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

When most ruled-based trading ceases to work, the Dow Theory continues to perform

In this post of my stress-test saga, I made clear that we are currently living a real “stress-test”. Current market conditions are not the best for the Dow Theory. Narrow ranges of less than 15% are detrimental (but not lethal) to the Dow Theory. Further declines following a primary bear market signal are of very modest proportions, and further advances following a primary bull market signal tend to be rapidly aborted. As I will explain in depth in a future post of this "saga", the very source of performance (further advance following a bull market signal) and outperformance versus buy and hold (further declines following a bear market signal) has been stopped in its tracks.

Dave Moenning, whose work I hold in high regard, of “The State of The Markets” has recently penned two very interesting articles (here and here) depicting “Why Many Tactical Trading Strategies Aren’t Working”. Moening questions himself:

“[t]here can be little argument that a great many tactical managers/strategies have struggled (sometimes mightily) since the credit crisis ended in 2009. Disciplined investing strategies designed to make hay while the sun shines AND when the market declines, which were all the rage after the S&P 500 was nearly cut in half for the second time in 9 years, have failed to impress since. Tried and true indicators possessing strong returns for decades have suddenly stopped working. The question, of course, is why?”

Moenning goes on to explain that one several powerful indicators, namely “the trend and breath confirmation model”, "the price thrust indicator", "the breadth thrust indicator" has passed from strongly outperforming buy and hold to fail miserably from 2009. Some indicators have resulted in losses whereas others, more fortunate, have remain positive but lagging buy and hold.

Moenning will give next week his opinion as to the "why". Let's stay tuned, as he's is a sharp analyst.

Here is my own explanation: From 2009 there has been a clear uptrend. However, this trend has been detrimental to trend following for three reasons:  

First, absence of big declines (yes: big, sustained, and clean declines, is the source of outperformance for trend following versus buy and hold).

Secondly, noisy advances. By "noisy" I mean, many failed breakouts. Eventually, the trend ekes out higher. However, it takes many false attempts to finally catch the succesful breakup. In the meantime many trend-following systems (not the Dow Theory) accumulate a string of losing trades.

Thirdly, when finally there is a succesful breakout, and even a winning trade, the advance following the breakout has little follow through, and soon after the breakup, the markets tanks. Not very much, but enough to trigger exits for most trend followers.

Hence, many trend followers are losing big, and hence many hedge funds are really suffering. Breakouts and breakdowns fail. Follow through is absent. The lack of follow through results in an inordinate number of (mostly) false signals, which of course are decimating investors (death by one thousand cuts). Curiously enough, mean reversion is having a field day. The same applies to buy and hold, were dips prove to be temporary and shallow. If you are patient enough (buy and hold) eventually a timid uptrend (in spite of false breakouts) will appear on the charts, and money will be made.

Many argue rightly, but with a dose of hope, that the current market environment is not the rule but the exception thereto. Others say that the market’s behavior has changed due to QE. My personal idea (which may be wrong) is that eventually big declines and big advances (“clean” trends, deprived of whipsaws) will come back again. However, personal ideas and hopes may be wrong. I don’t want to place my hopes of future performance on any preconceived idea (namely, “let’s hope that markets will trend without false breakouts soon).

Since Moenning complains that the advances seen since 2009 have been treacherous to ruled-based investors (especially those who are trend followers), I will show you how the Dow Theory has fared since 2009.

I take as the starting point March 9^th, 2009 (the primary bear market lows). At that point the S&P 500 was at 676.53 points. On March 23^rd, 2009, when the Dow Theory was signaled a primary bull market, the S&P 500 was at 822.92 points. I have tabulated all the up and down swings, further advances and declines following bull/bear market signals, and, of course, the outcome of every Dow Theory trade taken since. To compare “apples” to “apples” we finish our study on June 27^th, 2016 (S&P 500 at 2000.54), date of the lows of the last completed primary bear market. We started at a primary bear market low (3/9/2009) and finish at another low (6/27/2016). As to the current open Dow Theory trade that started on August 11, 2016, we still don’t know when it is going to finish (next bear market signal) and when the subsequent bear market low will be made.

Here you have the chart:

US market since March 2009 to June 2016: Under challenging conditions the Dow Theory is far from losing money

 

You can see that the Dow Theory has underperformed buy and hold. We start with 100 units. Buy and hold managed to make 195% (final level 295), whereas the Dow Theory managed to make 122% (final level 222). However, the underperformance is certainly not killing us. Returns remain firmly positive, and, if you look at the chart, it has been a quite smooth ride. If we added dividends, and given that the Dow Theory, has been roughly 1/3 of the time out of the market (missing ca. 1/3 of the dividends paid out), buy and hold would have slightly bettered it results.

Thus, the Dow Theory has fared much better than most rule-based systems. If under such a stressful environment for trend following, the Dow Theory has hold its line, and it is far from “self-destructing” as many trading models are currently doing. It is quite likely that it will do in the future. There are two key features that see to it: Firstly, double confirmation (time and extent and two indices). Secondly, unlike most rule-based trend following, it is not parametric. As I wrote here:

If we want to determine the trend using a moving average, we are just using the duration (time series) element, but have no regard to the underlying extent of the move (hence false signals on weak trends and multiple moving average crossovers). A moving average is blind to the previous price structure (i.e. whether there was big momentum before the crossover, weak momentum, how many days of big momentum, how many days of vanishing momentum, etc.). Furthermore, a moving average is the best example of a parametric system. Parametric systems, as I have explained here and here, are undependable and highly unstable.

Sheer momentum strategies have no regard to time element and focus blindly on the “extent” element. Thus, a stock that may have been languishing for 11 months, suddenly rockets in month 12, and suddenly ranks among, i.e. top 1 percent. However, sheer magnitude without regard to the time elements (what did the stock do in the 11 preceding months) can be misleading and prone to false signals too

 

 In a future post of this saga, I will explain why even under more stressful and hitherto unseen scenarios the Dow Theory is likely to perform well.

Hence, I don’t want to “hope” that the current market condition is likely to end sometime soon. I am agnostic as to the causes (QE?, HFT?) of this weird behavior, and how long will it last. I prefer to have deep knowledge of the Dow Theory and its hard and fast figures that prove me that the Dow Theory is a real 4-wheeler: Likely to survive and even perform reasonably well under a variety of market conditions.

If we went back soon to a market with deeper declines and sustained breakups, Dow Theorists would be happy (out performance); however, if we continued like now, it is comforting to know that we are far from nearing ruin.

Sincerely,

The Dow Theorist