Will future secular bear markets allow the Dow Theory to outperform buy and hold? Will future secular bear markets be so obliging to the Dow Theory as past ones?
The preceding two posts of this saga (here and here) dealt with the Dow
Theory performance under secular bear markets. I concluded that I thought that
future secular bear markets would resemble past ones in that the “swings” were
going to be of sufficient magnitude so that to allow the Dow Theory to be
profitable. Today, I will explain why I believe that the future will be similar
to the past, and hence, secular bear markets will not be characterized by small
swings (i.e. not reaching 20% from top to bottom) but rather ample ones which
may include even 50% swings.
First of all, I believe in trends. Trends persist. It
has been amply documented that the market is not a random walk (study, for instance, Michael Covel's book "Trend Following"). Trends exist because there is a tendency to overreact for psychological
and fundamental reasons. Hence, trends based on fundamentals (i.e. economic
crisis) will last longer than one expects and when coupled with psychology
(bandwagon effect, etc.) there will likely be overshooting
Secondly, the very rationale for pricing stocks
warrants big swings. Basically, the price of stocks depends on two factors: The
expected earnings and the discount rate (PER). An adverse economic environment,
results in decreasing (or slowing at least) earnings. However, as a side
effect, reduced earnings result in lower PER (high capitalization rates). In
other words, people are less willing to pay for earnings. Thus, an earnings
reduction of 50% may perfectly entail at the same time a PER reduction of 50%, a double whammy. Hence, if the stocks
market was at a level of 100 with earnings at 5 units and PER at 20, an earnings
reduction of 50% may result in the following stock market price:
100
-50% earnings reduction = 50 units.
50 –
50% PER reduction (PER of 10) = 25 units.
Which amounts to a total decline of 75%. This is
precisely what happened in the 1930’s. There was a drastic decline of earnings,
which at the same time triggered a massive PER reduction.
If you think it carefully, PER reduction makes fully
sense. Less earnings means less money (wages too, as companies lay off) to be
spent in the stock market (less demand). Furthermore, hard economic conditions
increases the supply of stocks (people now in dire straits which is forced to
sell, rich people getting less dividends who have to sell to maintain their
lifestyle, etc.).
Furthermore, I feel that current and future times will
encourage extreme swings, as central banking creates bubbles which subsequently
pop (as it may be happening right now as a write these lines). Credit expansion
and contraction further exacerbates the ebb and flow of earnings and PER.
Thus, it is not outlandish to predict an S&P 500
level of just 500. A dramatic reduction of earnings by 50% would see to that,
as PER would also likely decline by 50%. However, I distrust those pundits predicting
that it will occur tomorrow. I am not interesting in fundamentally calling the
top of stocks; I have the Dow Theory to help me if such a dramatic decline à la 1930 happens again.
Thirdly, on an empirical basis (which may not
necessarily be a guide to the future, but helps), primary bear market signals
as determined by Schannep’s Dow Theory entail, on average, a further -13%
decline until a bottom is made. Since we trade, and live or die, by such
primary bear/bull market signals, the past record seems to suggest that it is likely
that the average swing (as detected by the Dow Theory) amounts to ca. 20% from
top to bottom (-13% subsequent decline after the signal + ca. 6-7% from the top
until the signal is flashed). Swings of an average magnitude of 20% are
sufficient to be profitable traded according to the Dow Theory. More about the
average decline following a primary bear market signal, with updated
spreadsheet, here.
Forthly, even if we ignore the Dow Theory, and we just
stick to a “bear market definition” consisting of a simultaneous decline of
-16% both on the S&P 500 and the Industrials (more about it, on Schannep's website "thedowtheory.com", and his must-read, master piece book, "The Dow Theory for the 21st Century"), we know that in past
instances, a subsequent -13.20% decline followed the declaration of a bear
market.
For all this reasons, I feel it is very
likely that future secular bear markets will “oscillate” with a range
sufficiently ample to be profitably traded under the Dow Theory, especially “Schannep’s",
which is very reactive.
However, in spite of all the foregoing, an astute
reader could be asking himself: All this
is nice and dandy. However, the right “overlay” for Dow Theory signals
(especially , those of Schannep) are the cyclical bull and bear markets, not
the secular ones. A secular bear market may easily “contain” several cyclical
bull and bear markets, which at the same time “contain” primary bull and bear
market Dow Theory signals. Will such cyclical bull and bear markets allow the Dow Theory to outperform, and more importantly, avoid big drawdowns?
The answer to this rather abstruse but important question
will be given in the next chapter of this saga (with a clarifying graph to be
provided). In the meantime, digest the present post, and ponder about this
vital, question.
Sincerely,
The Dow Theorist.
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