Friday, July 5, 2013

Dow Theory Special Issue: Secular trend versus long term trend

Case in point GOLD

Followers of this Dow Theory blog know I am quite skeptical as to investing along the secular trend. My post “Fundamental versus Technical analysis and Dow Theory. Who is right?highlights the risks pertaining to investing along the secular trend.

When I refer to “secular” trend, I mean trends lasting at the very least 5 years or longer. Dow Theorist Schaefer spoke of trends lasting up to 14 years. The longer the time horizon of our investment, the more important fundamentals become. Conversely, technical considerations become of negligible importance.

Thus, investing along the secular trend forces the investor to make a judgment call about economic conditions. Her technical analysis skills are of little avail.

However, the appraisal of fundamentals is easier said than done, since we are fallible and our assessment may be proven wrong. Furthermore, even when the initial economic assessment is right, economic conditions are not static and change. Failure to adapt to a new fundamental scenario will result in losses. If determining fundamentals was an easy feat, then all investors would be successful. Of course, a similar criticism can be made of technical analysis. The sad truth is that to excel as investors (be it “fundamental” or “technical”) is not easy.

Thus, I see two terrible risks when investing along the secular trend:

1.      One can be wrong (either from the start or as conditions change).

2.  Even when right, investments along the secular trend are subject to wild swings resembling a roller coaster. The longer the time frame the more likely one will encounter draw-downs. I have repeatedly written than drawdowns can kill the investor: both financially and psychologically. In theory, it is easy to “digest” drawdowns. However, when a drawdown hits, the fortitude of the investor is really put to the test. Even the best psychologically prepared investor may not survive the drawdown if he lacks other sources of income and must tap on his investments.

Of course, astute readers might object: “You can control drawdowns by using stops." However, the use of stops is technical analysis, and accordingly stops negate the very reason for investing along the secular trend, which is to let time to build up profits. If you anticipate a secular trend lasting 10 years, and you get stopped out in the second year because the market went down -14%, you are out.

One thing is clear to me: the investor should not mix investment styles. Either you trade cyclical bull and bear markets, as those determined by the “Rhea/classical” Dow Theory, in which case the use of stops is part and parcel of the trading strategy, or if you take a leap of faith and invest along the secular trend you cannot chicken out when a drawdown hits, unless you think the fundamental thesis no longer applies.

As I wrote in my post “Jim Rogers and the Dow Theory”, which you can find  here

“[s]uch secular view, even when/if proven right, is not a straight line. The investments recommended by Rogers have experienced and will experience in the future tremendous draw-downs. This is why Roger’s brilliance was not and will not be useful to 99% of investors.

Not all investors have the resources (i..e liquidity) and psychological makeup to endure draw-downs. Those "secular" market forecasts, even when right (and I tend to agree with Rogers), have to endure long nerve wrenching periods. Many investors lack the liquidity to endure a 60% draw-down or even worse the psychological fortitude to remain unaffected. Hence, they sell out at the worst possible time.”

Since I am painfully aware of my own fallibility and my low ability to stomach draw-downs, I tend to eschew fundamentally-based investments (or at the very least never go all-in).

Having said this, I must confess that in life, we all must make fundamentally-based judgment calls. When we choose a job or a profession, we are making an assessment of fundamental conditions. Most of our daily decisions involve the assessment of fundamental conditions. Technical analysis or the Dow Theory will be of little help.

Furthermore, real investing is not as clear-cut as writing blogs. I know of no real investors that entrust his/her fortunes 100% to technical analysis. We all have our, hopefully little and contained, egos. Furthermore, allowing some measure of secular trend and fundamentals may entail wise diversification away from technical analysis. Of course, it is up to each investor to decide upon the percentage of one’s assets to be committed to fundamentally-based investments versus technically-based investments. Personally, the more I think I understand a fundamental idea, the more faith I’ll have in it when it is put to the test, namely, when the draw-down hits. However, since I am not omniscient, I am skeptical as to my knowledge.

So, in real life, it can be good practice to be aligned both with the secular trend for some very specific investments and with the long-term trend as defined by the Dow Theory (1-2 years) when it comes to investing in stocks.

Gold provides us with a real time example as to how we have to conduct ourselves when investing along the secular trend or merely the long-term trend.

Personally, I adhere to the free gold thesis when it comes to the secular, fundamentally-based opinion on gold. Free gold has nothing to do with the typical gold-bug, nor with making gold money again. Gold is too important to be currency. Gold is the reserve asset per excellence. Those interested in understanding the fundamentally-based free gold tenets are advised to study intently Fofoa’s blog which you can find here

Those willing to really understand gold, are encouraged to read all the posts written by Fofoa.

Thus, since I buy into Fofoa’s thesis (namely that physical gold will eventually experience a monster revaluation), I feel that physical gold is an investment on a secular basis. It is not something to be traded. To this end, one can use GLD.

However, and in spite of my liking physical gold for the very long pull:

1)     I can be wrong.

2)   Even if it plays out as predicted nobody can predict when it will happen. So, for practical purposes, such secular trend may only result useful for people with deep pockets and strong staying power. Staying power doesn’t necessarily mean “rich” but merely, if not rich, to live within your means. As Keynes said, the markets can remain irrational longer than you can stay solvent

(Paper) gold’s current lousy action is a good example of the pain to endure when investing along the secular trend. The drawdown is unavoidable, and, hopefully, the reward is uncertain, as it is dependent on one’s thesis being proven right.


The Dow Theorist

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