Part III Overall performance figures (2)
Let’s continue with our analysis of the Schannep’s
version of the Dow Theory versus the “Rhea/classical”
one. The first post of this saga, which you can find here, set out
the premises of our study, as it is important to do a real “apple to apples”
comparison.
The second post, which you can find here, started our analysis. Today we
will further expand our study. Please mind that my analysis is not discriminating
between secular bull and bear markets. The study of both Dow Theory “flavors”
under bull and bear secular bear market conditions will be made at a later date,
and will provide us with further insights as to what to expect from both Dow
Theory “flavors”
Schannep versus Traditional Dow Theory
vital statistics
Average winning trade
Schannep: 33.42%
Classical: 40.45%
As I explained in the previous post of this saga, performance percentages per se are misleading. We have to
normalize across time. In other words, what really interest us as investors is
how much money each Dow Theory flavor can
make given the same amount of time.
To this end, I derived the following figures:
Average total time in the
market (winning trades)
Schannep: 621.26 days
Classical: 828.35 days
Once again, we see that the transactions taken as per Schannep’s Dow Theory
tend to last slightly less than those taken in pursuance of the classical Dow
Theory. If we calculate the median duration, we obtain similar results (425 versus 645 days).
If we translate the average duration of winning trades into years, we obtain:
Schannep: 1.70 years
Classical: 2.27 years
If we divide the average percentage gain by the total time spent on the
market in order to achieve such gain, we obtain the normalized profit figure.
Thus, the annualized performance for winning trades for each Dow Theory “flavor”
would amount to:
Schannep: 19.63%
Traditional: 17.82%
This statistic is telling us that Schannep’s winning
trades “extract” more profits from the market in less time, or, in other words,
given equal time fully invested in the market, Schannep’s rules manage to make
more money.
Well, now let's turn our eyes to the losings trades. We learn more by observing defeat than by rejoicing when winning.
Average Losing trade
Schannep: 6.48%
Classical: 7.85%
When it comes to losing money, Schannep’s version makes a better job at
protecting one’s capital. Here you begin to see why the relative “restiveness”
(more trades generated) by Schannep’s flavor, comes to the investor’s help when
the going gets tough. There is a lot of talk about letting profits run, which is
true; however, to cut losses short, it is necessary to have a system that doesn’t
overstay markets when the trend reverses course. Schannep’s slightly shorter
duration of trades comes in handy when it comes to adverse market conditions.
Averages do not do full justice to Schannep’s Dow Theory, so we will further
study the universe of losing trades.
Let’s take a look at the two
largest losing trades.
Year

Schannep

Classical


1st Losing Trade

2008

10.45

19.33

2nd Losing Trade

1970

8.33

10.62

Well, the difference between both “flavors” is astounding. The implications
are obvious: When a bear market sets in, Schannep’s Dow Theory gets you out of
trouble in the blink of an eye. It is not the same in real life to lose
10.45% than 19.33%. Real investors and traders will certainly agree with me.
Therefore, what I wrote concerning the efficacy of the “classical” Dow Theory in containing losses becomes even truer when
dealing with Schannep’s Dow Theory:
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 yearend 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!
If you couple these findings with the fact that winning trades managed to
make more profits given the same amount of time in the market, or as we
examined in our last post, that overall Schannep’s version makes more money
than the “Rhea/classical Dow Theory, it is clear that slightly increasing the
number of trades has nothing to do with “overtrading” or churning one’s
equities account, but, rather, being able to spot changes of trend and get out
of trouble as soon as possible. I repeat ad
nauseam that the only way to avoid killing drawdowns when a bear market
sets in is by increasing the frequency of trades. There is no way around this
market truism. Thus, a slightly increased frequency of trading, contrary to Dow
Theory zealots, is no heresy or even detrimental to one’s survival in the
market.
Let’s further analyze the losing trades from another perspective. Hitherto
we have focused on the average losing trade. Let’s look at the standard
deviation of losing trades. The lower the standard deviation, the better, as it
shows a lower probability for “extreme” surprises to occur in the future. While
nothing is carved in stone, and anything may happen in the future, I certainly
prefer to stick to a system which has shown “stability” of losses under adverse
market conditions.
Standard Deviation of losing
trades
Schannep: 2.67%
Traditional: 5.84%
So, as you can see, the likelihood of scoring big losses is much higher (more
than double standard deviation) when following the classical Dow Theory.
The analysis I have just made of losing trades has profound implications.
Schannep’s Dow Theory isn’t just a way to “outperform” the classical Dow Theory
(and by implication buy and hold); it is an excellent devise to cut losses
short (and to avoid unpleasant surprises in the “untested” and “out of
sample” future) under challenging markets. We will further expand this
remarkable feature of Schannep’s Dow Theory when we break our analysis down to
secular bull or bear markets. Some astounding conclusions will emerge.
If, as I contend, Schannep’s Dow Theory does a better job at cutting losses
short, we should expect the average duration of losing trades to be shorter
than those of the “classical” Dow Theory. If Schannep gets out quickly out of
trouble, trades that get sour should have a shorter duration. Here you have the
answer:
Average duration of losing
trades
Schannep:123.00 days
Classical: 145.14 days
If we calculate the “median” instead of the average, we obtain even more telling results:
Median duration of losing
trades
Schannep: 81 days
Classical: 147 days
No matter how we measure it, losing trades under Schannep’s Dow Theory have
shorter durations. This is obviously a positive, and suggests, looking forward to the unknown future, that the risk of getting caught in a bad trade is smaller
for those following Schannep’s rules.
As a side note, I’d like to mention that the work of L.A. Little on the
duration of bear markets, clearly supports my contention that the earlier one
gets out of trouble the better. Mr. Little in his wellresearched book “Trend Trading Setups” provides compelling empirical evidence that losing trades
start losing money early on, which proves the market adage “cut your losses
short” right.
Win to lose ratio
I calculated this ratio by summing up the total of percentage points made
in winning trades and dividing this figure by the summation of total percentage
points lost in losing trades. Here you have the results:
Schannep:5.15
Classical: 5.14
Here Schannep’s Dow Theory manages to slightly beat the “classical” version
of the Dow Theory. However, both ratios are excellent. We should not forget
that the “Rhea/classical” Dow Theory is an excellent timing device on its own right.
Profit factor
Profit factor is the quotient of total points gained
divided by total points lost. More about the importance of a healthy profit
factor here.
From 1954 to 2013, we get the following profit factors:
Schannep:13.17
Classical: 12.5
Once again, both “flavors” manage to sport wonderful
profit factor. Please mind that in the trading world, any profit factor larger
than 2 is considered as outstanding. However, the profit factor only tells part
of the story. The volatility of losses and the likelihood of a very big one, is
something not to be underestimated. As I have shown in this post, while both “flavors”
manage to avoid big losses, Schannep’s version clearly does an even better job.
…...
My next post will focus on studying both Dow Theory
flavors under secular bull markets. Figures like the average trade duration and
average profit clearly vary depending on the secular condition of the market.
This is something to be taken into account by the real market practitioner in
order to adjust expectations and better assess the reward risk ratio of each
prospective trade. Thus, when being immersed in a secular bear market, it
should not come as a surprise that the transactions taken in pursuance of the
Dow Theory (of any “flavor” whatsoever) fall short of expectations. The problem
does not lie with the Dow Theory but with our expectations. If we break down
the historical record into secular bull and bear markets, we will have a more
accurate yardstick against which to measure our expected and realized
performance. As far as I know this is groundbreaking work, which has not been
performed yet. So readers of this Dow Theory blog, stay tuned!
Have a nice weekend.
Sincerely,
The Dow Theorist
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