Wednesday, April 29, 2015

Dow Theory Special Issue: “Internal” confirmation embedded in the Dow Theory: Time should confirm extent and viceversa. Therein lies its force.

Moving averages, Breakout strategies, etc. are no match for the Dow Theory

No new from the markets. Primary and secondary trends unchanged. And hence, I will further cogitate about the Dow Theory. Such moments of market lull are good to rethink one’s premises.

The more I know the entrails of the Dow Theory, the more fascinated I am about it. Clearly, Charles Dow was a genius, since mere chance cannot devise such a perfect way to determine the trend. And due credit should be given to Rhea and Schannep whose work has further streamlined Dow's insights.

When Dow Theorists appraise secondary reactions (hereinafter, “secondaries”), we routinely mention the “time” (at least 10 calendar days) and “extend”(at least 3% move) requirements. We are so used to it that we don’t give it a second thought.

However, by bringing together the time and extent element, the Dow Theory has nothing to do with its two closest competitors: Moving averages and sheer momentum (be it relative or absolute measured as a percentage change).

To begin with, the extent and duration requirements used by the Dow Theory to appraise secondaries are both non parametric. And this is a very good thing.

If we want to determine the trend using a moving average, we are just using the duration (time series) element, but have no regard to the underlying extent of the move (hence false signals on week trends and multiple moving average crossovers). A moving average is blind to the previous price structure (i.e. whether there was big momentum before the crossover, weak momentum, how many days of big momentum, how many days of vanishing momentum, etc.). Furthermore, a moving average is the best example of a parametric system. Parametric systems, as I have explained here and here, are undependable and highly unstable.

Sheer momentum strategies have no regard to time element and focus blindly on the “extent” element. Thus, a stock that may have been languishing for 11 months, suddenly rockets in month 12, and suddenly ranks among, i.e. top 1 percent. However, sheer magnitude without regard to the time elements (what did the stock do in the 11 preceding months) can be misleading and prone to false signals too. Furthermore, if we demand a determined percentage change threshold (i.e. it must be up 30% in the last 12 months), we are again toying with parameters, which may backfire in real life. As an aside, my personal take, is that the best way to use momentum is as relative strength, that is, by just taking the top “x” percent of a given universe, irrespective of their individual percentage gain. By doing this, we try to get rid of parameters as much as possible, being the only “weak” parameter the ranking percentage. In a future post of this Dow Theory blog I will write about “strong” parameters (dangerous, as they are prone to “overfitting” and share all the flaw of parametric systems) and “weak” parameters (which, are less dangerous, and less prone to over fitting). To say that I will select the top 10% high relative stocks of the S&P 500 is much less dangerous than selecting the stocks that gained more than 26.58% in the last 12 months.

Lack of distinction between “safe” and “unsafe” parameters misleads many system testers. For many years, I erroneously thought that any parameter was bringing my system closer and closer to curve fitting. This is not so. Thus, even if we considered the 3% minimum extent requirement of the Dow Theory as a “parameter”, we can see that it is a very “safe” one. You can successfully apply the Dow Theory, if in instead of 3% you take 3.5%, 4% or 5% as your definition of minimum movement...You just will get less secondaries and fewer signals (and more ample initial stops) but the system will perform roughly equally well. You will stand to lose a little bit more on some (not all) losing trades, but you will be less whipsawed. This proves that the 3% requirement is not a “parameter” or, if you deem it to be, a quite harmless one. Mutatis mutandis we can say the same of the “time” extend for a secondary to be appraised.

So both momentum and moving averages have two salient flaws.

a) Tend to be quite “parametric” (the worst offender are moving averages).

b) Each ignores the complementary element which would confirm (time should confirm extent, and extent should confirm time).

The Dow theory is non parametric. The time requirement (i.e. 10 days for sec reaction) and minimum extent (3%) are just this: minimum requirements to weed out noise. Called them if you want “weak, harmless, parameters”. However, there is no preset level of what constitutes the time and extent element of a secondary reaction which is the cornerstone of the Dow Theory (as primary bull and bear market signals depend on the breakup or breakdown of the highs and lows of secondaries and hence it is vital to properly ascertain them). You can have secondaries with just 4% downward movement and 20 days formation period , or with just 10 days and a 7% decline, all combinations are possible, and hence we see the beauty of the Dow Theory that it adapts to market conditions unlike inflexible moving averages. As an aside, the Dow Theory stops (secondary reaction lows) are not set at arbitrary levels (i.e. 20 days lows) but rather correspond with market action. A 20 days lows stop can be too narrow if the market has been raging of late (or too wide, if the market underwent a huge rally), whereas the Dow Theory stop based on the lows of the secondary reaction "adapts" to recent market action. And hence it can be larger or narrower depending precisely on market action.

Therefore, the net superiority of the Dow Theory is built in into the system: We depend on two non parametric variables: time and extent. So minimum time should confirm minimum extent and viceversa….So we can find the principle of confirmation even inside the entrails of the Dow Theory. If you add “external confirmation” (the classic rule “two indices” should confirm) with the “internal” one (“time and extent” should confirm), then you have in your hands, what I think is the most reliable tool to gauge the trend and keep whipsaws to an absolute minimum.

All in all, the Dow Theory:

a) Is non parametric.
b) Relies on “internal” confirmation: Time and Extent should confirm each other.
c) Relies on “external” confirmation. Indices should confirm each other.

Now go to my post analyzing the Dow Theory performance. It should not surprise you that ca. 70% of the trades are winners (something unknown in other trend following systems) with a remarkable win to lose ratio. Something unknown in typical trend following systems (we were taught that you either have a high batting average with a poor win/lose ration, or vice versa, but you cannot have both; well the Dow Theory proves this is simple wrong).

If you further cogitate, you will start to see that the Dow Theory is also clearly superior to traditional “breakout” systems (i.e., buy if today’s close is higher than the highest high of the last 50 days). Do such breakout systems include an “extent” element? Do such systems contain a dynamic exit point adapted to previous market action (as secondary reactions are)? Or they just have dummy parametric set stoplosses? Although, this is the subject of a future post, I can loudly say that I am not a turtle, as such systems are parametric flawed, and disregard the “extent” element, and hence the scares they give to their practitioners every now and then (and huge drawdowns which very few investors have the stomach to digest)

Once this post soaks in, you’ll have your “aha” moment.


The Dow Theorist

Tuesday, April 21, 2015

Dow Theory Update for April 21: Dow Theory, Trend following, noise and non parametric systems

Nothing has changed. Primary and Secondary trends remain the same. 


Trends have not changed. So what I wrote in my last post remains valid.

So let’s take advantage of the lack of news, to ponder a bit about trends, their nature and how to make money out of them. Now we have time to get somewhat philosophical, as the markets are giving us pause.

Let’s put it bluntly: To succeed as a practitioner of the Dow Theory you have to have faith in it. There is no way around it.

However, to believe in the Dow Theory you have to believe that trends exist and that the market is not random. A good book to convince you about the existence of trends and why they exist is “Trend Following: Learn to Make Millions in Up or Down Markets” by Michael W. Covel.

The book makes a conclusive case about the nature of trends and why they work. Personally, it helped me do years ago the leap of faith necessary to forget all about fundamentals and just trust the trend. On the other hand, maybe due to my own incompetence, the book did not teach me how to make millions or how to successfully trade the trend.It just helped to be sure that trends exist and are reliable.

The bottom line of all technical-based investments is to recognize a trend, jump on it, and know when to run for the exits. As one succesul trader said in one of the Market Wizards books: "The trend is your friend until it bends in the end".

However, recognizing the trend is not an easy feat. And even more difficult is to know when it really bends and ends.

First, of all there are many trends. One day, one month…one year…Most of the publications I read talk about the trend, but they are not precise enough to tell me what kind of trend. What is to be expected? A trade lasting one day, or one year?….

Secondly, there is a crosscurrent of trends, while the primary trend may be up, there may be a correction running against the main trend and such corrections of themselves are also clearly established trends (although expected to last less than the primary trend).

Thirdly, and irrespective of the time-frame, when many trends are finally recognized (i.e. by a 200-day  MA) it is too late, and the market is ready to stage a reversal. If the reversal is just a secondary correction, then it is not the end of the word, but if it is a change in the primary trend, then you are toast.

So to succeed as trend followers we have to:

a)     Know why trends exist and why it is more likely than not that once started, a trend will tend to last. This is the “faith” element which is vital.

b)     Know what your time-frame is: Are you chasing as a day trader an intra day trend, or are you looking for longer-term  trends (one month, one year?)?.

c)     Know whether your trend recognition tool (be it a moving average, trend line, or the Dow Theory) is well aligned with the time frame in which you intent to trade or invest.

d)     Be very aware that non-parametric trend following (i.e. the Dow Theory) is much less prone to curve fitting and more dependable when looking forward than parametric trend following (i.e. moving average). More about the net superiority of non parametric Dow Theory versus parametric moving averages, here.

We also have to know that the shorter the time frame:

a)     Noise is more pervasive, hence shorter term trends are more difficult to identify and to trade (even a tougher roller coaster). I have developed one indicator that clearly shows that the shorter the time frame, the higher the noise (“noise” being the likelihood of an aborted trend, whipsaw).

b)     There is a marked tendency to mean reversion, thus making trend following more difficult.

After having toyed with trend lines, moving averages, etc. for many years, I came to the conclusion that the Dow Theory is the perfect match for the trend follower really intent on protecting capital and making money. It is sufficiently long-term to avoid the noise plaguing shorter terms, while it is not so prone to whipsaws as moving averages, and not so long term to be a “buy and hold” in disguise (i.e. if one gets obsessed with the “secular” trend, which I find misleading at best, as I have written here).

This is why, after all is said and done, the Dow Theory shines and will likely shine for a long time provided trends continue to exist, which I think they will do as it is imbedded in human nature.

The Dow Theorist

Friday, April 10, 2015

Dow Theory Update for April 10: Trends unchanged

More on Gary Antonacci

One gentle reader recommended me this interview with Gary Antonacci. I recommend it to the readers of this Dow Theory blog too.

If I were to forget all about the Dow Theory, dual momentum would be my choice without hesitation. Furthermore, one could have two different portfolios: The first one, strictly Dow Theory based, the second one, as per “dual momentum." Bear in mind, though, that “dual momentum” seems to have deeper drawdowns than the Dow Theory. On the other hand, and even though, its back-tested (not real) track record is much shorter, it seems to extract slightly more profits from the market than the Dow Theory. More about these aspects in a future post.

In the interview, he praises Jeremy Siegel  author of “Stocksfor the long run." He says that it has been proven that US stocks consistently outperform the stocks of other countries.

I agree. I have one reservation, though: Past performance is no indicative of future performance. Most analysts assume that the US will continue to be the best-performing  country as it did in the last 200 years. While I am a trend follower, and hence, if the US is “trending positive” I would never “fade it," as a foreigner, and being skeptical about easy money, I would at the very least consider the possibility that maybe one day the US is not going to be the best-performing  economy (or stock market) in the world. If this were to happen, the Dow Theory (and Dual Momentum too) would come in handy, as:

            a) Negative trends would be spotted by the Dow Theory, thus keeping us out               of  the US Stock market.

            b) Positive trends would be spotted by the Dow Theory in other stock markets (let’s say, Germany). Please bear in mind that the Dow Theory is also applicable to other markets. More about this vital aspect here.

            c) Dual Momentum would prompt us to invest in foreign stocks markets, as it has     done according to the back tests. 

As to the trends: Lull and meandering continues. No changes, and hence I refer to what I wrote in past posts.

Have a nice weekend.

The Dow Theorist.