Saturday, March 2, 2013

Dow Theory Special Issue: A new Answer to the New Low Observer (NLO)




The New LowObserver (NLO) is an avid student of the markets. Its website contains a wealth of information, which spans many subjects (Dow Theory, specific stocks, book list, market observations, etc.)


NLO  posted a comment in my Seeking Alpha blog in the past which resulted in my post “An Answer to the New Low Observer (NLO)” which you can find here.
 
Last February 25, NLO produced a new comment to a new post of mine in my Seeking Alpha blog. Even though I tried to address the issues raised by NLO as a simple reply to the comment, I decided that the breath of topics raised were worth being dealt with in a separate post. This is what I am doing right now.

Basically, the allegations put forward by the NLO  are as follows:

·        Positions taken in accordance to the “classical/Rhea” Dow Theory last at least 2-4 years.

·        All positions taken in accordance to the “classical/Rhea” Dow Theory result in profits.

·        The positions hitherto suggested in this Dow Theory blog have lasted substantially less and have resulted in modest profits or minor losses.

·        This is likely to be caused by the Dow Theory “flavor” I use (basically Schannep’s with my own minor departures).

·        I should re-appraise my Dow Theory “flavor” as the trends it detects are not strong enough to result in substantial profits.

I am editing and simultaneously expanding a chain of comments and replies posted by both the NLO and truly yours in my Seeking Alpha blog.

Those interested in getting the full chain of comments are advised to go here because this post is not exhaustive, and some issues were exclusively dealt with by both the NLO and I in the Seeking Alpha blog.

On the other hand, some issues are subject to a more comprehensive explanation in this post, which includes the results of a thorough investigation of all Dow Theory signals since 1897 to date. Hence, lovers of the Dow Theory should read both this post, and the comments chain in Seeking Alpha. 

I am answering each of the objections raised by the NLO as if I were answering an email. Thus, I have inserted my answers into the text of the original NLO’s comment with a different font and red color to make it easy to distinguish objection and answer. 

My clarifications are made in the spirit of deepening our knowledge of the Dow Theory and are not intended to be contentious or dismissive of diverging opinions. After all, markets function through the existence of different opinions. Otherwise, we all would be selling or buying at the same time.

Have a wonderful weekend.

Sincerely,

The Dow Theorist





NLO:
This is getting back to the question of "what has the average length of the primary trend been historically?"

As we've maintained, primary trends (bullish) historically last at least 2-4 years (as found here:
http://seekingalpha.co...).

In all the work on the topic of Dow Theory, I have not seen (showing my lack of vision on the matter) a primary trend last only a month or two at a time. 

Answer:

Let’s focus on the “classical/Rhea” Dow Theory and let’s look at the whole track record as contained in Schannep’s book (pages 26-29) and his website. Until October 1956, the Dow Theory record reflects the reconstruction made by Edwards &Magee and from October 1956, until now, the record was recapitulated by Schannep by applying “classical/Rhea” Dow Theory rules.

The Dow Theory records spans 116 years, since it starts in 1897.

Let’s take a look at the results:

The average duration of each transaction taking according to the classical Dow Theory lasted 712 days. This is slightly less than 2 years.

The median duration amounts to 565 days, which is roughly 1.5 years.

The shortest investment lasted only 60 days (year 1990).

The longest investment lasted 2799 days (secular bull market 1900-1998).

All the instances lasting less than 180 days (ca. 6 months) occurred during secular bear markets (save one position, which lasted only 60 days and was taken in 1990 within the secular 1982-1999 bull market). Therefore, when assessing the probable duration of a new primary bull market, it is advisable to try to put the nascent trend in context. If it is born within a secular bull market, it is likely an “above average” duration. If, conversely, the market is under the spell of a secular bear market, the odds favor shorter trends. While I acknowledge than in real time not so easy to label the market a “secular bullish or bearish”, we can make our guesses.

Thus, we can conclude:

1.      The average duration of the positions taken according to the classical/Rhea Dow Theory last ca. 2 years on average. If we took the mean, we’d derive shorter time spans.

2.      While occasionally we may encounter trends (or better said, positions within a trend) that last 4 years or more, this is by no means the rule but rather the exception.

3.      Shorter trends (and accordingly positions) tend to occur during secular bear markets. In technical parlance, we would say that the market is prone to false breakouts.


NLO
Additionally, I have not seen a primary trend where it came out with a negative return in real time (whether acted upon or not).

Answer:

Neither have I. By definition, even the smallest trend will show a profit if we measure from bottom to top. We shouldn’t confuse, though, total duration of a bull market with total duration of the investments made following primary bull market signals. This aspect was explained ad nauseam here.

However, the issue at hand is whether the trend detected by the Dow Theory has sufficient strength or magnitude to result in profits allowing for the inherent delay of all timing systems in getting in and out of the trend.

I guess that what is really meant is that all positions/trades/investments made according to the “classical/Rhea” Dow Theory resulted in profits.

Well, let’s look at the record:

9 transactions made according to the Dow Theory resulted in losses for the investor. 7 such trades took place under secular bear markets. 2 took place under secular bull markets.

Here you have the details out of the spreadsheet:

                                 Date               Dow Industrials         Pctg lost
SELL
13/05/1940
137.5
-3.56291205
SELL
26/04/1962
678.68
-3.96083037
SELL
25/02/1969
899.8
-4.51226759
SELL
26/01/1970
768.88
-10.6244479
SELL
19/10/1978
846.41
-2.31965009
SELL
03/08/1990
2809.65
-4.27706554
SELL
25/06/2002
9126.8
-4.8054137
SELL
29/09/2008
10365.45
-19.3310017
SELL
04/06/2012
12101.46
-1.56612982


The “classical/Rhea” Dow Theory produced 38 transactions during the 116-year  time period. Since 9 trades were losers, 76% of all investments made resulted in profits. However, 24% of the trades resulted in losses.

Therefore, as it should be expected, there is no holy grail. The classical Dow Theory also experiences rough patches. Furthermore, if we consider that it is more likely than not (valuations, gold/dow ratio, etc.) that the secular primary bear market is not over yet, then we should conclude that all investments made according to the primary trend, as detected by the Dow Theory are facing considerable headwind. Should we fold? No, we have to take all signals, but being very aware that on a secular basis, we are not under the most favorable market environment for stocks. If the investor is very sure of his “secular” assessment, then what I wrote here, with all caveats, may be heeded:

“Of course, assuming that one is certain and not wrong, the secular condition of the stock market serves the investor in weighing the amount of capital to be invested in the stock market. Thus, as an example, if the investor reaches the conclusion that stocks are in a secular bear market or that valuations are not compelling whereas gold is in a secular bull market, the investor can allot less capital to stocks and more to gold.”


NLO:

Furthermore, your recent work on the "classical" Dow Theory showed exceptional performance compared to buy-and-hold BUT over periods ranging from a year or more.

Even though I question any interpretation that shows only a year for a Dow Theory primary trend, I cannot argue if the beginning and ending period showed a return that is positive on the representative index.

I feel I was not clear enough in my posts concerning the assessment of the Dow Theoryperformance. This is why the subtitle of the first post of this “performance” saga bore the nameEvaluating performance on a year-end basis”

In the same vein, I wrote:

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.

Therefore, my studies didn’t imply that the Dow Theory “trades” or “investments” lasted one year, but merely I took the profit or loss made on 12/31 by the Dow Theory and buy and hold. If the Dow Theory was fully invested during 4 years, then I took the unrealized profit or loss accrued at year-end. If the Dow Theory resulted in a short-lived trade and the investor was in cash on 12/31, I merely reflected the profit or loss accrued during such a year.


NLO

As an example, our Dow Theory analysis indicated that the primary trend was bullish on July 23, 2009. At the time, the Dow Jones Industrial Average was at 9,069.29. When the primary trend changed to bearish on August 2, 2011, the Dow was at 11,866.62, an increase of +30% above the July 23, 2009 bullish primary trend. Since August 2, 2011, the Dow has fallen as much as -12% (in two months after that call) and gained +15% as of 2/24/2013 (annualized return of +10.33%).


Answer:

I agree. Most followers of the Dow Theory agree as to the existence of a primary bull market during that time whose end was signaled on 08/02/2011. True to its protecting function the Dow Theory spared investors for incurring further losses as you rightfully note.

NLO

However, in the time that you've published on Seeking Alpha you've indicated primary trends, two full bull and bear primary trends for stocks and one full primary trend for gold, which have all resulted in negative final numbers.


Answer:

With all due respect, wrong as to the number of trends I signaled and equally wrong as to the statement that all trends signaled ended up in losses. Facts are:

As far as stocks are concerned, I signaled in my blog the existence of only one primary bull market. The primary bull market started on June 4, 2012 and was signaled on June 29, 2012. The primary bull market topped on October 4, 2012 and the exit was signaled on November 16, 2012.

The position taken according to such a trend ended in modest profits as any reader can see here:


By the way, from June 29 (buy date) and November 16 (sell date), four and a half months elapsed. 

On January 2, 2013, I signaled the existence of a new primary bull market. Until now, such bull market remains in force with unrealized gains, and hence it is premature to label my market call as a winner or a loser.

Bottom line: As far as stocks are concerned, I have called and completed only one bull market, not two, and the one I called ended up with modest profits not losses.

As to the bear market, we should bear in mind that never ever I advised to short the market. The sell signal merely implied to sell out of stocks, not to sell short stocks. Thus, no “losses” can be ascribed to my calling a bear market. The bear market was merely the sell signal that put an end to the only bull market Ihad previously called. Furthermore, the average duration of bull markets (ca. 2 years) is not applicable to bear markets, which are short-lived in general. I made this clear here.


NLO:

Additionally, you readily admit, "I am very aware that recently this Dow Theory ‘flavor’ has signaled too many signals in too short time." Isn't it worth reconsidering the primary trend analysis that results in signals of less than 6 months?

Answer:

It is neither an aberration of the market, nor an error of this market practitioner to spot primary trends that last less than 6 months.

Thus, there were 6 instances (out of 38 trades since 1897) according to the “classical/Rhea” Dow Theory that resulted in signals of less than 6 months. Here you have the list:

                                   Date                      Dow Ind    Pctg lost             Time (days)





SELL
25/02/1969
899.8
-4.51226759
147
SELL
26/01/1970
768.88
-10.6244479
91
SELL
19/10/1978
846.41
-2.31965009
135
SELL
03/08/1990
2809.65
-4.27706554
60
SELL
29/09/2008
10365.45
-19.3310017
164
SELL
04/06/2012
12101.46
-1.56612982
164



















Therefore, 15.7% of the trades were short-lived. Please mind that only one such shorter-than-average bull market occurred within a secular bull market. All of them occurred under secular bear markets.

Furthermore, it should be stressed that these 6 shorter bull markets were detected according to the “classical/Rhea” Dow Theory. Thus, I see no mistake or need to reconsider the way I applied the Dow Theory. Of course, I was aware that the bull market was short-lived, but this is well within the limits of the past observations of the Dow Theory.

Having said this, it is true that the “Schannep’s flavor” of the Dow Theory results in trades lasting on average less than those made following the Dow Theory (as per Schannep’s book, page 101). Consequently, the positions taken within trends determined by Schannep’s flavor last on average 13 months. However, this is a long shot from being a short term trader. Furthermore, there are thoughtful studies (i.e. M.J. Mauboussin, “More than you Know. Finding Financial Wisdom in Unconventional Places”,Columbia University Press, 2006, p. 126)  that suggest that the accelerating rate of industry changes means that the investment horizon for the investor (i.e. portfolio turnover) must be shortened accordingly. If we bear in mind that Schannep’s is the best performer Dow Theorist, we should conclude that there is nothing wrong with slightly reducing the average duration of each position. Schannep in his book is also convinced that modern accelerated times require a somewhat more reactive approach. 

NLO

While we disagree about the length of what a primary trend is, if it results in gains of +0.30%, then those who are uninitiated by the breadth of Dow Theory and its benefits may end up thinking (justifiably) that from a cost/benefit standpoint, it may be more work than it is worth to follow Dow Theory for that kind of return. After all, a 1-year CD could have garnered the same annualized return without all the work.

Answer:

Trends are what they are, and we humbly have to take what the market gives us. If a trend is weak, there is no way in the world to extract big profits out of it. We go with the flow, but we cannot force the flow to suit our wishes. As far as I know, neither the NLO, nor other Dow Theorists have been able to extract significant profits from the stock market or to beat buy and hold in the last six months (time I have been blogging and making my analysis of the markets). Classical Dow Theorists were on the sidelines during this period (which is nothing wrong, as I have nothing against the classical/Rhea Dow Theory) and only on January 18, 2013, a primary trend was signaled according to the “classical/Rhea” Dow Theory, which was echoed here.


Thus, there have been 3 instances where the “classical/Rhea” Dow Theory returned modest profits below 5%. Here you have the list:

                        Date               Dow Ind            Pctg Profit

SELL
01/06/1903
59.59
0.25235532
SELL
14/01/1913
84.96
3.72359907
SELL
23/03/1973
922.71
0.15521883

If we bear in mind that, in addition to these 3 “sub par” trends, there were 9 instances where the investor lost money, it stands to reason that many trends, even when detected according to the most orthodox Dow Theory, fail to extract a meaningful profit from the trend.

With all due respect to the NLO, there is no failing in the way I am applying the Dow Theory, unless one subtly wants to excommunicate Schannep’s version, which is akin to excommunicating the best performer of the pack.

As to the uninitiated that may be demoralized by the lack of performance shown by the Dow Theory in the last few months, I have a few words to say.

If any Dow Theory amateur is deterred from adopting the Dow Theory because one transaction was not able to beat 1-year CD, this amateur will remain an amateur for ever because he lacks the wits to understand (and the stomach to digest) the nature of long periods of underperformance, which is  the price to pay for long term outperformance (both in absolute returns and risk-adjusted). If any single trade resulted in guaranteed money, then technical analysis and the Dow Theory would self destruct. Everybody would be following it. Precisely, what separates the winners from the quitters is the ability to understand the nature of underperformance, as merely the price to pay to reduce significantly risk and even outperform in the long run.


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