Friday, May 13, 2022

Dow Theory Update for May 13: All investing strategies need protection against bear markets. Three examples. Make no mistake about it.

 

A brief update on the trends for U.S.U.S. stocks, U.S. Bonds, and precious metals & their miners' ETFs.

 

The primary trends for gold & silver, SIL & GDX, and U.S. bond markets have not changed since I last reported. What is new since my last reporting is a nasty secondary reaction against the primary trend for precious metals and their miners. However, the primary trend remains bullish. Below is my latest report. When time becomes available, I will post giving details concerning the ongoing secondary reaction:

http://www.dowtheoryinvestment.com/2022/04/dow-theory-update-for-april-20-update.html

As for U.S. bonds, they remain in a protracted bear market and no secondary reaction in sight. Below is my last update:

http://www.dowtheoryinvestment.com/2022/01/dow-theory-update-primary-bear-market.html

 

As to U.S. stocks, our Subscribers have been out of the market since 2/22/22 (first warning) and 4/11/22. Here is my last update concerning the U.S.U.S. stock market: 

http://www.dowtheoryinvestment.com/2022/04/dow-theory-update-for-april-19.html

 

The need for Bear market protection in all portfolios, even the best curated ones:

Now some thoughts on the current stock market situation, the destructive power of drawdowns, and the need to protect any portfolio, no matter how well selected the individual stocks, from vicious drops. 

Example #1: Nasdaq

One particular suit of specific stocks is the Nasdaq100 (NDQ), and, as you know by now, it has dropped big time. Many on the internet proclaim its unsuitability for many portfolios or even that it is a dangerous investment because of the vast drawdowns that occasionally afflict the NDQ. Such critics are right if one has a "buy and hold" mindset. However, I beg to differ. In our March 1st Letter to our Subscribers, I produced an in-depth study of the Dow Theory applied to the NDQ. I will share the tip of the iceberg here, as the full report is reserved for our Subscribers. Applying the Dow Theory for the 21st Century (aka. Schannep's Dow Theory) to the NDQ was astounding, as you can observe in the table below.

 

The key takeaways are:

  • The NDQ significantly outperforms the S&P500 on a buy-and-hold basis.
  • However, the NDQ occasionally undergoes devastating drawdowns.
  • Such huge drawdowns make the NDQ an unsuitable investment for many investors, especially those needing to tap on their stocks savings. Huge, unpredictable drawdowns are the enemy of the retiree, pension funds, etc.
  • The good news is that if we apply the Dow Theory to the NDQ., drawdowns dramatically shrink, and performance increases to really high levels (16.58% p.a. during the period tested that started on 11/1/1985)

In other words: Give the NDQ good bear market protection (the Dow Theory), and you'll keep its long-term huge upside potential compared to the S&P500 while getting rid of its vicious drawdowns. 

Example # 2: High quality and dividend yielding stocks:

A more specific example that shows that you can be very good at picking individual stocks and end up being decimated by a bear market is Mark Hulbert's article (5/13/22) published on MarketWatch. 

Mark shows the historical outperformance of Investment Quality Trends (average model portfolio). 

https://www.marketwatch.com/story/how-to-find-the-best-stocks-in-a-bad-market-using-legendary-investor-geraldine-weisss-proven-strategy-11652429742?mod=panda_marketwatch_author_alert&tesla=y

Click on the link above to see the performance charts of such a portfolio (and its horrible drawdowns).

As Mark explains, such a portfolio based on high-quality dividend-paying stocks tends to outperform the market. However, I noticed that when the bear strikes, as with all buy and hold, it drops big time. As with the NDQ, such a portfolio coupled with a good trend filter would work wonders. It would capture the outperformance in good times and eliminate the nasty drawdowns that also afflicted such a portfolio in the 2008-2009 and 2020 Bear markets, thereby increasing its outperformance in absolute and risk-adjusted terms. I have noticed that most investment strategies that outperform during the "good times" (example: Relative Strength and the Nasdaq100 itself) give back most gains during Bear markets. Bear market protection is necessary.

Example #3: Relative Strength stocks or ETFs:

It has been documented that high relative stocks or ETFs (strong momentum) tend to outperform their weaker peers. During bull markets, relative strength (RS) shines, but it comes at a price: RS tends to be one of the investment approaches that declines the most when the market turns bearish. It happens very often that RS underperforms buy and hold on a risk-adjusted basis (performance adjusted for drawdown). Once again, the Dow Theory comes in handy. If we apply a Dow Theory trend filter to a Relative Strength approach, we get the "upside" (the outperformance in bull markets) while we get rid of the "downside" (the vast drawdowns during bear markets). You may find an in-depth study HERE


Conclusions:


Bear market protection is necessary. Don't think that your investment prowess and pet stocks will help you when the market goes down. In a bear market, all stocks fall. Trend following, and more specifically, the Dow Theory, is the best method to buy insurance against bear markets for free. No need to purchase expensive hedges (i.e., puts). The best offense is defense.


Sincerely,

Manuel Blay

Editor of thedowtheory.com

Tuesday, April 26, 2022

Dow Theory Update for April 26: Shorting US bonds with the Dow Theory. Does it work?

 Answer: Yes!

Readers of this blog should know by now that the Dow Theory works. The measure of “working” is twofold: (a) drawdown reduction and (b) outperformance versus Buy & Hold (B&H). 

I recently explored the “long side” of the Dow Theory with US bonds (ETFs: TLT & EDV). The results were outstanding, as you can read HERE, HERE and HERE

Today, I’ll briefly explore the short side. What happens when we go short instead of going to cash when the Dow Theory signals a SELL (primary bear market)? Can the Dow Theory swim against a secular bullish tide? The answer is: YES. Even when confronted with a secular bull market (which may be recently over), the Dow Theory manages to be profitable, and it is not an oddity, as the Dow Theory managed to outperform B&H going long precious metals and oil when the secular trend was negative, as was explained here and here.

I performed two tests with TradeStation®:

The first one entails shorting EDV (the long-term duration bond ETF). The second one is going long TTT (inverse bond ETF). We had the following rules:

1. When a primary bear market was signaled, I shorted EDV (or went long TTT), and when a primary bull market was signaled, I covered EDV (or sold TTT).

2. I shun the long side. Only short and covering to isolate the shorting ability of the Dow Theory fully.

3. The test spanned from 12/26/2007 (first short) to 4/26/2022. For TTT, the test started on 4/27/2012

4. Start equity: USD 10,000

5. The Buy (cover)/Sell (short) signals were derived using the TLT & IEF pairs. You may find the specific rules here.

Below are the results for EDV:


 

The Profit Factor for a "short" trade against a mostly bullish market during the tested period is excellent: 3.25. The profit factor is the ratio between realized profits a losses. The current open short position with an unrealized profit of $2,755 has not been computed, as we still don't know how it will end. Had it been included, the P.F. would have been much higher. 

During the 14 years, three months, and 29 days tested, there were 12 closed trades. The current open trade is number 13. Hence, we get, on average less than one short per year—no overtrading.

The 12 closed trades netted out a realized profit of $ 6,511. The 13th open trade shows an unrealized profit of $ 3,187 for a total profit of $9,698. This is almost 100% on the starting equity.

The total time in the market was 44.95%. So if we adjust for time invested, the Dow Theory scores a very nice return. 

However, shorting EDV may not be the only way to bet on higher interest rates. Another option may be to buy an inverse ETF like TTT. Since TTT's inception date was later than EDV, we got fewer trades, as the first short (long TTT) was taken on 4/27/2012.

There was a total of 7 round trades. The 8th trade is still open. The Profit Factor amounts t0 1.63 (based on the seven closed trades). If we took the 8th open trade, it’d be 2.58.

The realized profit amounts to $ 2,526. The unrealized profit is $3,841, for a total profit of $6,367. This amounts to 63.67% made on the start equity in almost ten years. 57.14% of the closed trades were winners. While broadly in sync with the Buy (cover) /Sell (short) signals given by the pair TLT & IEF, TTT is less in gear than EDV, which should not come as a surprise.  

The good news is that irrespective of the way we short (outright or through an inverse ETF), the Dow Theory managed to be profitable shorting even when confronted with a period of overall rising bond prices. Couple these results with the good results attained by the Dow Theory going long with oil and precious metals swimming against a bearish tide, as you'll get an idea as to its robustness. So Dow Theorist Hamilton was right when he suggested that the Dow Theory could be applied not only to US stock indexes. It can even work on the short side against a secular bull market.

Sincerely,

Manuel Blay

Editor of thedowtheory.com