Saturday, February 15, 2020

Dow Theory Special Issue: Some introspection. Let’s go back to the basics in order to make the next leap forward (I)




Musings, and more musings before the meat


This is a long post which has been divided into two. It has really taken lots of introspection, as it crystallized when being alone in the countryside enjoying the sights of some wonderful lush hills dotted with grazing cattle. This post is a roadmap for the future tasks to be undertaken which I feel will expand the potential of the Dow Theory.

Yes, I am convinced that the Dow Theory has still lots of untapped potential. I alluded to this in past posts, but it bears repeating and expanding in this new post. Hamilton’s insight that the Dow Theory may be successfully applied to any market (not just US stocks) was tentatively proven right here. This is vital, as Hamilton’s insight opens new avenues for the application of the Dow Theory to more markets.


I also wrote that (after thorough back-testing to be done, I might add) the Dow Theory could be the basis for a successful futures hedge fund. This is not an overstatement. We already know that, at least for US stocks, the Dow Theory tracks much better the trend than breakout systems (even if confirmation is demanded), as was explained (for US stocks) here.


As far as I know no single fund is currently doing this (if some reader knows otherwise, please let me know). Hence, it is not outlandish to think that it is likely that the Dow Theory could be a better way to trading commodities than the typical breakout or moving average systems used by most futures funds. Probably, and due to the ample stops resulting from the application of the Dow Theory, we should adopt a shorter time frame (i.e. just requiring 3 or 4 days for an “abridged” secondary reaction to exist in order to trade futures (more on that in a future post). One preliminary test which I carried out with the oil sector (in a very raw state, and not yet polished for posting on this blog) seems to preliminary suggest that the application of the Dow Theory rules with just the exception of only demanding three days for a secondary reaction to exist, results in profits which are larger (percentage-wise) than those obtained by using the usual length for a secondary reaction. I preliminary see some degradation of the profit factor (that is the ratio between gross profit and gross loss) which is logical since as we shorten our time frame, there is more noise and less signal. However, we shouldn’t be purists. I’d rather prefer a system less “efficient” with more trades (and turnover) if I can accomplish more returns and less drawdowns (especially lengthwise, as the patience of most investors, I included, is in short supply). I could be very efficient in catching trends that last two years. However, if the average trade were just of 10%, I could end up making a paltry profit per year. On the other hand, shorter time frame trading, while less efficient (i.e. more losing trades), may result in an average trade of 3% with 5 such trades per annum. Hence, even if less “efficient” I prefer the shorter term system (unless capital constraints become an issue), as I can make percentage-wise more per annum, and more, importantly, each losing trade will tend to be smaller and the higher frequency of trades will get me out of any drawdown sooner. All these are complicated aspects, and before putting money on the line, one must really do his homework. This is what I attempt to do in the coming months or maybe years.

The takeaway is as follows: While I still have to perform many time-consuming tests (as the Dow Theory is not easily encapsulated into an algorithm), it seems that shortening the length of secondary reactions results in a system that may be able to extract decent profits (albeit less efficiently, with more losing trades), generate more trades (good things if they are profitable), cut losses short (as the Dow Theory stop based on the shortened secondary reaction is narrower), and have flattened shorter drawdowns. Such a system would be geared towards futures (commodities). More about the Dow Theory build in stop-loss here.

 There are also many issues which I still want to study in the future which are important for investors:

·        Deepen the principle of confirmation. What makes a good pair of indices? Should we expand Schannep’s insight of using three stock indices to other markets when possible (i.e. crude oil, heating oil and unleaded gasoline? Or we just make do with two? What level of correlation between the indices is desirable? I already alluded that this is like Goldilocks: Neither too hot, nor too cold. Since the principle of confirmation is vital to add value to our trades, we better be proficient at finding dancing partners when foraging outside the world of US stock indices.

·        Provide you with exact figures as to the loss of performance when we cannot entry and exit on the very same day of the signal (at the close). Hint: not so much lost.

·        Should we take all trades suggested by the Dow Theory? One tenet of trading is the “risk reward ratio” (RRR). In actual trading, we discriminate. Not all trades are born equal. If the particular setup of the signal shows that there is ample downside (i.e. the primary bear market lows which is our initial stop after we get a bull market signal) while historically the upside has been limited, should we skip the trade? I don’t know now. I am inclined not to dabble with the Dow Theory when applied to US stocks. However, what if I applied the Dow Theory with shortened secondary reactions to a portfolio of commodities? I feel, given the shorter term nature of such a system, that I would be strict in only taking the trades which would offer a good RRR (i.e. likely reward of at least two times the risk taken).

·        When dealing with US stocks, should we apply the Dow Theory signals to other indices? What about buying a midcap ETF instead of the SPY when a bull market signal is given? Or a growth ETF? Or an equal weight ETF such as RSP? Could we outperform the official Dow Theory record by doing this? Or are the extraneous ETFs out of sync with the signals given by using the Industrials, Transports and S&P 500?

·        And last but not least, could be apply relative momentum to the Dow Theory? The Dow Theory, as with any trend following method is “absolute momentum”. What about of using relative momentum (i.e. buying the best performing index within a given look back period) coupled with the Dow Theory’s absolute momentum? Gary Antonaccy, whom I have lauded in the past, in his seminal book “Dual Momentum Investing” advocated for using both absolute momentum (the asset class in question must be in an uptrend) and relative momentum (the specific asset must be outperforming some peers). From my many posts on this blog, I am convinced of the superiority of the Dow Theory over other trend following methods in order to appraise "absolute momentum". Hence, I feel that if we could couple the more efficient Dow Theory at signaling trends (in any market, by the way) with relative momentum (i.e. buying the strongest US stock sectors only when there is a primary bull market signal) we could further boost the already excellent track record of the Dow Theory. Of course, testing all these thoughts takes time and dedication but I feel the reward is worth, as I’m aiming specifically at:

 (a) adding even more outperformance to the Dow Theory (let’s say 2 or 3 additional percentage points p.a.) versus buy and hold;

 (b) with some luck (I need to see the tests results) reduce drawdowns (specially lengthwise); and

 (c) very importantly, reduce the time of underperformance versus buy and hold. We already know that, while buy and hold is a long term disaster as drawdowns can kill those lacking deep pockets and/or psychological fortitude (more about it here), it can outperform the Dow Theory for long periods of time. I have also explained ad nauseam (i.e. here) that the Dow Theory outperformance is made when big declines occur. Hence, the current hyper bullish environment is not conducive to outperformance for the Dow Theory. We are faring well (as you will see in my next post, no reason to bemoan) but clearly buy and hold is outperforming (at least for now). However, long periods of underperformance (even though one remains profitable) may try the patience of the less committed investors. Hence, I want to explore whether adding relative momentum to the Dow Theory (i.e. by buying the strongest US stock sectors) would result not only in adding some percentage points but also in reducing the time the Dow Theory underperforms buy and hold.


Thus, there are many projects in the pipeline. However, Schannep’s Dow Theory remains the cornerstone upon which I am going to build all these future research. Hence, before we try to push the envelope, it is advisable to make a pause, take a deep breath, and go back to the basics and review how both the S&P 500 (buy and hold) and Schannep’s Dow Theory have fared since 1998. 22 years is quite a good stretch of time to judge. Please mind that Schannep’s Dow Theory has an actual, real money, track record. No pipe dreams. By comparing both investment styles we will be able to reassert Schannep’s Dow Theory superiority.

By the way, soon I will post another chapter of the Capitulation saga. I'm still maturing the already written post. 

Sincerely,
One Dow Theorist

Friday, February 7, 2020

Dow Theory Update for February 7: Secondary reaction for US stocks ended yesterday, February 6th




Setup for a primary bull market in SLV and GLD explained

 

US STOCKS

Under Schannep’s Dow Theory

The primary trend, signalled on 10/25/2019, remains bullish as was explained here and here. On February 5th, the S&P 500 bettered its last recorded primary bull market highs unconfirmed. On February 6th, the Industrials confirmed.

Under Schannep’s Dow Theory we just need confirmation from two indices. Hence, the lack of confirmation of the Transports is immaterial in order to declare the end of the secondary reaction. By breaking above their last recorded primary bull market closing highs of 1/17/2020, the primary bull market has been reconfirmed.

However, to be “in the clear” (and to be more optimistic about the actual bullishness of the market) we need confirmation from the Transports. I am personally bothered by the persistent weakness of the Transports which have not been able to better their all-time closing highs of 09/14/2018, and, more recently, their last recorded primary bull market closing highs of 1/17/2020 .

All in all, the primary bull market continues, and we “reset” the clock to zero in order to appraise the next secondary reaction. Now both the primary and secondary trend are bullish

Here you have an updated chart:


It is important to note that Schannep, of thedowtheory.com who normally sees the bottle half full, in his most recent letter to subscribers has shown some skepticism as to the continuation of this bull market. His last letter is a real tour de force which every committed investor should read several times to let all the wisdom soak in. I also wrote some days ago that my own personal trading reflects underlying weakness still not fully manifested in the indices.


Under the classical/Rhea Dow Theory

If we appraise the trend under the “Rhea/classical” Dow Theory, the primary trend is bullish since April 1st, 2019, as was explained here

The secondary trend is bullish, as the Transport bettered on January 14, 2019 their secondary reaction closing highs (of 04/29/2019) hence confirming the Industrials.

GOLD AND SILVER


The primary trend was signaled as bearish on 11/07/2019 as was profusely explained here

The secondary trend is bullish (secondary reaction against the primary bear market) as was profusely explained here.

Now, dear readers, pay attention, as we have an interesting technical situation.

As you know, and as I wrote here, there are several alternative primary bull (and bear) market signals. The most frequent one is the following sequence: Primary bear market lows, rally (secondary reaction), pullback and breakout above the secondary reaction closing highs.


However, there is also an alternative primary bull (bear) market signal, namely that off the primary bear market lows a powerful rally emerges without any pullback which finally breaks up the last recorded primary bull market highs. The third one, not applicable in the current SLV/GLD situation, is the breaking out of the closing highs (lows) of the previously last completed secondary reaction.

Here you have the coarse chart depicting the three alternative bull market signals. 





Well, currently we are flirting with two alternative primary bull market signals.

On the one hand, the have the “unusual” one, namely that without any pullback, the last recorded primary bull market highs get broken out. On 1/6/2020 GLD broke up above the last recorded primary bull market highs unconfirmed by SLV. Lack of confirmation implies that we cannot declare the end of the current primary bear market until SLV break up above its primary bull market highs. In the charts below the blue horizontal lines depict the relevant levels to be bettered. The charts below display the price action from mid November 2019 to date. Please mind that this is one of the alternative primary bull market signals.

On the other hand, more recently, the setup for a “normal” primary bull market signal has been completed. Following the secondary reaction closing highs of 1/7/2020, there was a pullback on both precious metals which completed the setup for a primary bull market signal. The pullback of -4.95% complied with the minimum volatility requirement which currently stands for SLV at 4.58%. Please mind that when I deal with assets other that US stocks I adjust the minimum volatility requirement (3% for US stocks) to the volatility of the asset concerned. In other words, if the daily percentage change, averaged over a large number of days, of the asset “A” doubles that of the SPY (or S&P 500), for a movement to be meaningful I will demand a minimum percentage of 6% (2 x 3%). I calculated the 1000 days average of the daily volatility for both SLV and the SPY and the volatility adjusted figure reads 4.58%. Hence a pullback of -4.95% is relevant and should be taken into account in order to conclude that the setup for a primary bull market signal has been fulfilled. GLD, though, has not reached the minimum volatility requirement. However, this is immaterial, as the principle of confirmation is not applicable to the final pullback. More about the nuances concerning the principle of confirmation, which are vital to a proper application of the Dow Theory, here:

Here you have the spreadsheet with the specific dates and calculations:






The charts below display the current situation. The green thick horizontal lines display the price level of the last recorded primary bull market closing highs. As I explained above GLD broke up above the relevant level unconfirmed, and hence there was no signal, and there will never be, as the “normal” signal (blue horizontal line) is at a lower level.

The blue horizontal lines display the secondary reaction closing highs, which, as you can see, only GLD has broken. When or if SLV breaks out above the blue horizontal line a primary bull market will be signaled.

Two alternative primary bull market signals. The "normal" one (blue horizontal lines) will finally prevail

GOLD AND SILVER MINERS ETFs


The primary trend is bullish since 12/18/2018 as explained here. No changes. This specific signal is now more than one year old. Hence, we are dealing with a trade whose duration seems quite in line with what is to be expected under the Dow Theory (trades lasting more than one year on average, please mind the word “on average”).

On 09/04/2019 SIL and GDX made its last recorded primary bull market closing highs. From that date both ETFs declined and the secondary trend turned bearish (secondary reaction against the primary bull market) as explained in-depth here. The secondary reaction closing lows were jointly made on 10/15/2019

On 10/25/2019 the setup for a primary bear market has been completed as explained here

From that date GDX flirted with violating its secondary reaction closing lows which it did not. SIL was much stronger and has hitherto remained at a safe distance of those lows.

On 12/24/2019 SIL bettered its primary bull market closing highs unconfirmed by GDX. (blue arrow on the right side of the upper chart). Hence, we cannot declare the secondary reaction as extinguished. Thus, we remain in a primary bull market with an ongoing secondary reaction.

US INTEREST RATES

As it was explained here, TLT and IEF (two ETFs that relate to US interest rates) are in a bull market (since 12/18/2018 or 11/19/2018 depending on the way one appraises the secondary reaction). I also explained that they are currently under a secondary reaction. Here you have an updated chart displaying the current situation. As you can see from the charts, both ETFs are close to bettering their last recorded primary bull market closing highs. 

US interest rates remain in a primary bull market and are close to reconfirming it


Sincerely,

One Dow Theorist