Monday, December 7, 2015

Dow Theory Special Issue: Putting the Dow Theory under stress-test (I)

A new Dow Theory saga is being started


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” à 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?

The Dow Theorist.

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