Dow Theory Special Issue: Why drawdowns matter

And why most investors should avoid them

Some weeks ago, one reader of this Dow Theory blog alleged that the focus on “timing” the market, and hence avoiding drawdowns was not a good idea, since in the long run US stocks (or at least US stock indices) end up being winners. Furthermore, no dividends are cashed by the investor while being out of the market as a consequence of “timing”. Hence, the admonition was: Buy and hold and know that eventually stocks will recover.

If we were certain that stocks will recover (this is the “mantra”), and we knew in advance that the drawdown length lies within our financial tolerance (in other words, we don’t need to tap into these savings while stocks remain underwater) then buy and hold could be ok.

Thus, if armed with a crystal ball we had known in 2008 that the precipitous decline was going to be erased in 4-5 years, people in no need of their savings during this time frame would have been well advised to just hold and don’t panic.

However, in real life, in real time, we really don’t know whether the drawdown is going to be of short duration (or at least of a duration that does not exceed our financial staying power) or, like it happened from 1929 to the mid Fifties, a drawdown in the vicinity of 25 years, which, more likely than not, will try everybody’s patience and staying power.

I recall vividly when stocks were falling in earnest by the end of 2008. I had a business meeting unrelated with the market with an aging lawyer. He was by then 70 years old. He was devastated and panicking as his life savings were invested in the stock market. He felt that the sky was falling under and hence told me that he had just ordered his broker to sell all of his holdings in order to sit in cash. He told me he was grieved as he had endured losses in the vicinity of 60% (yeah, stocks can decline more than indices), and to add insult to injury, this was the second time in his life to be wiped out. He told me that in the early 80’s we lost all his savings in real estate investments when real estate collapsed and he had to repay debt whose value exceeded that of the real estate he owned. His humble conclusion was that he was a lawyer, and hence “clobber stick to your trade”. He bemoaned that had he been cleverer in the early 80’s with real estate and had he avoided the stock mayhem of 2008 he would be a pretty rich person. He confided that the 60% realized loss in stocks in 2008 was tantamount to postponing his retirement as a lawyer for at least another 10-13 years (that is: NEVER). By 2008 I was already very interested in the markets, and investing, so I cannot say that the experience of that unlucky lawyer prompted me to study the markets. However, his financial predicaments confirmed me that I had to deeply understand markets, anticipate big declines (“timing”) and highly respect drawdowns. I also recalled in real time that Richard Russell had clearly signaled the existence of a primary bear market by the beginning of 2008, and hence, I was not caught unawares by the dramatic declines. I even cautioned about Russell's dictum to some investment acquaintances of mine, who disdainfully brushed off any thought concerning the bear market and ridiculed Russell. Well, the final "ridicule" was for those "fundamental" arrogants.

The take away is this: in real time, by the end of 2008, the 70 years old hapless lawyer did not know:

 (a) when to get out early (the "sweet" moment was the beginning of 2008); 

 (b) that we were nearing a bottom, and 

 (c) that after 5 years stocks would be making again higher highs. 

In real time nobody knows the future, and the mantra that everything will be ok in the long run, may be proven wrong (I insist: look at the drawdown that started in 1929 or go to other countries not so lucky as the US).

Under the Dow Theory, we cannot know letters "b" and "c" above (namely, whether we are nearing a bottom, or whether the big drawdown will be recovered in a few years). Let's remember Rhea: Nobody can predict the extent and duration of primary bear markets. However, what we can know under the Dow Theory (and this is very valuable, indeed) is the right moment to get out. Sometimes, our Dow Theory exits will merely avoid small drawdowns. However, sometimes, our exits will get us out of big trouble. More about the declines following the Dow Theory primary bear market signals, here.

Hence, a temporary loss may become permanent loss. Thus all good traders know when to run for the exits.

What about Buffet and other paradigmatic buy and hold investors? Well, their situation is quite different from the average Joe’s situation for the following reasons:

1) Firstly, their investments in a given stock are so sizable that “timing” is a losing proposition. In other words, they would move the market. Furthermore, given that they must make disclosure statements, they risk making the decline of the stock even more precipitous. For big investors is not so easy to get in or to get out, and hence they cannot sell a stock “next day at the open” and forget about it. Volume matters.

2) They are owners, not traders. As Minervini in his master piece “Trade Like a Stock Market Wizard”(p. 62)  says:

 

“Valuing a company on intrinsic value is not trading stocks; it’s buying assets. Your goal is to make money consistently, not accumulate a lockbox of assets that you really don’t own -just pieces of paper that were made for trade”.

Traders are not owners; we just own a digit or a piece of paper. Owners have control, and quite often perks (board meetings, etc.), and insider knowledge. We, traders, lack all of this. An owner should behave like an owner, that is accompanying the enterprise, selecting and controlling competent management, etc. Furthermore, owners quite often manage to derive extra benefits like providing incompetent relatives with cushy jobs, etc. We, as traders, given our minuscule commitment, don’t have any power, and the only compensation for our lack of power, is the ease of getting in and out. To each his own.  

Furthermore, as evidenced by this post, with proper timing (here the Dow Theory comes in handy) the investor can sport positive returns when the market is declining (see my studies concerning the Dow Theory outperformance during secular bear markets).

3) “Big investors” have huge staying power. The average trader does not. If Mr. Buffet’s holdings declined by 60% he would remain a billionaire. Furthermore, even a measly 0.5% dividend amounts to many million dollars, and hence, there is no need to tap into savings in order to keep up with daily expenditures. There is no comparison between the average saver and big, really big investors. Once again: To each his own. If I were Buffet, I’d be interested in ensuring that my companies perform well, and wouldn’t give a hoot about the Dow Theory, since it would be a distraction, and diminish my focus on the important thing: Being a company owner. Of course, the buy and hold crowd will vociferously say: “Buffet started small, and his ability to build a fortune from ground zero attests to the bounties of buy and hold. He’d never have achieved that by being a market timer”

My retort is as follows: First of all, many market timers find it terribly boring buy and hold. I don’t want to say that we crave for excitement (which is a bad thing in investing), but, certainly, God has not endowed us all with the same talents and inclinations. What works for Buffet does not work for the large majority of the population. Of course, the same applies to “timing”, since not all people are cut out for it. However, as Schwager’s “Market Wizards” saga makes clear, there are lots of market timers which have managed to amass some billions. Thus, it seems that market timing is no hindrance to grow a small stake into something bigger.

4) Personally, I feel that Mr. Buffet and the buy and hold crowd has had exceptionally good tailwind during the past decades, Thus, drawdowns have been never "life threatening" (at least for investors with a +20 years time horizon). Things can change, though. Buffet is fond of saying that he believes that US will continue to remain exceptional and hence continue to be a profitable investment for long term investors. As a foreigner, I deeply admire the US, its drive, ingenuity and reward for talent (albeit the clouds of envy and resentment begin to gather on the horizon in a manner that begins to resemble old Europe). I wish the USA “of olde” would remain forever. However, truth is that nobody knows the future and making an optimistic bet on the future of the USA is betting on “fundamentals”, and the skeptical “technical” dog that dwells in me tells me that this is a dangerous proposal. Hence, I personally hope that the US will remain a free market economy, and, if possible, become even a “freer” economy. However, if the US is to remain the beacon of free markets, I know that the charts will tell me so, as stocks will continue to go up. Why do I need to jump the gun and make a “fundamental” leap of faith? The Dow Theory will see to it.

Sincerely,

The Dow Theorist