A new Dow Theory saga is being started
Introduction
While followers of this Dow Theory blog may be
inclined to think that I am a true believer in the Dow Theory, and hence, to
some extent blinded and unable to see its flaws (if any), truth is that I am
skeptical of everything when it comes to money. Getting rich is difficult.
Staying rich is even harder. Hence, the investor should always keep a
reasonable level of skepticism and disbelief. If I look like a true believer it
is just because after having examined almost everything in the investment
world, I find the Dow Theory to be the sturdiest investing system both aprioristically (that is, its rules make
sense rationally) and empirically
(real life proves its premises true). This does not mean, though, that I take
for granted great outperformance and reduced drawdowns when looking forward. The
road to riches is paved with obstacles (otherwise, everyone would make it). It
is very clear to me that past performance is no guarantee of future
performance, and even a +110 years track record might be deceptive after all,
if the economic environment radically changes.
The US people tend to be optimistic by nature. And
this is good as, as Napoleon Hill put it, “you
are your thoughts”. A good deal of positive thinking coupled with almost
two centuries of growth, while being spared of massive destruction (ask the
Europeans about that) have resulted in: (a) a very lenient stock market with a
sustained upward bias; (b) a too complacent and optimistic investment public. Thus
US investors tend to take for granted that 2-3% annual growth is almost
guaranteed and that no major obliteration of capital is to threaten the economy, and by implications, their portfolios.
The “buy and hold” mantra attests to this complacency and ingrained optimism
about the future: “With patience things
will turn out well after all” Ask, though, to a European fleeing his
country due to persecutions, or a Lebanese, and they will tell you that one
should be always on alert. Wealth, and the means to achieve/protect it, should never be taken for granted. Never.
The Dow Theory +110 track record is outstanding, and
it beats the pants off many alternative investment strategies. So there is no
issue about the superiority of the Dow Theory. However, the nagging thought that
corrodes me is what would happen if, suddenly, the US economy were to
experience the shocks Latin Americans, Europeans and Asians are accustomed to. Would
the Dow Theory still deliver outstanding results? Recently, I wrote about the
Chinese stock market not being as lenient to investors as the US market is. Thus, I wrote:
"[f]or those who think that the Chinese situation is not repeatable in US
stocks, I’d like to make two observations:
Firstly, the Dow Theory is basically long term oriented. This results in few
signals. Hence, we can say that for the last +115 year less than 80 signals
have occurred (much less with the classical Dow Theory). While such a
successful sample is reassuring because it spanned +115 years under very
different economic conditions, it is far from being an exhaustive sample. I’d
feel more comfortable if we had a +500 years sample with 400 signals.
Therefore, albeit I remain committed to the Dow Theory, I am aware that more
extreme scenarios are not to be ruled out. As traders say: “your worst drawdown is always ahead”.
Furthermore, please keep in mind that the US stock market has been very lenient
with investors, as for over one century the US has been the economic leader of
the world."
Would investors be protected by the Dow Theory if
during ten years in a row the economy contracted by 3% annual? Or, even deeper,
under what conditions will the Dow Theory fail to perform? Under what
circumstances the Dow Theory may result in death by a thousand cuts (that is a
long string of small losing trades)? Have we seen such an adverse environment
before? Is it likely that we find extremely challenging conditions in the
future?
These are deep questions. These are the questions any
serious investor should be asking himself. No complacency with any
investing strategy, the Dow Theory included. If we are really intend on
protecting our capital we should put our pet strategies (Dow Theory included)
under a rigorous stress-test.
This is what I hope to accomplish in the next months.
Little by little, I will examine the Dow Theory under the most challenging conditions,
namely:
·
Under
secular bear markets.
·
Under
crashes.
·
Under
abnormally weak cyclical bull markets.
- What happens if the market enters into "fibrillation" mode?
·
Likelihood
of a long string of losing trades (death from a thousand cuts).
· Estimate
of future performance, if the stock market were to embark in an extended continuous
decline (like boiling a frog) with a dramatic contraction of PER.
·
What
are the market conditions (not necessary dramatic declines) which are like kryptonite
to the Dow Theory? Are they likely to occur?
It is easy to say the Dow Theory outperformed
buy-and-hold by ca. 4% with a dramatically reduced drawdown, when on a secular
basis US stocks have had an upward bias. However, I’d like to see the very same
Dow Theory when a downward bias grips the stocks market. There are no taboos,
and hence, I don’t buy into the narrative that US stocks (and its economy) will
go forever up (well, it can go “up” Ã la
Weimar, that is during the German Weimar Republic and its resultant hyperinflation
German stocks went up, but they lost purchasing power, reflecting the ongoing capital
destruction) If history is to give me
some perspective, sooner or later (hopefully, later) the ailments that
afflicted other countries will also visit the US and in the wake of such problems
capital destruction.
It will take months to write all the posts dealing
with this issue. Each post will take time, and this is the thing I precisely lack. However, I feel the results will be
useful to all investors.
For the time being, readers of this Dow Theory blog
could start mulling over hypothetical harmful environments for the Dow Theory.
Can you picture them in your mind? How would you act?
Sincerely,
The Dow Theorist.
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