Face off: Schannep versus “classical” Dow Theory

 

Part V. Performance comparison under secular bear markets

This post was overdue. But time constraints prevented me from writing it before. This is the last post of the saga “Face-off: Schannep versus classical Dow Theory”.

As you well know, until now, four posts have analyzed the Schannep’s Dow Theory and Rhea’s (classical) Dow Theory from all possible angles. You can find all my findings here

Thus, we compared performance figures, time in the market, average gains, etc. We also zoomed in and analyzed performance within secular bull markets.

Today we will close this saga by comparing Schannep’s Dow Theory and the classical Dow Theory during secular bear markets.

You can find here the full explanation as to what constitutes a “secular” bull or bear market. This is important stuff as the secular condition of the market clearly influences the outcome of the trades taken in pursuance of the Dow Theory (be it “Schannep’s” of “classical”).

 

Average Trade duration during bear markets

Classical: 1.19 years (436 days)

Schannep:     0.7 years (283 days)

Some people I have in mind would immediately jump on Schannep and say:

“You see…transactions following Schannep's Dow Theory last too short, as the “classical'” Dow Theory signals last significantly longer. This proves Schannep’s Dow Theory is not so effective"

Well, this is very bad analysis. Very bad and superficial analysis, indeed.

During secular bear markets the “gravitational force” intensifies, the market is prone to false breakouts, and even successful cyclical bull markets tend to be smaller in extent (and time, as there is a direct correlation between profits and duration of the trade). Under these adverse circumstances overstaying the market is not advisable. The investor should be ready to leave as soon as there is any hint of danger. This is why transactions taken as per Schannep’s Dow Theory flavor last less during secular bear markets. We are ready to turn on a dime.

Furthermore, the duration of each transaction is not so important, what really matters is how much money we make. So now let’s look at the average gain following each Dow Theory “flavor”:

Average gain made in each transaction during secular bear markets.

Classical: 6.52%

Schannep: 5.46%

Now the crowd gets more vociferous against Schannep:

“You see, your trades last too short, you don’t give your trades enough time to build profits. Can't you see that the classical Dow Theory has a larger average profit!”

Well, once again wrong, plain wrong, since we have to look at the total number of transactions during bear markets. From 1954 to 2013 there have been the following number of transactions:

Total number of transactions during secular bear markets:

Classical: 13

Schannep: 20

Thus, Schannep’s Dow Theory, signaled more buy and sell signals than the classical Dow Theory during secular bear markets. This is neutral. It rests to be seen whether so much “activity” was noise or resulted in more profits to the investor than the less restive classical Dow Theory.

To this end, we have to look at the total percentage points gained during secular bear markets by each Dow Theory “flavor”:

Total percentage points gained during secular bear markets:

Classical: 84.77

Schannep: 109.10

So, surprise, surprise! Schannep’s Dow Theory manages to extract more profits from the market during secular bear markets. This implies that:

a)  Schannep’s Dow Theory is much more effective during secular bear markets than the “Rhea/Classical” Dow Theory in determining when to get “in” and, more importantly, when to get “out”. If market conditions do not warrant a long strong trend, so be it; Schannep’s Dow Theory will not be remiss in terminating a trade, even if this means a shorter average trend duration than the classical Dow Theory.

So by being more attuned to market conditions, Schannep’s Dow Theory flavor managed to make more money for investors during secular bear markets. Schannep’s made 28.7% more profits than the “Rhea/classical” Dow Theory during such fateful periods.

b)  If we divide the average percentage made in each transaction by the total average time, we see that Schannep’s Dow Theory, in spite of trades that last on average 35% less than "classical" ones, manages to “extract” from the market more money per time unit. If we divide the average trade by the average duration of each trade, we can see the average profit extracted from the market each day. Let’s do the math:

Classical:

6.52% (Avg Trade) /436.54 (Avg time) = 0.01493687% per day.

Schannep:

5.46% (Avg Trade) /283.45 (Avg time) = 0.01924533 % per day.

Thus, Schannep’s Dow Theory manages to make 28.86% more than the classical Dow Theory on average per day.

Of course, such figures are not carved in stone and we don’t know what the future has in store for us. However, I’ll tend to side with the Dow Theory flavor that shows a greater degree of responsiveness; especially when the market is more likely to cause devastating losses.

The best offence is a good defense, so let’s take a look at the losing trades.

Average Losing Trade

Classical: 7.19%

Schannep: 6.48%

So we can see that Schannep’s Dow Theory manages to lose less when the market refuses to oblige.

One could say that averages are misleading, so we have to look at the individual trades. Thus, a lower average percentage loss might be concealing a monster loss. To this end, let’s take a look at the two largest losses incurred by each Dow Theory flavor.

Largest loss (Schannep): -10.45% (Jan 30, 2009)

Largest loss (Classical): -19.33% (Sep 29, 2008)

So the largest loss under the Rhea/Classical Dow Theory almost doubles the loss suffered by Schannep’s Dow Theory.

Let’s take a look now at the second largest loss:

Second largest loss (Schannep): -8.33% (Jan 26, 1970)

Second largest loss (Classical): -10.62% (Jan 26, 1970)

Hence, while we can make no assurances about the future, it seems that Schannep’s Dow Theory does a remarkably better job at “cutting your losses short”. Furthermore, as we have amply seen during this saga of post, Schannep’s Dow Theory reduces risk (losses) without compromising returns (actually, returns are increased by Schannep’s Dow Theory).

Conclusions:

Well, this post and this saga is drawing to an end. Each market practitioner should derive his own conclusions. Personally, I find that the evidence weights overwhelmingly in favor of Schannep’s Dow Theory. I am not implying the the “Rhea/Classical” Dow Theory is flawed, far from it. I still consider the classical Dow Theory as an excellent market timing device. However, I feel Schannep’s “improvements” far from being “ego-improvements” are real, are well substantiated and empirically are shown to work.

While it may be argued that “past performance is no guarantee for future performance”, I’d say that the very structure of Schannep’s Dow Theory is likely to continue outperforming the “classical” Dow Theory in the future. By design Schannep’s Dow Theory is more responsive (i.e. detects earlier the onset of a new trend) because:

1)     It uses three indices (it includes the S&P), instead of just two, whereas it requires just two indices confirming.

2)  The definition of secondary reaction (which is vital to determine breakout points, which in turn, define primary and bear market signals) is “shortened” as, 10 days, or even less, is enough to qualify a movement as a secondary reaction.

3)     In the same vein, by doing away with the 1/3 to 2/3 retracement rule (which is one of the requirements under classical Dow Theory for a secondary reaction to exist) and merely requiring a 3% move, many movements which under classical Dow Theory escape the definition of secondary reaction are labeled as such under Schannep’s Dow Theory.

Thus, the very make up of Schannep’s Dow Theory makes it foreseeable that in the future it will continue to cut losses short (that is detecting earlier changes of the primary trend) because its very rules are designed to spot secondary reactions in an early fashion.

Of course, critics could say that everything comes at a price, and that premature labeling of secondary reactions makes Schannep’s Dow Theory prone to false signals or worse yet, reduced profits.

However, such objections have been exhaustively debunked during this “face off” saga. Schannep’s rules, while being “early” both in signaling entries and exits, manages to increase profits, not reduce them.

So for a long-term investor (long term being for me trades lasting on average one year or more) Schannep’s Dow Theory is the closest thing to the holy grail. Losses are greatly diminished while profits are increased.

Sincerely,

The Dow Theorist