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

 

Performance of GLD/SLV and GDX/SIL from 2012 to date. Our premises

 

To the casual observer, the Dow Theory is just a timing device for US stock indexes. However, the Dow Theory lends itself well to being applied to other asset classes. None other than Dow Theorist Hamilton stated that the Dow Theory could be applied to other markets. Hamilton, though, did not actually apply the Dow Theory to other markets. As far as I am aware, no Dow Theorist followed Hamilton’s hint.

 

I started this blog in August 2012 and, based on Hamilton’s insight, I started applying in real-time the Dow Theory to precious metals (gold and silver as a pair) and their precious metals miners’ ETFs (GDX and SIL). Occasionally, I applied it to Chinese stocks, and since 2018, I have applied “live” to US bonds. I also conducted a test with oil markets with encouraging results.

 

For the years 2013, 2014, and 2015, I posted the annual performance of the trades taken according to the Dow Theory. Even though the results were encouraging (outperformance of the Dow Theory versus Buy and hold – BAH- and drawdown reduction), I discontinued reporting on an annual basis, given that one year is not the adequate yardstick to compare the Dow Theory versus BAH. We should keep in mind that, on average, the Dow Theory results in less than one trade per year. Hence, in any given year, anything can happen, as we won’t have enough trades. To make a meaningful comparison to BAH, we need a sufficiently large sample size. This is why I stopped reporting on an annual basis.

 

Now armed with a track record of almost nine years, I feel it’s time to make an assessment.

 

As a reminder:

 

1. I am evaluating the trades as I discerned them in real-time. So what follows is not a backtest. I posted every signal on this blog and my Seeking Alpha blog as it occurred. So, for good or worse, the trades reflect my interpretation of the Dow Theory in real-time. So I am not making things up ex post facto (after the fact). Hence, it is a reliable experiment.

 

2. The Dow Theory “flavor” is the “classical” with Rhea’s influences. I couldn’t use what I call “Schannep’s Dow Theory”, as I didn’t have three indexes (The S&P500, the Dow Industrials, and Transportation). The most obvious candidates I found was gold (GLD) and silver (SLV) and their ETF miners (GDX and SIL). By applying the “classical” Dow Theory, I could not use some of the specifics of “Schannep’s Dow Theory”, which have been tested by Jack and I to add to performance (i.e., among others Capitulation, Bull/bear definition, etc.). Thus, I settled with the “classical” Dow Theory. It wouldn't surprise that I could successfully test in the future a combination of three ETFs (i.e. GLD/SLV/GDX or GDX/SIL/GLD, etc.) with most of the tenets of Schannep's Dow Theory. My gut tells me we'd increase performance and likely reduce drawdowns. 

3. As you know, the Dow Theory is based on the principle of confirmation. To this end, we need at least two markets. In 2012, my gut feeling told me that gold and silver made a good “pair”. Both are precious metals, and both tend to act quite similarly. Same with GDX and SIL. The issue of finding the right “pair” is not a settled one for me. I still continue researching it. What makes the best “pair”? Both assets should be similar enough but not identical. If the correlation of the two assets were close to 1, then we would derive no benefit from confirmation. By the same token, we’ll derive no benefit if the two assets behave very differently (i.e., S&P500 & Copper). So finding the right “pair” is like Goldilocks, neither too hot nor too cold. The new inroads I’m making with the principle of confirmation and selecting the best “pair” is the subject for a future post. My preliminary research shows me that:

 

a) GLD/SLV might not be the best “pair”. Currently, I am researching betters pairs (SLV/SIL to trade only SLV, GLD/GDX to trade only GLD, etc.). We should consider lead/lag issues when selecting the pair, and  we should not necessarily trade the two components of the pair. However, as we will see, results with the non optimized pair GLD/SLV have been satisfactory;

 

b) Any given “pair” may not work equally well with both assets. One of the two assets involved will outperform the other. Hence, as an example, GLD might work best with GDX, but GDX might work best with SIL. Lead/lag has to do with finding the proper “pair”.

 

c) There must be a logical explanation confirming the empirical results. If backtests showed that bitcoin worked as a good “pair” for crude oil, I’d be suspicious, as many correlations are spurious. Back to GLD/SLV, while may be not the most “optimized” pair, it makes sense and gives me confidence to trade it.

 

4. Given that the “pairs” used have not been optimized for one of the two assets making the “pair”, I recommend taking a 50% position in each of the assets involved. We will never be too wrong by doing this, and we will be more in tune with the underlying buy and sell signals. Exception: In the “pair” TLT&IEF, I don’t trade IEF as it has too low volatility. 

 

5. By splitting our investing capital in half, we derive the added benefit of taking two trades instead of one (we buy 50% GLD and 50% SLV, instead of just 100% GLD or SLV). Since the Dow Theory is a long-term trading device with less than one trade per year, we know that if we stumbled across three bad trades (which may happen without the system being broken) we’d be underperforming for a long time. This is why long-term trend following tends to be unusable for most traders. It wrecks your nerves, as the scarcity of trades get you stuck in long periods of underperformance. After a couple of bad trades, it may take a long time to reach new equity highs. By taking a 50% position, each Buy signal implies two trades that add to diversification and tend to lower the time in drawdown (the more trades we take, the more likely the system's expectancy will reassert itself).

 

6. I will compare the performance of the Dow Theory to B&H. The proper way to comparing performances was explained in-depth in this post.

 

7. While the Dow Theory may be successfully applied to many assets; not all assets are created equal. The Dow Theory is particularly good at avoiding bear markets. So the Dow Theory works best with assets that have a big upside and, occasionally, a sizeable decline. Hence, the Dow Theory is an excellent trend filter when applied to high relative strength stocks. We know that high relative strength stocks tend to outperform the index but are plagued with drawdowns. We'll fare well if we remove the downside (drawdown in bear markets) while keeping the upside (stronger performance in bull markets). This assertion has been tested by me, so it is not a casual statement: Relative strength + Dow Theory does work. Accordingly, we’ll probably make more money trading SIL & GDX than SLV & GLD. The miners have more potential for significant gains than the metals themselves, provided we cut losses short.

 

Sincerely,

Manuel Blay

Co-Editor of thedowtheory.com