Dow Theory Special Issue: Hamilton’s insight that the Dow Theory may be applied to many markets seems to be right (II)
Applying the Dow Theory to oil markets while exploring
the short side. Towards building a Dow Theory portfolio
In the first post of this new Hamilton saga, I applied
the Dow Theory to the oil sector. I took the pair formed by USO (crude oil) and XLE (oil stocks) ETFs. I analyzed
the “long” side, that is buying when a primary bull market is signaled and
selling and remaining “flat” when there was a sell signal. As you can read in
that post, in spite of heavy declining markets, the Dow Theory managed to remain
positive while dramatically containing drawdowns.
Today we are going to explore the short side. What
would have happened if instead of just going flat when a primary bear market
got signalled we would have actually shorted (and covered when a primary bull
market was signalled)? This post merely analyses the short side, not the
combined performance of going long and short (that is covering and buying when
a primary bull market signal is given and selling and shorting when a primary
bear market is given). The combined long/short performance will be the subject
of another post.
First off, I have to make clear that shorting is not
made for everyone. In this post, I made very clear that in most instances is
not advisable to short US stocks. Please read the linked post carefully.
From such a post, we can conclude that if the US keeps their
persistent upward bias of ca. +8 p.a. and we continue to be subject to shorting
fees, paying dividends to the lender, etc., shorting US stocks may result in
very modest gains or outright losses.
However, not always are conditions so negative for
shorting. What if one were to short S&P 500 futures? In such a case, there
aren’t any shorting fees and no need to pay dividends as there is no lender.
Basically, we would be confronted with just the upward bias of ca. 8% p.a. of
US stock indices (something which on any given year may not be the case and which
is not carved in stone and is likely to change as I wrote here)
What if a hedge fund manager were utterly convinced
that US stocks indices were not going to deliver more than 1-2% p.a. in the
next ten years? What if such a hedge fund manager is not going to short ETFs
but S&P 500 futures (even by having full collateral and not leveraging). In
such an instance, the only worry would be contango or backwardation (which can
benefit or harm one’s position when rollover is due). Hence, in such a setting,
shorting, with all caution, could be attempted.
Furthermore, there are many markets with no Godfather.
Markets which, unlike US stocks, seem to have no one to prop them up. No plunge
protection team. Nada. Nichts. Nothing. Gold, silver, oil, their miners, wheat,
corn, soymeal, soy beans, etc. decline with gusto. There is no 8% p.a. upwards
bias for those bereft asset classes. They go up and suddenly got clobbered for
years. Nobody to step in as a buyer of last resort. Free to fall. Vested institutional
interests favor their falling (who wants high commodities?). And fall do them!
Furthermore, outside the US there are many stock
indices which regrettably lack any upward bias. Not all countries are as
blessed as the USA. Here you have the CAC 40 (French index). In the period
spanning from the end of 1999 to 2019 the CAC has basically made zero gains.
French Stock Index CAC 40. No upward bias from the end of 1999 to date
And what about the Spanish IBEX 35 (made of the 35
most important companies of Spain). Well, a similar fate than that of France.
In the last 20 years. No gains at all. Even modest losses. Talk about the long term view!
Spanish Stock Index IBEX 35. How not to make any money in 20 years. Quo vadis (where are you going) Spain?
These two charts are courtesy of Yahoo! Finance
While I try to get outside politics on this blog (even
politics get discounted by the markets) one thing seems to be clear. The
business of USA is business. In spite of everything, USA remains a good place
for goal oriented and entrepreneurial people.
My point is that not all stock indices have a build in
upward bias which makes shorting a losing proposition. Even the upward bias of
US stock indices may one day come to an end, or at least, take a long a pause.
Even within the US stock universe, not all stocks go
up. While I don’t advocate shorting individual stocks (one earnings surprise
can wipe you out as shorts have unlimited losing potential), we can see certain
stocks ETFs that have persistent down trends, as we have seen for the last 7 and odd years in
this blog with precious metals miners ETFs, they are made of stocks but without
the fanfare of other industry sectors.
The same applies to oil stocks. At least in the period
I tested (2009-2019) the only bias I could see is a negative one.
Shorting, when used judiciously, may add value. On the
one hand, it acts as a diversifier. Maybe some markets are declining and their
longs result in small losses or very modest gains. However, their shorts are doing great. We cannot
know in advance which markets will go up and down in the next years and hence
if confronted with a declining market, being short would allow us to extract
performance whereas the long side stalls. And I write "stalls" because the Dow Theory even when confronted with declining markets tends to win less or lose little but you are not likely to lose your shirt.
The USO/XLE example of this post is a clear example of
the value added by shorting. Picture yourself as an investor in 2009 (when my
exercise began). You were bullish on commodities because the preceding 10 years
had been bullish. You decide to apply the Dow Theory by only going long.
Thereafter, you have to suffer a secular bear market and your longs suffer. As
we saw in the previous post by going only long the Dow Theory would have
managed to make a modest +5% while buy and hold lost money. However, such an
outperformance cannot hide that +5% in 10 years is a very modest result. Not to
blame on the Dow Theory but on a market that had hair curling declines.
However, as we shall immediately see, if the investor had shorted, he would
have made a respectable gain (the tide was on his side).
The take away is this: We don’t need to predict the
future. Just to properly apply the Dow Theory and the very trend will take care
All in all, my opinion on shorting can be summarized
general, I don’t recommend shorting individual stocks (exception: very short term
trades lasting few days and under very specific circumstances).
general, I don’t recommend shorting US stock indices. Hitherto, the odds have
been stacked against you. Upward bias, shorting fees and paying dividends to
the lender make it a long term losing proposition.
shorting S&P 500 futures may in some specific instances be thinkable.
US stocks ETFs may be suitable candidates for shorting (but keep in mind
shorting fees and dividends to be paid to the lender).
stock indices of other countries (especially through their futures) may be a
good way of getting short exposure to one’s portfolio without confronting an
commodities (which would be through futures) seems plausible. No upward bias,
no shorting fees, no dividends to pay and just having to worry about contango
and backwardation, rollover and liquidity,all of these issues which the trading desk of any hedge fund worth its
salt masters to perfection.
After this somewhat lengthy introduction, let’s analyse
what would have been the performance of applying the Dow Theory to the USO/XLE
pair by going short when a primary bear market was signalled and covering and
going flat when a primary bull market was signalled.
·Total short trades taken: Five. The average duration of each trade is less than one year,
as declines tend to be faster than rallies.
·Maximum drawdown short (closed trades): -27.03%. Please mind that given the asymmetry between being long and short, one is more likely to experience higher drawdowns (and losing trades) when being short. A decline from 100 to 50 entails a loss of 50% when being long. A rally from 50 to 100 entails a loss of 100% when being short. This is why, one should construct portfolios, that is diversifying one's capital across many markets so that one can take shorts but any specific losing trade doesn't decimate one's capital. Portfolio construction under the Dow Theory is a field which I hope to explore in future posts.
·Maximum drawdown buy and hold: -64.33%
·Maximum rally buy and hold:When comparing drawdowns, and when being in a short
only mode, it is good to measure the magnitude of the largest upward swing (the
tide against our shorts) during the time we had shorts. Our last short in this
test was closed (covered) on 4/12/2016. As you can see from the spreadsheet
below USO rallied a whopping 97.51%
from 2/18/2009 to 4/29/2011. XLE rallied
a remarkable 165.71% from 3/2/2009 to 6/23/2014. Thus, even if, for the
whole period considered, there was a downward bias which resulted in a net loss
for buy and hold, there were strong rallies which had to be confronted by the
shorts taken according to the Dow Theory. All in all, the short side wasn’t
easy either. A quite "noisy" market nothing like the calm seen with US interest rates or US stock indices.
·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%. There
were strong rallies but also strong declines with a global negative outcome.
·Final capital Dow Theory(starting at 100): 156.75,
which translates to an outperformance
versus buy and hold of ca. 6.5% p.a. (annualized). It also
represents an annual performance of ca. +4.6% annualized. Please mind that the
negative “gravitational” force against long positions has been favorable for
shorts during the period tested, as there was a maximum decline of -64.33%. We
also observe, that by being short when there was an predominantly bearish tide
resulted in making positive returns.
All in all, shorting in markets (USO/XLE) which lack upwards bias would have resulted in positive
returns. The maximum drawdown experienced by the Dow Theory when shorting was also
much smaller than that of buy and hold.
Here you have a breakdown
of the trades taken.
In the next post, I’ll show
the performance if both long and short positions had been taken. In that post
I will also display the charts containing all Dow Theory signals.
Until then cogitate this
post and the preceding one.