Dow Theory's
Prescription for the Bond Debacle Dilemma
Due to the surge in interest rates, long-duration
bonds have experienced a significant loss of value, amounting to a 50%
drawdown. This substantial decline in the so-called safe haven asset class
resembles the drawdowns seen in stock indexes, underscoring the fact that
unexpected events occur. Investors sometimes harbor a false sense of security
through simplistic strategies like buy and hold or the 60/40 portfolio.
So, let's assess whether the Dow Theory (DT) protected bond investors throughout the bear market that commenced
in August 2020.
To begin, we know that since the inception of
TLT, the Dow Theory has consistently delivered strong results by outperforming
buy and hold and mitigating drawdowns. In previous posts (found HERE,
HERE,
and HERE),
I substantiated these results with robust data, illustrating the effectiveness
of the DT when applied to TLT and EDV. I also demonstrated that the DT was much
more effective at cutting drawdowns and achieving outperformance vs. buy and
hold (BAH) than other trend-following systems. Therefore, my emphasis on the
Dow Theory is not a trivial fixation but a thoroughly reasoned choice.
However, the research I linked to above concluded in
March 2022. Therefore, we need to assess the developments from that date and,
more crucially, evaluate how the DT has performed in safeguarding bond
investors since the onset of the bear market on August 4, 2020. In essence,
scrutinizing the most recent bear market offers an excellent "out of
sample" test. Moreover, my prior research primarily took place during a
thriving bond bull market. Given the substantial shift in the market environment, assessing how the DT performs when confronted with a significant bear market makes sense.
The following trades are the ones that I have publicly
disclosed on my blog and in my monthly letter to subscribers. So, it is not a simulation but a compilation of the actual
trades I discerned in real time.
The rules applied are as follows:
1. I initiated the analysis
at TLT's market peak on 8/4/2020, beginning with an equity of $100 for both Buy
and Hold (BAH) and the Dow Theory.
2. The analysis concludes on
10/6/2023, marking the most recent bear market low.
3. Dividends are not
factored in for either BAH or the DT; the focus is on pure price action.
4. For BAH, the calculations
are straightforward: I consider the initial price of TLT and the final price.
5. For the DT, two subsets
are calculated. The first is the DT "only long," which means that
when a Sell signal is generated, the portfolio moves to cash. No interest
accrual while in cash has been taken into account. The second subset is the DT
"long/short," in which the DT triggers a SELL, resulting in a short
position. Conversely, when a BUY signal is given, the short position is
covered, and the portfolio goes long. This approach maximizes the potential
inherent in the Dow Theory. Like BAH, the DT commences at the top on 8/4/2020.
Now, let's delve into the
performance comparison, as shown in the Table below:
We can observe that Buy and Hold (BAH) yielded a
negative Compound Annual Growth Rate (CAGR) of -19.92% with a substantial
maximum drawdown of -50.50% (a clear example of capital destruction!). On the
other hand, the Dow Theory's "only long" approach, which shifts to
cash when a Sell signal triggers, incurred considerably smaller losses,
boasting a CAGR of -5.07% and a drawdown of only -19.73%. This means the
drawdown was more than halved. In terms of outperformance, the Dow Theory
outpaced BAH by an impressive 14.85% annually. Quite remarkable!
The right column shows the full and logical application
of the DT, which entails going short. This strategy resulted in a significant
CAGR increase to 9.02%, and the drawdown was minimized to -10.37%. The
outperformance of the "long/short" Dow Theory compared to BAH
skyrocketed to 28.04% annually. Do you recognize the distinction between a
-19.92% annual loss and a 9.02% annual gain?
Such outperformance is not an anomaly; I have
documented in my blog that the Dow Theory excels during market downturns. After
all, if the market consistently rose in a straight line, trend followers would,
at best, match the performance of Buy and Hold. Bear markets are the breeding
ground for our outperformance and drawdown reduction. This is why trend
following tests investors' patience. When any market enjoys a sustained upward
trajectory, trend following (including the Dow Theory) will, at best, keep pace
with Buy and Hold. Market timing truly shines during challenging periods, which
are inevitable. Patience is vital, but it is well rewarded.
The table below displays the breakdown of the DT trades, including the
percentage gained or lost, as well as the percentage reduction in
drawdown compared to BAH.
Conclusions:
1)
The Dow Theory is not, as many believe, a cult. When
applied to stocks, it boasts a well-documented, third-party-validated track
record spanning over 130 years.
2)
As elucidated in several posts (example HERE
& HERE),
the DT can also be applied to other markets (oil, precious metals, crypto, and
bonds).
3)
The DT is, in my opinion, the most accurate trend
following method. Why?
HERE and HERE is the answer.
4)
The DT worked beautifully during the secular bond bull
market, but, more importantly, it has also shown great outperformance vs. BAH
and drawdown reduction in the present colossal bear market. Therefore, precisely
when it is most needed, the Dow Theory has proven to be a protective shield for
investors.
5)
Hence, multimarket application, documented track
records, proven outperformance, and drawdown reduction should boost our
confidence in utilizing the DT in our investment strategy.
Sincerely,
Manuel Blay
Editor of thedowtheory.com
