Thursday, June 24, 2021

Dow Theory Special Issue: Assessing the Dow Theory’s performance when applied to precious metals and their miners (III)

 

Results for and SIL/GDX

 

The first post of this saga set out the premises of our study while the second post, analyzed the outperformance of SLV/GLD versus Buy and Hold (BAH).

 

Today, we will see the outcome of the trades that were signaled on this blog “live” for SIL/GDX  since its start in August 2012. I repeat the word “live”. The performance is so impressive that it seems hard to believe it has not been “cooked”. However, I appraised all trends in “real-time” as they were happening, and posted accordingly on my two blogs.


The test spans. 8 years, ten months and 16 days (from 5/15/2012, bear market bottom before the first Buy signal and 3/03/2021 bear bottom before the current Buy signal). On 5/7/2021, the Dow Theory signaled a new long position. However, we cannot include it in our study as the trade has not been closed and the final lows following the future sell have not been made.

 

As for the highlights:

 

Total long trades: Six round trades. Each trade lasted almost 1.5 years, which fits with the “typical” classical Dow Theory duration for the average trade (more than one year). On each Buy signal (primary bull market), we take a ½ position in each ETF (GDX and SIL).

 

Maximum drawdown buy and hold: -78.58% (for a 50% position in SLV and 50% in GLD).

 

Maximum drawdown Dow Theory (closed trades): -39.88. % (for a 50% position in SLV and 50% in GLD).

 

Final capital Buy and Hold (starting at 100): 77.73. Hence buy and hold lost for an allocation of 50% to each ETF -22.27%.

 

Final capital Dow Theory (starting at 100): 122.86, which translates to an outperformance versus buy and hold of 45.14%, that is ca. 5.08% p.a. Please mind that the negative “gravitational” force against long positions has been powerful during the period tested, as BAH suffered a maximum decline of -78.58%. Therefore, the outperformance of the Dow Theory versus BAH is remarkable. Confronted with a “negative force” of -78.58%, the Dow Theory managed to net out a positive 22.86% during the period under evaluation.

 

The Dow Theory reduced the maximum drawdown by 49.25% when compared to that of Buy and Hold. This significant drawdown reduction confirms what I have repeatedly asserted: The primary source of the Dow Theory outperformance is loss avoidance. Therefore, when markets (as US stock indices in the last 12 years) lack significant drawdowns, the Dow Theory will indeed underperform. However, “underperform” does not entail “losing”, just winning less.

 

Now some observations and ideas for actual trading:

 

1. Unlike the SLV/GLD pair, my preliminary research shows that SIL/GDX is a perfect pair to assess trends to trade SIL and GDX. In 2012, I selected the pair SIL/GDX because it seemed logical: both were miners and relatively similar in their price behavior but not identical. Now, armed with more background, it seems that SIL/GDX is indeed an excellent pair to derive trends. Nonetheless, I will likely unearth another good “pair” in the future. Preliminary research looks positive.

 

2. Was the outstanding outperformance just luck? Since SIL/GDX is a good pair to look for signals based on confirmation, I tested the same pair with a breakout system based on the following rules.

 

a) Pair used to appraise trends: SIL/GDX. Assets tested SIL and GDX.

b) We buy an “n” days high provided there is confirmation (on the very same day or in the last 50 trading days). Input values from n=10 to n=130 with increments of 10 days.

c) We sell an “n” days low high provided there is confirmation (on the very same day or in the last 50 trading days). Input values from n=10 to n=130 with increments of 10 days.

d) Start capital 100 units. One half for GDX and one half for SIL.

e) For the sake of comparing “apples to apples”, I selected the breakout value for each ETF that resulted in 6 round trades, the number of trades we got using the Dow Theory. A breakout value of 95 days resulted in 6 trades for SIL. GDX needed a 94 days breakout value to produce 6 trades. The breakout system resulted in a loss of -24.27%, meaning that the Dow Theory outperformance has nothing to do with “luck”. Below the specifics of dismal results for the breakout system:

 

 

As an aside, most breakup values from 10 to 130 resulted in losses for both SIL and GDX, underscoring the light-years superiority of the Dow Theory versus typical trend following devices. Hence, it puzzles me that many “trend-following” hedge funds managing millions if not billions of dollars continue to base their trades on breakout systems. I am not criticizing “breakout” traders, as indeed, breakout systems have a slight edge (google “turtle trading” or “Richard Dennis”) but are much more vulnerable to dry spells than the Dow Theory.

 

3. Can we improve the gains made by the pair SIL/GDX traded on SIL and GDX? Yes, there are several ways. The most logical and Dow Theory-inspired solution is to seek trend confirmation from the pair SLV/GLD (multi-market confirmation). What would happen if we only bought and sold SIL and GDX when simultaneously the trend, as determined by applying the Dow Theory to SLV/GLD, is in gear with that of SIL/GDX? When analyzing GLD and SLV, we saw that seeking trend confirmation added value. Well, confirmation works. Instead of 6 round trades for our SIL/GDX system, we would have just had 4. However, our net profit over the period tested would have been 49.96% versus 22.16% for the SIL/GDX-only system. So, performance more than doubles. We must note that trades have been cut by 1/3 (4 instead of 6), implying that our accuracy has been boosted by demanding trend confirmation. We make more trading less.

 

4. We can also trade SILJ and GDXJ (the “juniors” ETFs) based on the trend determined by the pair SIL/GDX. The “juniors” tend to perform better in good times and worse in bad ones. By  mitigating the downside (bear markets) thanks to the trend appraised by applying the Dow Theory to SIL/GDX and demanding confirmation from the pair SLV/GLD, we would probably make more money. A 50/50% position in SILJ and GDXJ would have returned 84.24% over the period tested. Remember that over the same period, BAH lost -22.27%. Please mind that SILJ was not available at the beginning of our test, so we only had 3 trades for SILJ, whereas GDXJ had 4 trades.

 

Whether the trend determined by the pair SILJ/GDXJ would be even more accurate should definitely be tested. Another project for the future.

 

5. What if we traded SIL and GDX based on the trend determined by applying the Dow Theory to the pair SLV/GLD? We would have lost -2.17%, which remains much better than BAH. So, trends appraised from the pair SLV/GLD have some predicting power and outperform BAH. However, the pair SIL/GDX is more reliable.

 

6. As of this writing, the secular trend for SIL/GDX remains bearish, so unlike SLV and GLD, we cannot trade SIL and GDX on a secular trend filter. However, if we traded SIL and GDX by applying SLV/GLD secular filter, our performance would have been a respectable 45.01% with only two trades.


The spreadsheet below summarizes our findings:



7. And what about shorting? When a bear market signal is given, we close our long position and open a short position instead of going flat. I do not particularly appreciate shorting as the gain is limited (maximum 100%), and the loss is open-ended. We also have to pay shorting fees, dividends (as with GDX/SIL), and, when dealing with futures, we have to be careful with contango. I only go short when my time horizon is just a few days. However, I find it an excellent exercise to see what would have happened if we had shorted each time a bear market was signaled. After all, the only source of outperformance for any trend-following device (Dow Theory included) is the further decline that follows a Sell signal until the final bottom is made. If we had gone long and short, our final equity would have been 179.28, a gain of 79.28% versus 22.86% would have made by going only long. The maximum drawdown would have been -37.32%, slightly lesser than the -39.88% when going only long. 
 
Can we further improve our results? Yes: If we use the secular trend filter based on SLV/GLD and take only short trades when the secular trend is bearish and long positions when the secular trend is bullish, we would have made an astounding 138.86% with a drawdown of only -6.38% (closed trade basis) with just four short and two long trades. Please mind that Buy and Hold netted out a loss of -22.77% over the same period. 
 
 

Ten conclusions for this post and the previous one:

 

1. The Dow Theory produced outperformance versus BAH in both SLV/GLD and SIL/GDX. Drawdowns were cut by roughly one-half.

2. SIL/GDX, at least for the period tested, was an even more accurate “pair” to assess trends than SLV/GLD. I have solid reasons to believe that this is not an anomaly. The miners tend to lead the metals, and, more importantly, significant trends in the miners tend to imply that the trend is “for real” (meaning more likelihood of persistence).

3. If we combine alternative Dow Theory approaches (i.e., demanding confirmation from two pairs, demanding the secular trend in a bullish mode, etc.), performance boosts, and accuracy improves.

4. It seems that the more volatile the asset, the better results are when applying the Dow Theory. We keep the upside while cutting short the downside.

5. If we traded a combination of all the Dow Theory alternatives, we would achieve more efficient use of capital, more trades, and, more likely, reduce the depth and time in drawdowns.  I have concrete ideas about Dow Theory-based portfolio construction, which I will share one day if time allows. 

6. The issue of “pair” selection deserves further study. My preliminary research favors creating pairs that we would trade in only one asset (i.e., SLV would be best traded with a SLV/SIL pair, whereas SIL would be best traded with a SIL/GDX pair). By creating several good “pairs”, we can have more trades resulting in more diversification and more efficient use of capital (when one “pair” is not signaling a trend, the alternative “pair” may be signaling “Buy”).

7. I feel that Schannep’s Dow Theory, which is the very best Dow Theory “flavor” that can be found, could be adapted to other markets (i.e., precious metals and their miners) and could result in even better risked-adjusted performance. To this end, we should appraise trends based on three assets (i.e., GDX/SIL/GLD). Schannep's Dow Theory also includes Capitulation, betting on a trend reversal when prices have gone down too far too fast. The inclusion of Capitulation to our trading arsenal could likely add value but needs to be studied. Another project for the future.

8. What began as an experiment in 2012 has been vindicated. The Dow Theory is an excellent timing system (do you want to know why? Click here and here). It has nothing to do with traditional trend-following devices such as breakout systems and moving averages. More importantly, as Hamilton predicted in the nineteen twenties, it can be successfully applied to many markets; not only to US stock indexes.

9. With all the caveats about shorting, going short adds value. Those willing to increase their odds of succeeding when shorting might only take short trades when the secular trend is bearish.

10. One is not necessarily compelled to trade GLD, SLV, GDX, SIL, GDXJ, and SILJ strictly according to the primary bull and bear market signals. One can trade on a shorter time horizon (i.e., some kind of swing trading) or with tighter stops (leveraged hedge funds based on breakout systems that necessarily must have narrow stops) aligned with the primary trend as determined by the Dow Theory. I draw several actionable ideas for my own trading. And you?

 

Sincerely,

Manuel Blay

Co-Editor of thedowtheory.com

Monday, June 21, 2021

Dow Theory Update for June 21: Secondary reaction in gold and silver and GDX/SIL against the primary bull market

 Primary trends unchanged.

 

GOLD AND SILVER

 

A) Market situation if one is to appraise secondary reactions not bound by the 3 weeks dogma.

 

While it’s subject to interpretation, I explained why I consider the primary trend bullish since 4/21/2021 here.

 

A secondary reaction against the primary bull market has been signaled for gold and silver (GLD and SLV). From its 6/2/21 bull market highs, GLD declined until 6/18/21 for 12 trading days. SLV did so from its 5/17/2021 highs until 6/18/21 for 23 trading days. So we consider the time requirement as fulfilled.

 

As to the extent requirement, things get a little bit trickier than when we deal with assets outside the realm of US stock indexes. We know that we require a minimum movement equal to or larger than 3% for US stock indexes. However, assets like gold, silver, etc., have different volatility than that of US stock indexes. Hence we have to perform a volatility adjustment to determine the equivalent of our 3% threshold for US indexes. For instance, silver (SLV) is more volatile than the S&P500. Hence, for a movement to be meaningful, we have to demand a larger percentage figure.

 

We calculate volatility adjustments as follows. We calculate daily percentage change for both the S&P500 and the asset concerned. We average over 1000 days. If, for example, the volatility of the asset doubles that of the S&P500, then our volatility-adjusted minimum movement will be:

 

As you can see in the table below GLD and SLV have amply exceeded the volatility-adjusted minimum movement.

 

 

So now we  have two options:

 

a) Either a rally lasting at least two trading days exceeding the minimum volatility for at least one ETF develops, in which case, the setup for a primary bear market would be completed.

b) Or the markets continue lower until the last recorded primary bear market lows (3/8/2021 at 157.49 and 3/30/2021 at 22.26 for GLD and SLV, respectively) are jointly broken down, in which case a primary bear market would be signaled.

 

Here you have an updated chart. The orange rectangles display the current secondary reaction:

 

 

B) Market situation if one sticks to the traditional interpretation demanding more than three weeks of movement in order to declare a secondary reaction.

 

The primary trend was signaled as bearish on 11/27/2020, as was explained here.

 

Off the 11/30/2021 bear market lows, both SLV and GLD rallied for 24 trading days until 1/5/2021. So the time requirement was more than met. As to the extent requirement, it was fully met. Both percentage-wise, as in terms of retracements of the previous bear market swing, which started on 11/6/2020. Please spare me the calculations as the chart patterns speak for themselves.

 

So the secondary trend is bullish (secondary reaction against the primary bear market).

 

If we stick to a very strict (or rather misguided) interpretation of the classical Dow Theory, the change of the primary trend from bearish to bullish will occur if either one of the two alternatives below materializes:

 

1. The first one entails the breakup of the last secondary reaction closing highs (1/5/2021). SLV broke them up on 2/1/2021, unconfirmed by GLD. So, once GLD broke up its 1/5/2021 secondary reaction highs, it’d be indisputable that the primary trend has turned bullish.

 

2. The second one entails the breakup of the highs of the last completed secondary reaction (the first one of the current bear market). I have written profusely (i.e., here and here) about the importance of the highs/lows of the last completed secondary reaction (not the current one, but the previous one). The closing highs of such a reaction were made on 11/6/2020 for both SLV and GLD. On 12/7/2020, SLV broke up above its closing highs, unconfirmed by GLD. Once GLD confirmed, the primary trend would be bullish.

 

Below you have the updated charts:

 


 

GOLD AND SILVER MINERS ETFs

 

A) Market situation if one appraises secondary reactions not bound by the three weeks dogma.

 

The primary and secondary trend is bullish since May 7th, 2021, as explained here.

As you can see in the table below, the ongoing decline has met the time and extent requirement, so a secondary reaction has been signaled.

 

So now we have two options:

 

a) Either a rally lasting at least two trading days exceeding the minimum volatility for at least one ETF develops, in which case, the setup for a primary bear market would be completed.

b) Or the market continues lower until the last recorded primary bear market lows (3/1/2021 at 30.90 and 3/30/2021 at 38.74 for GDX and SIL, respectively) are jointly broken down, win which case a primary bear market would be signaled.

 

Here you have an updated chart. The orange rectangles on the right side of the charts display the current secondary reaction:

  

B) Market situation if one sticks to the traditional interpretation demanding more than three weeks of movement in order to declare a secondary reaction.

 

The primary and secondary trend is bullish since May 7th, 2021, as explained here.

 

Since the current pullback has not reached at least 15 trading days on SIL, we cannot declare the existence of a secondary reaction. Thus, the secondary trend remains bullish.

 

Here you have the updated charts. The current pullback has been highlighted in grey instead of orange (the color I use to display secondary reactions against primary bull markets), as no secondary reaction has been signaled yet. 


 

 Overview:

The spreadsheet below displays the primary trend in the pairs SLV/GLD and SIL/GDX when we appraise them with either the “shorter-term” or longer-term interpretation of the Dow Theory. Red color displays a primary bear market (cash), and blue displays a primary bull market.

 

Sincerely,

Manuel Blay

Co-Editor of thedowtheory.com