Applying the Dow Theory to oil markets and towards building a Dow Theory portfolio
Hamilton was Charles Dow understudy, and writer of the
book “The Stock Market Barometer”
As I have written here, Hamilton was of the opinion
that the Dow Theory may be applied to other markets. Based on that insight,
when I started this blog, I wanted to apply the Dow Theory to precious metals,
interest rates, and occasionally, even to Chinese stocks.
As I wrote in my previous post, from eyeballing the
charts I know that my applying the Dow Theory to the pairs SLV/GLD and SIL/GDX has outperformed buy and hold since August
2012 while dramatically reducing drawdowns (when I started the blog). In
order to draw final conclusions, I have to wait, though, until the current
swing for those markets makes their final lows. As readers of this blog know,
in order to properly compare the Dow Theory and buy and hold performance, we
need to wait until the final lows of the primary bear market are made (the further decline following the primary bear market signal). However, we don’t
know the final lows until the next primary bull market signal is given. Hence,
I still have to wait some months to give final figures.
Therefore, while I wait the final figures of
outperformance for precious metals whose trades have been publicly made known
on this blog in real time, I decided to apply the Dow Theory to the energy
sector. My premise was as follows. Oil stocks should more or less move in
tandem with their underlying commodity. If oil is weak, oil stocks should, more
or less, be weak too. Hence, I took USO (crude oil) and XLE (oil stocks) ETFs.
While maybe not the best pair to apply the Dow Theory, I did it as per the
following rules:
·
At
least 15 trading days on both indices in order to declare a secondary reaction.
·
At
least 1/3 minimum retracement, save when it has been a very long secondary
reaction (i.e. 50 days, etc.) and retracement for both indices nears 1/3.
·
At
least two days pullback/rally after the secondary reaction to setup the ETFs
for a primary bull or bear market signal.
·
Both
the secondary reaction and the subsequent pullback/rally must exceed the
minimum movement (volatility adjusted). Hence, negligible movements, even if
the satisfy the time requirement, do not qualify.
·
Both
for buy and hold and the Dow Theory I divided the hypothetical trading capital
by two. One half for USO and the other half for XLE.
·
I
calculated the results and drawdowns in two different ways: One way, by only
going long and being in “cash” (out of the market) when there was a sell
signal. The other way, by going short when a sell signal was given, and
covering and going long when a buy signal was given.
As you can see, I applied a “classical” Dow Theory flavor. I didn’t apply Schannep’s, as I just had two indices.
First off, I’ll analyze the results by just taking
long trades and being out of the market when a sell signal is given. In another
post, I will discuss results (truly good, by the way) when shorted when a sell
signal was given.
The test spans from 08/05/2009 (first long taken) to
08/11/2018 (last long closed). Since 08/11/2018, the Dow Theory did not signal
any new long position.
Here you have the highlights:
·
Total long trades taken: six. Since the test spans ca. 10 years, we have a
“typical” classical Dow Theory duration for the average trade, which is more
than one year.
·
Maximum drawdown buy and hold: -64.33%
·
Maximum drawdown Dow Theory (closed trades): -17.95%
· Final capital buy and hold (starting at 100): 90.93. Hence buy and hold lost for
an allocation of 50% to each ETF ca. 9.1%
· Final capital Dow Theory (starting at 100): 105.28, which translates to an outperformance
versus buy and hold of ca. 1.5% p.a. (annualized). Please mind that the
negative “gravitational” force against long positions has been very strong
during the period tested, as there was a maximum decline of -64.33%. Confronted
with such a bearish force, the Dow Theory managed to remain positive by going
long. This is a huge accomplishment.
· Hence,
the Dow Theory reduced the maximum
drawdown by 72.08% when comparing the drawdown of buy and hold to that of the Dow Theory. This dramatic drawdown reduction confirms what I have
repeatedly asserted: The main source of the Dow Theory outperformance is
loss avoidance. Hence, when markets (as US stock indices in the last 10
years) lack significant drawdowns, the Dow Theory will surely underperform.
However, “underperform” does not entail “losing”, just winning less.
· Therefore,
Hamilton seems to be right. While I
want to perform more tests to extraneous markets, it seems that the Dow Theory
may be successfully applied to other markets.
Here you have the breakdown of the trades taken and other interesting data:
Trades taken by applying the Dow Theory to oil ETF (USO) and oil stocks ETF (XLE) |
This exercise has been useful, as I have always
thought that US stocks have behaved too nicely for the last 120 years. By
“nicely” I mean that there have been few drawdowns and their depth was quite
mitigated. By “nicely” I also mean that even in those rare occurrences of big
drawdowns (i.e. 1932, 1974, 2000-2002, 2008-2009, and to some extent October
1987) the Dow Theory was “nice” enough to signal a bear market before the
really big declines occurred. As I wrote here, there is no guarantee
that the Dow Theory (or for that matter any trend following method) can get us
out in time when markets become unruly, as Chinese stocks behaved in August
2015 (see here and here, if you want to see scary market action even when applying the Dow Theory). Hence, it is a good exercise to apply the Dow Theory to many markets, and
especially markets that have experienced deep declines before a primary bear
market signal was signalled. What if 2008 had not been preceded by a relatively
soft decline at first (secondary reaction) followed by a rally (setup for
primary bear market completed), and would have declined overnight by more than
30% with no prior warning? When one applies the Dow Theory to precious metals,
oil markets (as with this post), wheat/corn, etc., one can experience first-hand
much more unruly markets. What if one day US stocks behaved like that?
Are Dow Theorists and trend followers in general prepared to weather such a
storm? Personally, I don’t like to fake reality and say, “well this will probably never happen to US stocks, after all the Fed will
take care of an orderly decline” or say something like this “the US is different, such drastic declines
are unheard of”. In markets
everything is possible. It is your capital (or your client’s) what is
at stake and I just don’t want to hope for the best. I must mentally rehearse
worse scenarios ahead than those previously seen. Maybe I am paranoid, but the
best offence is good defence. Drawdown reduction is key to long term investment
survival.
I just see two
ways to play defence against markets that get “unruly” and experience drastic
declines before a primary bear market signal is given.
The first line
of defense is to diversify across time frames. This idea is not new but it is worth repeating: We can trade
the very same markets with alternative definitions of secondary reactions.
Hence, we can split our trading capital between two different ways of applying
the Dow Theory. For instance, one demanding strictly 3 weeks confirmed and 1/3
retracement and performing volatility adjustments so that there is a minimum
movement; and other one, just requiring 10 or 8 days for a secondary reaction
to exist and giving away the 1/3 requirement (as does Schannep) and being less
strict with the minimum volatility adjusted movement. By splitting the capital
between two alternative ways of applying the Dow Theory (one more reactive,
with smaller losing trades, but with a lower profit factor, and the other one
less reactive, with better long term profit factor but more prone to occasional
big losing trades) one is more likely to avoid a monster losing trading when
markets become crazy.
The second line
of defence is to diversify your capital across many markets. As an example,
one could devote 1/5 to US stock indices, 1/5 to precious metals, 1/5 to
energy, 1/5 to US interest rates and 1/5 to agriculturals (i.e. pairs as
wheat/corn, soybean/soy meal, etc.). Thus, if you are caught wrong footed, your
losses will be, nevertheless, smaller. A 30% loss (or drawdown resulting for
some consecutive losing trades, or just by one monster losing trade) when one
has just allocated 20% of his capital to the unruly pair of markets is just a
6% loss for the whole portfolio, which is bearable (and quite likely some other
market will be winning, hence further mitigating the 6% loss). The key is
diversification, as all futures hedge fund manager know. No futures hedge fund
manager in his right senses would ever attempt to apply his trend following
method to just one market, no matter how good past performance has been in the
past. However, we, Dow Theorists, seem to be blinded by the generous Dow Theory
record when applied to US stock indices. While I have not yet applied the Dow
Theory to, i.e. French or Spanish stocks indices in the last 15 years, one
thing I know is that, their charts look quite pathetic, nothing short of the
booming pattern seen in US stock indices. What if one day the US becomes like
those old Europe laggards? What if one day the US manages to screw its own
economy up by imitating the failed policies of some old Europe countries? Would
it then be so easy to make 7% p.a. by just being buy and hold? And how would
the Dow Theory perform under such conditions?
Well, enough for today, I feel this has been a good “stress
test” as we have seen that even when confronted with a profoundly bearish
environment, the Dow Theory managed to even make some modest gains. Off course,
there is no guarantee to make positive results even under strong secular bear
markets. However, it seems clear that the Dow Theory will most probably do
better than buy and hold or even many trend following systems based either on
moving averages or breakout systems.
In the second post of this Hamilton saga, we will see what
would have happened if we had shorted. As an appetizer: Very positive results. While I am not friend of shorting US stocks, it may make sense in some markets. More about this in a future post.
Sincerely,
The Dow Theorist
No comments:
Post a Comment