Monday, June 29, 2015

Dow Theory Special Issue: Maximum Drawdown and average returns for the Dow Theory versus buy and hold





Trends remain unchanged.


This post is the detailed answer to one question posed by a follower of this Dow Theory blog. Hope it will serve Algyros and other readers to further a deeper understanding of the Dow Theory.

 Here is question:


"I was wondering if you had CAGR and Max DD backtested information for your flavor of the Dow Theory for a meaningful expanse of time. I hesitate to ask because I imagine that this information is somewhere in this blog, but, I've not succeeded in unearthing it."

And here is my answer:

Hi Algyros,

I am quite leery as to CAGR and such measures, as markets and future performance are not so easily tamed by past performance figures. Furthermore, the Dow Theory is a process, and hence, its practitioners should perform their own calculations. A figure such as CAGR means nothing, if the investor has not fully apprehended the intricacies of the Dow Theory. The courage to stick to the Dow Theory when there is an under performing spell, and there are many as I explained here, will come by fully internalizing the Dow Theory, not by its “dry” performance figures. Thus, rather than just looking at a CAGR figure, it is much more important to understand how fared the Dow Theory during secular bear markets, during past market crashes, and the like. Averages such as CAGR are misleading, and I feel it is more important to focus on the market traps that inevitably we’ll have to confront sooner or later. 

Having said this, I can give you the following information:



a) Here you can find a comparison of “buy and hold” versus Schannep’s Dow Theory. I created the charts and calculations using TradeStation®. You find the details enabling you to calculate CAGR in the link I have provided. Since the start capital for the simulation was USD 100 K, you can by yourself derive the CAGR made by Schannep’s Dow Theory versus the CAGR of buy and hold. Please mind that dividends have not been considered. More information as to Schannep’s out performance, in his master book “The Dow Theory for the 21st Century” and his website “thedowtheory.com”.



b) From the link I have provided, you can see that the deepest drawdown was caused by a string of three consecutive losses for a total loss of -19%. I insist you can download on Schannep’s site his Dow Theory track record so that you get the details of each signal (or you can find them in his book as well). By contrast, “buy and hold” had to endure three times drawdowns in the vicinity of -50% (in the seventies, 2000-2002 and 2008-2009)

c) Nobody knows whether the Dow Theory will encounter in the future a longer string of losing trades, thereby causing “death by a thousand cuts”. What would happen if the Dow Theory were to find six consecutive losers (something which hitherto has never occurred)? Well, knowing that (a) the average loss for Schannep’s Dow Theory is in the vicinity of -6.5% (why?: here), we could extrapolate that under a spell of very bad luck, the Dow Theory could endure a drawdown of ca. 30%-39%, which remains well below buy and hold (and furthermore, the likelihood of its ocurrence is more remote than for buy and hold, since we can see that in ca. 60 years buy and hold has declined more than 50% three times, whereas this has not happened one single time when following the Dow Theory). This is not a bad assumption. Traders say that “your worst drawdown is always ahead of you”, and, hence, in the very long run, it is likely that the hitherto made worst drawdown is going to be exceeded. Furthermore, another assumption of traders, is to just double the hitherto realized worst drawdown to estimate your worst drawdown in your career. Thus, if we take the hitherto worst drawdown of ca. -19% and double it we get -38%. Please mind, that these are just approximations. Nobody can predict the future, and we are at the mercy of the markets. However, we have reached a similar figure of the worst "likely" draw down we could encounter in the future by performing two different calculations.


d) To fully apprehend why Schannep’s Dow Theory outperforms buy and hold by ca. 4%, and, more importantly, when and why such outperformance occurs, I encourage you to read this study:



The issue of draw downs is a very important one (this is what traders refer as "risk of ruin") and it pertains to extrapolating what the future has in store for the Dow Theory. I am cogitating a future new saga of posts which would bear  roughly the following name: "Putting the Dow Theory under stress-test". The past +115 years have been, after all, very lenient for US stocks. How would the Dow Theory fare under radically adverse market conditions? I have studies of the Dow Theory performance under secular bear markets (which remains positive and with contained drawdowns), and hence we can get a foretaste of the looks of adverse market conditions. However, what I have in mind for my test is even more adverse market conditions. How would the Dow Theory perform if we were to encounter 10 years with an average decline of -7% annual? What if the economy enters a deflationary spiral of -5% p.a. with real GDP contraction of -4% p.a. during ten years? Would the Dow Theory scape unscathed (buy and hold wouldn't)? Which market conditions would result in 10 consecutive losing trades? Is the Dow Theory inherently protected against such a string of 10 consecutive losers (I feel "yes")? Why? All these are questions that hopefully I plan to write about in the future (If time allows).

Sincerely,

The Dow Theorist.

P.S. In spite of all market volatility with Greece, etc.,  primary and secondary trends remain unchanged for US Stocks, US debt, Gold, Silver, and their miners ETFs. As to Chinese stocks, they are immersed in a secondary bearish reaction against the primary trend, but have not set up yet for a primary bear market.



1 comment:

  1. Thank you very much for your thoughtful answer.

    ReplyDelete