Dow Theory Special Issue: Putting the Dow Theory under Stress-Test (II)

Performance under secular bear markets

On December 7^th, 2015 I started what is going to be a new “saga”. Its aim is to put the Dow Theory under a “stress-test”. We will try to think out of the box and imagine adverse scenarios which hitherto have not occurred yet. How would the Dow Theory perform under turbulent and uncharted waters? More about the reasons and premises underlying the present study, here.

There are many market environments which we could label as “adverse”. Of course, “adverse” environments, are also detrimental for “buy and hold” or any other trend following method (moving averages, breakout systems, etc.). Let’s be frank, the best environment for us all is a rising market. If stocks go up, all investing strategies will fare well, even buy and hold.

There are many “adverse” environments: sudden crashes, secular bear markets, weak bull markets prone to failure and reversals, dried up liquidity, etc.

In this post, we will focus on secular bear markets.

A secular bear market is a long period of time (i.e. 10 years) where the stock market goes nowhere (or even with a downward bias). Sharp declines (real bear markets, not just pullbacks) are punctuated by bull markets but, overall, the market is unable to make any meaningful gains. More about the concept of “secular” bull/bear markets, here. 

A secular bear market is clearly “headwind” for stocks. It is like a huge gravitational force which prevents stocks from gaining ground. Accordingly, buy and hold suffers.

I am not going to reinvent the wheel. In 2013 I analyzed in depth the performance of the Dow Theory under secular bear markets, as was explained here. Hence this post will borrow heavily from the studies I performed in the past. My 2013 study of performance under secular bear markets was a comparison between Schannep’s and the Rhea/classical Dow Theory. As you may expect both “flavors” suffer under secular bear market conditions. However, “suffer” is not tantamount to “losing”, as both flavors managed in the past to post positive results under secular bear markets, and outperformed buy and hold (both in absolute returns and risk-adjusted).

For the remainder of this post (and futures ones of this “saga”), I will exclusively focus on Schannep’s Dow Theory, which is the “flavor” I use in real life (and for good reason, since it outperforms the classical/Rhea Dow Theory).

While defining “secular” bull and bear markets is subjective, I have tabulated the following periods:

From 1954 to 1967: SECULAR BULL

From 1968 to 1981: SECULAR BEAR

From 1982 to 2000: SECULAR BULL

From Mid 2000 to 2013?: SECULAR BEAR.

During secular bear markets, Schannep’s Dow Theory managed to make an average of +5.46% on each trade taken. So, on an overall basis, the Dow Theory made money even when stock indices remain flat at best. We may hope that in the future the Dow Theory will manage to extract some profits out of the market even when there is no meaningful long term movement, and when every now and then huge drawdowns hit the investors. 

Of course, averages are misleading; we should study losing trades under secular bear markets. An average gain of +5.46% per trade, means nothing if the investor has to endure a -40% drawdown in between. Well, the average losing trade amounted to -6.48%. Hence, on average, losses were well contained, and did not endanger capital integrity.

Furthermore, we should focus on the largest losing trades. An average loss of -6.48% may not be indicative of the real dangers besieging the investor. The largest loss endured by Schannep’s Dow Theory during secular bear markets amounted to just -10.45% (Jan 30, 2009). Please mind the date: The Dow Theory largest loss coincided with one of the most vicious bear markets. A largest loss of -10.45% is still bearable, and can be quite easily recovered.

Let’s take a look at the second largest loss. It amounted to -8.33% (Jan 26, 1970). As we can see losses are bearable, and have nothing to do with the drawdowns underwent by buy and hold.

Therefore, if we are to judge the performance of the Dow Theory according to past secular bear markets, we can tentatively conclude that it remains profitable, whereas losses were kept at bay. This is good news, as past secular bear markets where not lenient in the least to buy and hold investors.

However, I feel that past secular bear markets were to some extent favorable to the Dow Theory. Let me elaborate: As I wrote here, the Dow Theory outperforms buy and hold when markets decline (by cutting losses short).

Hence, secular bear markets characterized by deep declines, and subsequent recoveries, are not necessarily “bad” to the Dow Theory. We know that Schannep’s Dow Theory tends to exit at a close distance from the top, at ca. -6%. If during a secular bear market (as we saw in the 1970’s and 2000’s), we experienced two big bear markets in the vicinity of -50%, this would be “good news” for the Dow Theory, as we would exit roughly at -6% from the top, and the market has still a lot to decline. If after the -50% decline (as in 1974, 2009), the market rebounds (even modestly), the Dow Theory stands to make good money.

Let’s imaging a decline of -50%. The Dow Theory manages to exit at just -6% from the top. After such an exit, the market further declines for a total loss of -50%, Following the market bottom, a weak bull market of +35% sets in (which, hence fails to even match the last recorded high). While such a market action is disastrous for buy and hold, for the Dow Theory this is a great environment, as 100 units would become:

100 minus 6% (exit signal, primary bear market) = 94 units left to the investor.

Normally, the Dow Theory flashes its buy signals (primary bull market) at ca. +6% from the bottom, hence a +35% recovery might entail ca. +23% “extractable” profits from the rally (35% total advance from bottom to top, minus ca. 6% “lost” in the entry, minus ca. 6% “lost” in the exit) . Hence we have:

94 units x 1.29 (+35% rally minus 6% “lost” as the entry was 6% “late”) = 121.26 units paper profit

121.26 units minus 6% (exit signal, new primary bear market) = 113.98 units, that is +13.98% profit, whereas buy and hold would have lost:

100 units -50% = 50 units left to the investor.

50 units + 35% recovery = 67.5 units, 

67.5 units minus subsequent -6% decline = 67.5 x 0.94 = 63.45 units, hence a -36.55% loss from the first top.

 

Please find below graph displaying the core idea:

Secular bear market action with downward bias. The Dow Theory manages to remain positive.

 

Hence, the Dow Theory is able to make money in an ever declining market provided the reentry price remains below the exit price (something which tends to occur on most of the trades taken in pursuance of the Dow Theory).

The only requirement is that stocks should further decline (which they almost always do) after the primary bear market (sell) signal, and the next buy signal (primary bull market) should be signaled close enough from the bottom (let’s say 5~7%) so that one “rebuys” stocks at a lower price than previously sold.

Since we know that we tend to exit at ca. -5~-7% from the top and re-entry at ca. +5~7% from the bottom, we infer that in most instances a bear market swing from top to bottom exceeding ca. 10~14% will be ample enough to avoid losses. Any such a swing will result in profits, whereas swings not exceeding this threshold will be losers (albeit very small ones). More about “fibrillation” (when the stock indices remain for a long time caught in a narrow range displaying false signals in a future post of this saga).

Past secular bear markets underwent bear market swings of enough magnitude so that the Dow Theory (even the classical one, which normally enters and exits trades not so close from the bottom/top, as Schannep’s) managed to be profitable. Rollercoasters are not necessarily bad for the Dow Theory, just those of modest percentage swings.

I feel it is likely that future secular bear markets will witness ample swings, as those seen in the past, and not just “fibrillation swings”. In other words, I think that future secular bear markets will, to some extent, resemble the “swing pattern” of past instances, and, hence will allow the Dow Theory to deliver positive results. Why am I of this opinion? The answer will be given in the next post of this saga when I discuss “fibrillation”.

Until then you have material to cogitate.

Sincerely,

The Dow Theorist