Which is a better timing system?
The post you are going to read was overdue, as it is vital for any trend follower. I could finally find some time to put some ideas together.
It is well known that moving
averages (hereinafter, “MA”) are used by investors to help “timing” the
markets. So, as with other systems (breakups, etc.) MA share similarities with
the Dow Theory, as we all are involved in the business of avoiding drawdowns
when the trend turns really negative, and hopefully, over time, try to
outperform buy and hold.
What prompted me to write this
post was an email that some time ago sent me renowned Dow Theorist Schannep, of
“thedowtheory.com”. Schannep’s email contained a valuable piece of research
concerning MA. You can find the study about MA, here.
The MA study was based on
applying to the S&P 500 the following rules:
1. Buy the S&P 500 every
time it crosses above and closes above its 10-month exponential moving average
(EMA) on a monthly view.
2. Also, buy the S&P 500
every time its monthly relative strength index (RSI) crosses upwards through
the 30 level.
3. Sell the S&P 500 every
time it closes on an end-of-month basis below its 10-month EMA, and reinvest
the proceeds in 3-month T-Bills.
So, we are comparing apples to
apples, as the studies I have conducted in this Dow Theory blog have been based
on the same index as the MA study, namely the S&P 500.
What follows are the
observations I wrote to Schannep. Read them carefully, as you will gain many insights as to the net superiority of the Dow
Theory over MA. Market analysts tend to lump together the Dow Theory
with other “timing” techniques; however, while similar in objectives, the
Dow Theory has no match.
So here you have my written
observations, with very slight editing in order to make them more
comprehensible to my readers:
Thx for forwarding me this piece of research. I do appreciate it, and I
encourage you to send me more info you may deem interesting in the future.
My two cents, which might be of your interest:
I am not quite fond of using RSI in order to assess the long-term trend
(i.e. the cyclical bull and bear markets spotted by the Dow Theory). We
shouldn’t forget RSI is not a trend detector but an oscillator. In any
instance, the author fails to mention the period used for calculation of his RSI
(14 months? As the default setting in charting software is 14??). I found great
use for RSI indicators for short-term trading, but this is another story…
The RSI “rule” is a poor substitute of your capitulation indicator. I find
much more solid yours.
If a moving average does a decent work, I am leery as to adding an
additional rule like RSI. It looks great in back tests, but we are adding one
degree of freedom, which makes this rule less likely to be so effective in the
future when it comes to spotting long term bottoms.
Clearly, timing reduces risk (the standard deviation of returns). Ditto for the Dow Theory.
As you and I
well know most of the years “buy and hold” outperforms timing systems, whereas timing
systems underperform. While you and I understand the nature of such an “underformance”,
most investors would not stick to the timing system when in a good year, the
S&P clearly outperforms the timing system. The great problem for the
average investor is not of skills but of psychology.
When it comes to the specific figures, the MA system is no match for the
Dow Theory. It should convince us both (even more, since we are
“true believers”) of the hidden treasure contained in the Dow Theory:
The MA system trades last significantly less than those taken in accordance
to the Dow Theory, be it the “classical” or yours. Remember that in an
almost identical time period (from 1871 to 2012), the classical Dow Theory only resulted in 38 transactions versus 113 for the moving
average (MA) system.
In real life, we should factor in at least 0.5% percent slippage and
commissions per round trade. The less trades, the better. Thus, in real
life, with so many trades, performance would be impacted to a larger extent in
the MA system.
Furthermore, in many countries, the holding period that separates tax
exempt capital gains (or reduced tax rate) and fully taxed gains is 1 year. For
a taxable account, the longer the average transaction the better. The Dow
Theory tends to fetch long-term capital gains and when losing tends to be
shorter term (which is good). The MA system would be not as tax friendly as the
Dow Theory in many Western countries, and in real life.
Again, we see the beauty of the Dow Theory: Much larger outperformance (ca.
+2%) with fewer trades and less slippage and commission.
The MA system was in the market ca. 75% of the time; the Dow Theory only
2/3 or 66% of the time. With less time the Dow Theory manages to extract
more profits from the market.
The worst trade (greatest loss) for the MA system was a daunting -35.6%
which is much larger than according to the Dow theory (of any “flavor”
whatsoever). As I posted here, the greatest loss for the classical Dow Theory
was -19.33% in 2008. If we follow Schannep’s Dow Theory, the largest loss was a mere
-10.45% The average loser is very similar (ca. -6%). Don't forget that
drawdowns kill the investor both financially and psychologically in real life.
The Dow Theory does a remarkable better job at containing the worst case
Only 47.8% are winners in the MA system, versus ca. 76% in the Dow Theory. This says a lot as to the
accuracy of the signals and the ability to spot real breakouts and not
return: Again, it pales by comparison with the Dow Theory. Two worlds apart.
All in all,
I get the feeling of riding a Porsche Cayenne with the Dow Theory versus a Mazda with the MA system.
However, a Mazda is better than a bike. Your Dow Theory "flavor" is
like the 4WD Porche Cayenne and with turbo 6 cylinders.
While the MA
system is an improvement over naïve buy and hold, it certainly is years light
apart from the Dow Theory.
everything comes at a price. It is much easier to program a MA system and
disconnect your brains, than applying the Dow Theory, which ultimately is
subject to human judgment and takes years to apprehend it (at least this was my
case, and I still learn new facets every day). So psychologically, for many
investors, the MA system may be easier to accept and understand than the Dow
What follows are some observations not included
in my email, which I would like to add:
I agree with the study which
used monthly bars in order to avoid the noise inherent with the use of daily bars,
and the whipsaws resulting therefrom (false signals quickly reversed by the
daily movement). However, the use of monthly or even weekly bars when using MA
has a drawback: Even though they may have performed well in back tests,
forward-looking losses could be scary if the market plunges by, i.e., 20% in a couple
of days. MA based on monthly or weekly bars, may signal the exit too late.
On the other hand, the Dow
Theory is applied on daily bars, but it is based on patterns, not on one bar
arbitrarily crossing a parametric MA. The close of one daily bar crossing a MA
is just noise. However, under the Dow Theory, one bar is not noise, as it integrates
within the pattern it helps to form. However, while not prone to “daily noise”,
the Dow Theory allows me to react on a daily basis (Dow Theory signals).
Traders say that your worst drawdown lays ahead in your career. When looking
forward I feel more confident about loss containment when using the Dow Theory:
I get the best of the two worlds: I can get signals on a daily basis (which
helped us in the past to avoid crashes like the one of 1929 or 1987, as
explained here), whereas, unlike
with MA, it is not so easy to be blinded by daily noise. Thus, Dow Theorists
get their bull and sell signals (which happens seldom, as well as with long
term MA, Rate of Change, etc. when applied on monthly charts) on a daily basis
before catastrophic losses occur.
Finally, we should remember
that the Dow Theory does not have a parametric nature. MAs rely on parameters. What
has worked in the past (i.e. a 200-day MA),
may not work in different market environments. On the other hand, the non
parametric nature of the Dow Theory makes it more likely to perform well under
a variety of market environments. While nothing is certain when it comes to investing,
the Dow Theory is likely to be more stable and to perform well (and
avoid drawdowns) in the future than MAs. More about the importance of non
parametric systems, here. The parametric issue is vital, and serious investors should cogitate (and look for resources on the web) about it.
Have a nice weekend.
The Dow Theory