Saturday, August 17, 2013

Face off: Schannep versus “classical” Dow Theory

 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.

1st Losing Trade
2nd Losing Trade

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 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!

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 well-researched book “Trend Trading Set-ups” 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:

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:

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.


The Dow Theorist

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