permanent tailwind (something similar doomed famed Dow Theorist Schaefer).

The slight underperformance of the Dow Theory during the 1982-1999 secular bull market may disappoint investors. However, what I wrote here remains fully applicable:

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

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