Part I
In previous
posts of this Dow Theory blog, we occupied themselves with the evaluation of
the Dow Theory performance, as explained here.
Furthermore, we broke down such data into secular and bull markets as presented
here and here.
One thread in
common was that all these studies focused on a comparison of the Dow Theory versus
buy and hold on year-end basis. Thus, if on December 31 of any given year
the Dow Theory was up 4% and a position taken in the Industrials was up 3%, we
would say that the Dow Theory outperformed buy and hold by 1%.
However, such
analysis did not focus on the specific
transactions taken in pursuance of the Dow Theory buy and sell signals
(which correspond to primary bull
and bear markets).
We want to
know basic statistics concerning each Dow Theory signal, namely:
·
How many signals have been flashed in
the last +115 years?
· How long does the average position
taken in pursuance of the Dow Theory last?
·
What percentages of signals end up
winners? And losers?
·
What’s the average gain?
·
What’s the average gain in winning
transactions?
·
What’s the average loss in losing
transactions?
What's the win to lose ratio?
·
What percentage of time I am in the
market?
·
What’s the profit factor?
·
Do secular bull and bear markets
affect the Dow Theory signals?
Such statistics are vital to master in "real time" the application of the Dow Theory and, as far as I know, they have never been published before with this kind of breath.
Accordingly, I
plan to start a new series of posts in this Dow Theory blog dealing with all
these issues.
This post
will focus on the generalities of the Dow Theory signals and, thus, I will not
distinguish between secular bull and bear markets. In further posts, I will
narrow down my examination to secular bull and bear markets.
A final
caveat: This analysis concerns what I label the “classical/Rhea” Dow Theory. In
a nutshell: This is the Dow Theory as advocated by Dow Theorist Rhea in the ninety's
thirties. It only uses two indices (the Industrials and Transports). The
“classical/Rhea” interpretation of the Dow Theory tends to disregard values (versus the more secular oriented
Schaeffer’s version) and focuses on the technical side of the market. You can
find more about the classica/Rhea “flavor” here.
The
“classical/Rhea” version of the Dow Theory stands half-way between the too long
and secular oriented (in my opinion) Schaefer’s version and the slightly more
reactive Schannep’s version (which avails itself of 3 indices). Personally, I
tend to like more Schannep’s version, since it clearly outperforms the
“classical/Rhea” version. However, the “classical/Rhea” version is not to be
overlooked, as it has an excellent track record and has been the object of
study by many brilliant minds like Russell of the Dow Theory Letters’ fame.
Thus, I see Schannep as an improvement over something that what was close to
perfect. Nevertheless, in order to understand Schannep we must be fully
conversant with the “classical/Rhea” Dow Theory.
This Dow
Theory blog, little by little, is completing an in-depth analysis of the
“classical/Rhea” Dow Theory as our foundation stone. This is our starting
point, and before we delve into Schannep’s intricacies, we must know inside out the “classical/Rhea” Dow
Theory. This knowledge of the “classical/Rhea” Dow Theory is to be broken
down into two areas:
a) On
the one hand, to master the technical rules (grasping the nuances of a
secondary reaction, primary bull and bear markets, etc.), so that one can spot the signals on the charts and determine
current market conditions.
b) On
the other hand, to be fully acquainted with the empirical record. When
faced with an ongoing position, the investor must be able to know how similar
signals performed in the past. While the past is no guarantee for the future, a
record spanning +115 years is not to be disregarded out of hand.
Fortune
punishes the unprepared. The more the investor knows the rules and the past,
the better the odds for success.
The record I
have used spans more than 115 years. In begins with a buy signal on July 12,
1897 and finishes with a sell signal on June 4, 2012. The last primary bull
market buy signal was flashed on January 18, 2013 (details of such a signal here) and is not included in my
analysis, since, as I write these lines, no sell signal has been flashed.
As no
“official” record of the Dow Theory exists, I derive my record from these
sources:
From 1897 to
October 1956, as contained in the book “Technical
Analysis of Stock Trends," 8th edition, by Edwards and
Magee, and reproduced by Schannep in his book “Dow Theory for the 21st Century” (pages 26-29).
From October
1956 to date, the “classical/Rhea” Dow Theory record has been reconstructed by
Schannep in pursuance of the classical rules and not his own.
The whole
record can be found on Schannep’s website, thedowtheory.com
Well, after
this lengthy introduction, let’s get started with the meat of this post.
CLASSICAL DOW THEORY VITAL STATISTICS
Total number of transactions (trades) taken: 38
Comment:
We can see
that 38 trades in +115 years has nothing to do with short-term trading. The
positions taken in pursuance of the Dow Theory rules tend to last significant
time. If we take into account that almost 1/3 of the time one is “in cash”
standing on the sidelines, it is clear that no hectic trading is necessary.
This implies a low turnover, and with it, lower transaction costs.
In my
opinion, the Dow Theory strikes a perfect balance between being the guy holding
the proverbial hot potato (and being killed by a +50% drawdown when a vicious
bear market sets in), and being a stressed short term trader.
Average duration of each transaction: 712 days.
Comment:
I quote what
I wrote in this post:
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.
Winning
trades (positions) versus losing trades
29
transactions resulted in profits versus 9
losers, that is 76.3% winners, versus
23.7% losers.
While this is
not carved in stone, it gives us a pretty good indication of what to expect in the
future.
A healthy
percentage of “winners” is important. I know that in trading circles, it is
said that the percentage of winners is immaterial, and what really counts is
the win to lose ratio. If when winning one makes 10% but when losing one loses
40%, then 76.3% of winners can lead directly to the almshouse. Thus, many
traders favor systems (normally breakout systems) with a low percentage of
“winners” (i.e. 30%) but a high payoff ratio (i.e. 4 to 1). However, in my
opinion, this is true (and to a very limited extent) for shorter term trading
and when dealing with leveraged positions with narrow stops. Most trading
systems place stops at quite arbitrary levels and most of such stops rather
than being technically determined are dictated by the amount the trader is willing
to lose in each trade.
Things are
different for the Dow Theory investor. Our stops, as I have written here and here are clearly technically determined. Investors along the
primary trend are not supposed to be leveraged. Thus, any attempt at leveraging
Dow Theory positions and, with it, narrowing stops to “contain” risk, would be
a mockery of the Dow Theory.
Such a high
percentage of winning transactions (76.3%) tells us something important about
the accuracy and solidity of the Dow Theory. In essence, the Dow Theory is a
breakout system. One buys penetrations of previous highs and sells violations
of previous lows. As I wrote above, breakout systems tend to have a low
percentage of winning trades (30-35%), since many breakouts are false ones and
prices immediately reverse and hit the stoploss. Thus, the Dow Theory clearly
excels at determine which “highs” are the relevant
ones to be broken (buy signal) and which “lows” are the relevant ones to be
used as stoplosses, as not all “highs” and “lows” are relevant under Dow
Theory. We can confidently say that the Dow Theory does an excellent job in
separating the wheat from the chaff and in this fashion, it manages to achieve
an astounding 76.3% of winning trades thanks to the combination of finding the
“right” breakouts and placing the proper technically defined stoplosses.
Finally, we
shouldn’t underestimate human nature and our psychological frailty. While a
system with a 30% of winners can be profitable,
it takes a toll on the investor’s physique. I know this firsthand. A
system with a 30% winning trades will result in long strains of losses, which
eventually destroy the trader’s ability to stick with the system.
A healthy
76.3% reduces the odds for a long string of losses and, thus, it is “tradable” in real life; not just
in trading books or trade labs.
Average gain in each position: 32.33%
Comment:
32.33%
average gain is a respectable figure. We should bear in mind that this average
gain is made in somewhat less than 2 years (average trade duration). If we also
bear in mind that almost 1/3 of the time we are flat with no long position,
32.33% is an even more remarkable figure.
As with any
trend following system, the Dow Theory does not catch the absolute tops and
bottoms. Thus, we can confidently say that buy signals (primary bull market
signals) are flashed with a delay of ca. 10% (that is 10% after the market
lows). The same applies to sell signals (primary bear market signals). Thus, if
the average gain stands at 32.33%, this means that the total average trend
should be increased by 20% from top to bottom (10% lost from the top and 10%
lost from the bottom). This implies that the average trend implies an average
gain from bottom to top of ca. 52.33%. Alas, only 32.33% can be “extracted” as
profits by the Dow Theorist.
While, this
may seem outrageous for an outside investor, this is the price we have to pay
to be reasonably sure that a new trend (or trend reversal) has been
established. I don’t know of any timing or trend following method that can spot
earlier trends without jeopardizing the overall profitability. In investing
there is no free lunch.
32.33% is a
respectable figure for the buildup of capital. If we assume transaction costs
of ca. 1% (slippage +cost of buy and sell and custody if the shares are not
held in the street’s name), such 1% is a modest amount of cost and doesn’t eat
up much of the raw performance.
The average gain in winning transactions stands at 54.12%
Comment:
Here we focus
on the winners. The average gain in such instance stands at 54.12%.
This is an
important figure in order to establish the risk-reward ratio of each prospective position. Depending
on the specific setup, each primary bull
market signal will have a different stoploss. When a primary bull market signal
is flashed, our initial stoploss stands at the last recorded primary bear
market lows. Such stoploss may be as tight as 4.2% (i.e. buy signal of
5/13/1980) or a loose as 20.3% (buy signal 10/7/1982). Of course, if one uses
the Schannep’s stoploss, which I explained here,
our stop should never exceed 16%.
In any
instance, the “risk” in the reward risk ratio is very variable depending on the
specific setup. Once we know the
denominator (“risk”), be it tight or loose, we can make our best guess as to
the reward. If we are very conservative, we can take as reward, the average
gain of 32.33%. However, technically it may be more appropriate to take as the
likely reward the average winning trade, instead of the average trade.
Why? Because, we only have two outcomes in a given trade: Either it is a winner
or a loser.
If it is a
loser, we know how much we stand to lose (our Dow Theory stop). Here we don’t
talk of likely losses, but of hard-and-fast
figures.
If it is a
winner, then….it is a winner. Do you get it? If it is a winner, our proper
reference is the average gain made in winning positions, not just the
average gain (which includes both winners and losers).
However, I err
many times on the side of caution, and when assessing the reward risk ratio of
a new Dow Theory position, I just take the average gain, instead of the average
gain of winning trades.
Average loss in losing transactions: -6.10%
Comment:
What else can
I say? It is self-explanatory. A loss of -6.1% clearly fits within the
parameters I gave concerning the initial Dow Theory stop (at the primary bear
market lows). I wrote above that it ranges from a modest 4.2% to a whopping
20.3%. Of course, this is the worst-case scenario, since, as soon as secondary
reactions develop and the lows of the reaction are not broken, the Dow Theory stop
is raised, and, accordingly, the amount to be lost diminishes (and in most
instances, profits are locked in). Serious investors should have a seamless
understanding of the Dow Theory trailing stop. The first step is to read this post and study its graph.
Averages can
be misleading. Here you have the actual figures of all losing trades:
Day/Month/Year Price Indust Pct Lost
SELL
|
13/05/1940
|
137.5
|
-3.56
|
SELL
|
26/04/1962
|
678.68
|
-3.96
|
SELL
|
25/02/1969
|
899.8
|
-4.51
|
SELL
|
26/01/1970
|
768.88
|
-10.62
|
SELL
|
19/10/1978
|
846.41
|
-2.32
|
SELL
|
03/08/1990
|
2809.65
|
-4.28
|
SELL
|
25/06/2002
|
9126.8
|
-4.81
|
SELL
|
29/09/2008
|
10365.45
|
-19.33
|
SELL
|
04/06/2012
|
12101.46
|
-1.57
|
Avg Loss
|
-6.11
|
Well, the
maximum loss was suffered on September 29, 2008 (-19.33%).
We also
observe that the Dow Theory avoided catastrophic losses in all instances. Even 2008s
-19.33% loss compares favorable with the ca. -50% meltdown the market
experienced. In all other instances, losses are few and well contained. Thus,
Dow Theory acts as an excellent capital protector. The best offense (returns)
is a good defense (contained losses). As I wrote here when evaluating year-end returns:
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 drawdown 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 drawdown
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!
The astute
reader should be asking: “What happened
in 1929 and 1987, I don’t see such years in the spreadsheet?” Here is my
answer: the Dow Theory managed to get investors out of stocks before the market
crash. In other words, a sell signal (primary bear market) was flashed shortly
before the crashes began in earnest. Here you have the details of the two
positions which preceded both crashes:
Day/Month/Year Price Indust Pctg gain
BUY
|
07/12/1923
|
93.8
|
|
SELL
|
23/10/1929
|
305.85
|
226.07
|
BUY
|
21/01/1985
|
1261.37
|
|
SELL
|
15/10/1987
|
2355.09
|
86.71
|
As you can
see in both instances, the investor was forewarned on time by the Dow Theory.
Furthermore, in both cases, the investor managed to lock in sizeable profits
(226.07% in 1929 and 86.71% in 1987). You can find more details about the
remarkable job the Dow Theory did in 1987 in my post “Revisiting the 1987 crash,"
which you can find here.
Well, this is
enough for today. In a future post I will examine other statistics such as “win
to lose ratio”, “percentage of time in the market”, “profit factor” and “secular
bull and bear markets”.
In the meantime,
have a nice weekend.
Sincerely,
The Dow
Theorist
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