Thursday, June 20, 2013

Face off: Schannep versus “classical” Dow Theory

Part I. Delineating the object of our study

It is no secret that this blogger truly yours has always passionately defended Schannep’s Dow Theory “flavor." For the uninitiated, it suffices to say that the Dow Theory is not monolithic and, hence, different variations of a common theme cohabit in hopefully peaceful harmony. More about the different Dow Theory flavors here.

 Classical Dow Theorists are very adamant about any changes of the Dow Theory as was expounded by Rhea, and, in my opinion, due to a lack of understanding of Schannep’s flavor tend to dismiss any improvement of the Dow Theory as heretical or defective.

However, I have always contended that Schannep’s rules make full aprioristic and empirical sense. To learn more about Schannep’s flavor of the Dow Theory and Rhea, please go here.

To put it succinctly, three different ways of investing coexist under the name “Dow Theory," Theory”, namely:

1.     One based on the secular trend, lasting the secular trend 10 or more years. Positions taken along the secular trend can last even a decade and good values (i.e high dividend yield) are paramount to establish a long position. At the risk of oversimplifying this is the way Charles Dow and Schaefer advocated.

2. One based on spotting cyclical bull and bear markets irrespective of value considerations. While the writings of Charles Dow contain hints as to this kind of investing, Dow’s understudy Hamilton, and finally Rhea are the ones that really developed the rules pertaining to this specific kind of trend following. Most market practitioners agree that the Rhea version of the Dow Theory is the “classic” one.
3.   Schannep on the footsteps of Rhea produced a more updated and responsive Dow Theory “flavor.", which is essentially Rhea's Dow Theory with steroids. This is the Dow Theory “flavor” which is followed by this blogger truly yours.

Well, actually, Schannep’s goes beyond tweaking the Rhea/classic Dow Theory. While the backbone of Schanneps’ timing system is the Dow Theory (as improved by him), he avails himself of other “tools” to improve his market calls. Thus, Schannep’s timing system is made of:

1.      First of all, the Dow Theory. I’d confidently say that 90% of his buy and sell signals are based on the Dow Theory (which is pure trend following).

2.      5% or so of the buy and sell signals is Schannep’s bull and bear market definition, namely a decline of -16% for a bear market and a rally of +19% for a bull market. While many Dow Theory buy and sell signals overlap Schannep’s bull and bear market definition, in some rare instances the market makes such powerful movements before a Dow Theory signal is flashed (here you can read more about Schannep’s bull and bear market definition). In any instance, taking buy and sell signals based on previous advances or declines is without any shade of doubt trend following. Schannep’s website “” contains the list of bull and bear markets according to this definition.
3.   The remainder is a buy-only signal, the so-called “capitulation." When markets experience a dramatic decline (as measured by Schannep’s proprietary indicators), investors are advised to exceptionally deviate from trend following and, instead, bet for a trend reversal. In other words, when the market is severely oversold, buy and expect a new bull market soon. Of course, this is not trend following but, rather, mean reversal trading, which is in the antipodes conceptually of trend following. However, Schannep’s capitulation indicator (more about it here) has served him well in the past.

4.   In addition to the three “tools” I have just mentioned, Schannep’s toolbox contains a final tool: The “timing indicator," which is proprietary, although Schannep discloses a good deal of its entrails here. 
Schannep’s“timing indicator” is a final source from which to derive buy and sell signals. Most of the time, the “timing indicator” is closely aligned with the Dow Theory or the bull and bear market definition. However, in some occasions, the “timing indicator” serves to increase responsiveness to trends and to avoid whipsaws.

Therefore, it is very important to make a rigorous comparison of the “Rhea/classical” Dow Theory with Schannep’s. After all, we shouldn’t get blinded by Schannep’s outperformance of ca. 2% versus the “Rhea/classical” Dow Theory. If such outperformance was achieved with deeper drawdowns or with an extremely high turnover (and its attendant commissions and slippage), then we would be better advised to stick to the traditional Dow Theory, which is a great timing system in and of itself. Thus, I set out to study Schannep’s performance and transactions from all possible angles. I will leave no stone unturned.

However, I want to make an apple to apples comparison. If I am going to compare Schannep’s Dow Theory flavor with the “classical Rhea”, I feel I cannot take the full corpus of Schannep’s tools, since some of these tools, in spite of their effectiveness, have nothing to do with the Dow Theory.

Accordingly, before I proceed to compare Schannep’s Dow Theory flavor with the “Rhea/classical” one, I am going to somewhat trim Schannep’s system.

First of all, I will get rid of the “capitulation” rule. As I said above, the capitulation rule suggests the opening of a long position when the market is severely oversold. It is catching the proverbial “falling knife." Thus, this indicator, although effective, has been ignored in the calculations I have made. An oscillator by its nature (mean reversal) is in the antipodes of any trend following method (among which is the Dow Theory).

Secondly, I won’t use the Schannep’s “timing indicator” because of two reasons: (a) In the first place, because the indicator integrates fundamental data such as monetary policy in addition to pure momentum (trend following) elements; (b) last but not least because its composition has not been fully disclosed to the public, and I cannot test what I don’t fully know.

On the other hand, I will integrate Schannep’s definition of bull and bear markets (+19 and -16% movements, respectively) because this is pure trend following. This is the essence of any breakout, momentum based system, and, hence, it bodes well with the Dow Theory. In any instance, there were only 1 buy and 1 sell signal based upon this rule during the time period studied (which spans almost 60 years) out of a total of 31 round trades.

Curiously enough my “trimming” of Schannep’s sophisticated machinery didn’t result in a significant deterioration of performance. This attests to the robustness of Schannep’s Dow Theory rules. In other words, Schannep’s Dow Theory rules don’t need the crutch of other indicators to excel and outperform the Rhea/Classical Dow Theory. This is not to downplay the importance of the capitulation and the “timing indicator” because they are the icing on the cake, and add value (more than in raw performance by smoothing signals and enable the transitioning from a full invested to a partially invested position and vice versa). However, since the “Rhea/classical” Dow Theory record doesn’t contain any of these indicators, the proper way to compare Schannep’s interpretation of the Dow Theory is by reducing his system to just the Dow Theory, and the bull/bear market definition of +16 and -19% market movement respectively.

Bearing in mind the preceding considerations, I am confident that I have conducted a real "apple to apples” comparison. I have really compared two trend following systems of a very similar nature.

In the coming posts, we will compare both “flavors” from the following angles:

·        Total performance.

·        Trade duration.

·        Time in the market.

·        Profit factor.

·        Percentage of winning trades.

·        Average winning trade.

·        Average losing trade.

·        Largest losing trade.

·        Win to lose ratio.

·        Profit factor.

·        Total performance in secular bull markets

·        Total performance in secular bear markets.

·        And much more…

Well, now is time to put an end to this lengthy post. Those thirsting for “data” should wait for the next post, which I hope to post next weekend. However, since this is a serious attempt to analyse both Schannep’s and the “Rhea/classical” Dow Theory, it was necessary to clarify our premises and the object of our study. To begin with, it suffices to say that Schannep's Dow Theory "flavor" excels on all counts. My conviction regarding the importance of Schannep’s contribution to the art of market timing has been further cemented after having performed this in-depth study.

Have a nice weekend.

The Dow Theorist

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