Thursday, June 5, 2014

Dow Theory Update for June 5: Fact, fiction and Momentum investing


Debunking anti-trend following myths and how the Dow Theory boosts momentum strategies.

AQR Capital Management has recently issued a working paper, which confirms something Dow Theorists, and in general trend followers have never doubted: Momentum (trend following) works.

Dorsey Wright’s website has published the whole paper, which you can read here.

The conclusions of the paper should be an eye-opener for any investor really intent on putting aside his/her ego in order to protect capital and, hopefully, make some money in the market. Here are the main conclusions, which are no substitute for reading the whole material:

·        Momentum returns (outperformance) are remarkably stable and robust.

·        Momentum (unlike value investments) works with all kinds of stocks (small and big cap).

·        Trading costs don’t kill the momentum investor (as you can see in this blog where following the primary trend market results in many boring days with no action to be taken)

·        The tax burden (for US residents/citizens) doesn’t kill the momentum investor because momentum holds on to winners and sells losers (“let your profits run, cut your losses short”), which avoids short-term gains in favor of long-term ones.

·        It seems momentum returns are not a one-time anomaly. If it is “abnormal” it has survived for more than 200 years.

·        In spite of its high volatility, the sharpe ratio speaks favorable of momentum strategies.

However, you shouldn’t settle with a good sharpe ratio. You should aim for the moon. Here the Dow Theory comes in handy: if you add a Dow Theory filter (i.e. not investing in momentum stocks, no matter how strong they look, during primary bear markets, and exiting all positions when a primary bear market is signaled, and only initiating new positions when a primary bull market has been signaled) downside volatility (i.e. drawdowns) is dramatically reduced. Most of the downside volatility (the one that deters many investors from following momentum strategies) of momentum strategies occurs during primary bear markets. Avoid them with the best trend detector (the Dow Theory), and eliminate most of the downside volatility (and boost the sharpe ratio). I have mixed the Dow Theory (Schannep’s one) as a filter and screened for high momentum stocks. This portfolio of high momentum stocks filtered by the Dow Theory outperforms the S&P by ca. 10% annually whereas drawdowns are dramatically reduced. Many momentum strategies can be concocted when using a Dow Theory filter.

This Dow Theory filter has a drawback, tough: The investor’s ego. It is hard for a money manager (what would their clients think?) and even for the average private investor to stay on the sidelines sitting on cash during primary bear markets (ca. 1/3 of the time). Most investors would rather lose money during the times the market refuses to deliver returns, rather than taking a protracted vacation. However, if one is able to harness one’s will, the Dow Theory filter results in the closest thing to the Holy Grail.

All in all, the roller coaster which results from using momentum strategies can be significantly tamed by using the Dow Theory as a filter. Thanks to the Dow Theory you keep the outperformance inherent in high momentum stocks, while you avoid the horrific drawdowns which plague momentum when the market changes its course. Here there is ample field for further research.

US Stocks

The SPY, Transports and Industrials closed up. The Industrials and SPY made higher confirmed closing highs. The bullish picture for stocks continues. Eventually, trends will change but my Dow Theory readings continue to tell me what they have been telling me for months: Don’t fight the bullish trend!

The primary trend remains bullish, as explained here, and more in-depth here

The primary trend was reconfirmed as bullish on October 17th, 2013, and November 13th, 2013 and March 7th, 2014, for the reasons given here, here and here.

So the current primary bull market signal has survived three secondary reactions.

The secondary trend is bullish too, as explained here and here.

Gold and Silver

SLV, and GLD closed up. For the reasons I explained here, and more recently here the primary trend remains bearish.

For the primary trend to turn bullish, SLV and GLD should jointly break above the secondary (bullish) reaction highs. As a reminder, the secondary reaction closing highs were made on August 27th, 2013. From such highs the market declined without jointly violating the June 27th, 2013 primary bear market lows.

Here I analyzed the primary bear market signal given on December 20, 2012. The primary trend was reconfirmed bearish, as explained here. The secondary trend is bullish (secondary reaction against the primary bearish trend), as explained here.

On a statistical basis the primary bear market for GLD and SLV is getting old. More than one year since the bear market signal was flashed has elapsed. However, I am extremely skeptical as to the predictive power of statistics. I prefer price action to guide me, and the Dow Theory tells me that the primary trend remains bearish until reversed. However, the secondary bullish reaction against such old primary bear market is also getting quite old. Tie. 

Furthermore, the June 27, 2013 lows remain untouched. The longer this situation lasts, the higher the odds that something might be changing. But I wait for the verdict of price action.

As to the gold and silver miners ETFs, SIL, and GDX closed up.

I profusely explained that SIL and GDX set up for a primary bull market signal. You can find all the relevant information from a Dow Theory standpoint here.

Please mind that a setup is not the real thing. So the primary trend has not turned bullish yet (or maybe “never”).

The secondary trend is bullish, as explained here. In spite of short term bullish accomplishments, SIL and GDX are not in a primary bull market.

The primary trend for SIL and GDX remains, nonetheless, bearish, as was profusely explained here and here.

The secondary trend is bullish, as explained here. In spite of short term bullish accomplishments, SIL and GDX are not in a primary bull market.

The primary trend for SIL and GDX remains, nonetheless, bearish, as was profusely explained here and here.

General note for both GLD/SLV and GDX/SIL: Unless it is a “fake out”, the “coiling” seems to evolve into a breakdown for the precious metals. Today’s action (if continued) could be the snap back into the trading range I was demanding during the past few days. If there is no following to today’s action, the picture is bearish. More about the “coiling” here and here.

The Dow Theorist

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