Dow Theory Special Issue: Does it make sense to short with the Dow Theory?

Primary and Secondary Trends unchanged

This post is my answer to Algyros, a faithful follower of this blog.

Basically, he asked about shorting with the Dow Theory. Does it make sense?

My first answer read as follows (link to it here):

I’d summarize my opinion concerning shorting as follows:

• Primary bear markets last less than primary bull markets.
• Primary bear markets decline percentage wise less than bull markets.
• Hence, the amount likely to be made is lower than in primary bull markets, whereas the potential loss is higher (market reversal).
• Furthermore, shorting costs money: dividends have to be paid, and most brokers charge expensive shorting fees, which grow higher the longer the trade (it is like paying interest on the amount shorted).
• Shorting forces you to use a margin account. This is not the most suitable account for a long-term investor concerned with safety because it also implies that, when being long, shares can be loaned out.
• Thus, I don’t favor a short position along the primary bear market.

For those who know very well what they do, short term shorting along a primary bear market (and even in a primary bull market at very sweet spots with selected equities) may be OK. However, such shorts:

• Try to exploit bearish secondary reactions (optimally within a primary bear market).
• Last a few days.
• Only short when an excellent risk reward ratio is present.

And don’t forget that the longer your time frame, the less likely your shorts are going to perform well.

Furthermore, given that we know that the average further decline following the primary bear market signal averages ca. -12.5% and given that we know that we lose on average ca. 7% getting in and out of a position (ca. 14-15% total), we can see that "on average" bear market swings lack enough magnitude to be profitable.

As a follow up to my answer, Algyros posted in Seeking Alpha an additional comment/question:

The answer, persuasive as it is, still leaves me wondering. If, indeed, on average, shorting the market during a Dow Theory sell signal, is not profitable, then, does it not follow that, on average, Dow Theory calls are no more profitable than a buy and hold strategy?

Of course, a strategy may be as profitable as another one, yet still be more desirable because it is subjected to smaller drawdowns. Is that, in your view, the advantage of Dow Theory?

As always, I am grateful for your generosity.

Well this post is an answer to Algyros hoping to dispel all doubts concerning shorting with the Dow Theory.

I am very roughly speaking but I hope my readers get the idea.

The US stock market has roughly gained (dividends excluded) ca. 8% p.a. since 1940 (here you can find annual returns):

http://www.moneychimp.com/features/market_cagr.htm

Eight per cent p.a. is a clear upward bias. When shorting you have to fight against prices rising on average 8% p.a.

Schannep’s Dow Theory has managed (on the long side) to add ca. 4% to the average 8% annual gain, while reducing dramatically drawdowns. This is the “improvement” of Schannep’s Dow Theory versus buy and hold.

Let’s flip sides and go to the sort side.

A “short and hold” shorting strategy would be losing ca. 8% p.a. (and please include dividends, commissions for shorting, etc.). Let’s assume that the Dow Theory, when using its signals to short, manages to also “create” 4% p.a. (as it does on the “long side”).

However, given that we are facing headwind (the 8% p.a. upward bias), we could expect to make when shorting:

-4% (from the Dow Theory shorting) + 8% (upward bias) = +4% p.a.

Please mind that a positive number when shorting means losing money. When shorting you are likely to lose on average 4% p.a. (plus dividends you have to pay, shorting fees, etc.), which may well represent a real loss of 6-7% p.a. (“short and hold” would be losing something in the vicinity of -10% if we take into account dividends too)

The Dow Theory adds value: ca. 4% outperformance and drastic drawdown reduction. However, 4% "added value" is not enough when shorting to outweigh an upward 8% p.a. bias.

Of course, nobody knows the future. If stocks were going to deliver ca. 8% p.a. in the future, then shorting would not be advisable. Even under conditions of modest growth (something which by the way is expected for the next 20 years) of just 4% p.a. shorting would at best break even. If stocks were to have zero growth for the next years, then it’d be likely (although not guaranteed) that shorting according to the Dow Theory could deliver modest, albeit positive results (depending on the dividend payout).

Armed with this knowledge, we can also guestimate what we can expect of the Dow Theory (long side) under negative market conditions. The Dow Theory does not float in a vacuum. It is sensitive to the vagaries of the stock market. If there is an upward bias, it will capitalize on it (by hopefully adding +4% p.a. on average and reducing drawdowns) to the average annual return. If markets remain flat, then we should expect to make just ca. 4% p.a. (and cash some dividends during the time we are invested). More about what to expect (on the long side) of the Dow Theory on the next 20 years here.

 If stocks were to decline -4% p.a. during the next decade or so, then the long side of the Dow Theory would be likely to just break even (-4% +4% outperformance = 0). In such a case, shorting with the Dow Theory might add some value (0 -4% outperformance short) = -4% (a negative number is a positive return when shorting). However, in real life, when we account for dividends, short fees, etc. real profits would be much smaller. 

Personally, I see shorting for short term trades under very specific circumstances and very specific stocks. Thus, I can short certain stocks as a very short term trade when the Dow Theory is bearish. However, my personal use of shorts, rather to add value to my trading merely serve to smooth performance. In other words, at best I just make marginal profits with my selected short term shorts. However, such shorts tend to do well when my longs fail to perform (i.e. under severe market declines) or when I have no longs because my filters tell me to eschew longs.

Sincerely,

The Dow Theorist