Dow Theory Special Issue: Putting 2014 in perspective

US Stocks

Let’s briefly recap how our Dow Theory analysis fared in 2014. Did we do a good job at determining the primary trend of the markets? 2013, as explained here was a good year for those applying the Dow Theory to stocks, gold, silver and their miners. 2014 has been a good year too (by avoiding losses with losers, and by winning with the winners).

Today I focus on US stocks. In the coming days, I will review how gold, silver and their ETF miners fared when traded in pursuance with the Dow Theory.

The year began on January 2 with an ongoing primary bull market, which had been reconfirmed on November 13th,2013, as you can read here.

 

This primary bull market signal lasted until October 10th, when a primary bear market was signaled, as explained here.

The long position was closed with profits, as explained here.

For the sake of completeness, I must say that Schannep, of “thedowtheory.com” interpreted the Dow Theory in a different fashion which resulted in his not signaling a primary bear market on October 10, 2014. Thus, Schannep remained fully invested. Our friendly discrepancy gave rise to a “saga” wherein I analyzed the reasons advocated by Schannep and I. Actually, this saga is not finished yet, as I have to write yet the closing chapter (which in many aspects will acknowledge Schannep’s acumen). You can find the hitherto four chapters of the saga here:

http://www.dowtheoryinvestment.com/2014/11/dow-theory-special-issue-schannep-and-i.html

here:

http://www.dowtheoryinvestment.com/2014/11/dow-theory-special-issue-schannep-and-i_25.html

here:

http://www.dowtheoryinvestment.com/2014/12/dow-theory-special-issue-schannep-and-i.html

and here:

http://www.dowtheoryinvestment.com/2014/12/dow-theory-special-issue-schannep-and-i_9.html

 

The primary bear market was short-lived and on October 31, a new primary bull market was signaled, as explained here.

This primary bull market remains in force as of this writing.

Here you have a chart displaying 2014, from January 2nd (first trading day) to December 31st. The orange rectangle displays the period we were sitting on the sidelines due to the primary bear market signal.

The trend is your friend. Don't fight it!

Now let's have a look at profits, as shown in the spreadsheet:

  

	BUY AND HOLD			DOW THEORY
	SPY			SPY
Jan 2	182.92		Jan 2	182.92	entry
Dec 31	205.54		Oct 10 Primary bear mkt	190.54	exit
Proft	0.1236		Profit 1 (realized)	0.042
			Oct 31 Primar bull mkt	201.66	entry
			Dec 31	205.54	end of 2014
			Profit 2 (unrealized)	0.0192
			Nominal profit (1+2)	0.0612
			Capitalised profit	0.062
Dow Theory outpeformance		-0.0616

Please mind that the real profits made by the investors are those that I label "capitalised". This is the money you'd have made starting with 100 units, cashing out 104.2 units at the Oct 10 exit and reinvesting the 104.2 units at the second buy signal on Oct 31. As you can see the Dow Theory made 6.2%. Nonetheless, buy and hold managed to make 12.36%. 

However we should put this numbers in perspective (don’t get too carried away by “buy and hold”)

If we adjust total returns by taking into account the maximum drawdown suffered during 2014, then buy and hold begins to shine a little bit less. A proper measure of performance (that takes into account risk, losses), is to obtain the ratio of total returns versus maximum drawdown. As you will see on the spreadsheets below, when we adjust for risk, buy and hold has a more modest outperformance.

MAX Drawdown 2014 SPY buy and hold				MAX Drawdown 2014 SPY  Dow Theory
	Price	date			Price	date
Closing High	201.82	09/18/2014		Closing High	201.82	09/18/2014
Closing low	186.43	10/15/2014		Exit	190.54	10/10/2014
Max Drawdown	-0.07625607			Max Drawdown	-0.055891388

So we see that buy and hold had to endure a deeper drawdown than that of the Dow Theory (and a -7.62% drawdown is certainly a very mild drawdown according to historical standards).

Now, if we divide total performance by the largest drawdown, we obtain the risk adjusted measure of performance:

Ratio total return/Max DD for year 2014				Ratio total return/Max DD for year 2014
	buy and hold				Dow Theory
total return	12.36			total return	6.12
max DD	7.625607			max DD	5.55891
Ratio	1.620854576			Ratio	1.100935255

So, even in a very lenient year (as far maximum drawdown is concerned) when we adjust for risk, we see that buy and hold, outperformed the Dow Theory but by a smaller degree than raw performance.

And please bear in mind that the deeper the drawdown, the more degraded the risk-adjusted performance of buy and hold. I give you an example that, alas, happens every now and then in the stock market. Let’s imagine that the October 2014 drawdown had been much deeper, let’s say 15% (which is not a rare occurrence). In such case, the Dow Theory, on a risk-adjusted basis would have outperformed buy and hold.

The bottom line is: focus on avoiding risk (losses). Don’t get blinded by performance. Performance will come, once you learn to contain losses.

Thus, for those thinking that buy and hold was better than trying to time the market, please heed this: Don't get blinded with 2014 (or 2013, for that matter). Please bear in mind that in “good” years buy and hold outperforms any timing device which tries to follow the primary trend. Furthermore, as I explained in my post "How often does the Dow Theory outperform Buy and Hold", we have to bear in mind that 41.2% of any given year the Dow Theory underperforms buy and hold. The global outperformance of the Dow Theory (be it "classical" or Schannep's) is made in relatively few years (normally, when markets are weak).

You can see what I have stated many times: it is close to impossible to beat buy and hold when there is a strong trend, since by definition timing devices (such as the Dow Theory) will always get aboard too late or exit prematurely (when there is a failed signal). However, as I have said ad nauseam in past posts, the Dow Theory manages to outperform buy and hold (both in terms of performance and in terms of reduced volatility) thanks to the “bad” times. In other words, the outperformance comes from cutting losses short. Thanks to the Dow Theory we manage to win slightly less than buy and hold when the sun shines, but we lose much, much less during bad times. The overall result is slight outperformance and, more importantly, dramatically reduced drawdowns. You are referred to the “Face off” saga for more information.

Conclusion: the Dow Theory did a good job keeping us most of the year on the right side of the market. While many fundamentalists and macro analysts were predicting a stock market decline (as they did in 2013 during this most hated bull market), the Dow Theory, impervious to ego or fundamentally-based ideas, told us that the trend was up. Out of 12 months, the Dow Theory had us invested in the market 11 months and some days. I pay with pleasure the price of being some weeks out of the market (and foregoing the corresponding performance) as an insurance against a real primary bear market.

To be continued with an analyisis of gold, silver and their miners ETFs during 2014.

Sincerely,

The Dow Theorist