How often does the Dow Theory outperform buy and hold?

  Evaluating performance on a year-end  basis.

It is no secret that I am deeply influenced by Schannep’s Dow Theory flavor. To learn more about Schannep’s flavor, I suggest you go here, or if you plan to buy his excellent book here.

For reasons that go beyond my comprehension (maybe because he’s the best-performing Dow Theorist) his „flavor“ meets frequent criticism from the Dow Theory fraternity. One such common criticism has been recently made here and answered here.

 

I quote:

“To proffer Jack Schannep or E. George Schaefer’s theory for your method of interpreting the markets is great, especially when it works.”

Implicit in the criticism is that Schannep’s interpretation of the Dow Theory doesn’t always work, and hence it is not as dependable as the “classic” Dow Theory. Those interested in finding a short and good explanation of the basic tenets of the “classic” Dow Theory (as explained by Rhea) can go here.

For the purposes of this post, it suffices to say that Schannep’s Dow Theory flavor unambiguously outperforms the “classic” Dow Theory. And this is quite a feat because it improves something that is close to perfect as it is the “classic” Dow Theory. I leave for future posts in this Dow Theory blog a more in-depth dissection of Schannep’s out performance, because I feel that, before dealing with Schannep, we should fully squeeze all the juice out of the “classic” Dow Theory orange. IMHO Schannep can only be analyzed by comparing him to the “classic” Dow Theory. Hence, it is vital that we first become fully acquainted with all the intricacies pertaining to the “basic” Dow Theory, or if you want to call it this way “Dow Theory 1.0."

To this end, I will dedicate a series of special issues devoted to analyzing the “classic” Dow Theory. I will focus on aspects such as, longest draw down, deepest draw down, average winning trade, average losing trade, percentage of winning trades, performance under secular bull markets, performance under secular bear markets, average trade duration and a long etc.

Once we know inside out what to expect from the “classical” Dow Theory, we will be in a better position to evaluate Schannep’s Dow Theory flavor. Furthermore, we will do ourselves a great favor, as we will better understand the “classic” Dow Theory which, I insist, is in itself good enough.

Today, we will begin by addressing the first criticism branded against Schannep, namely that it looks great….when it works.

The best way to address such criticism is by looking under the magnifier the “classic” Dow Theory. Since it is alleged that Schannep’s “flavor” is not so dependable, we should look at how the classic Dow Theory fares in this respect.

Our question is: How often does the classic Dow Theory outperform buy and hold?

Does it outperform more often than not buy and hold? Does it lag behind a significant period of time?

Personally, I would never have the courage to invest with the Dow Theory (of any “flavor” whatsoever) if I couldn’t give an answer to these questions (and more questions that will come in future posts). The key to success as an investor is discipline, to stick to your system. Discipline comes in two ways. Either you go a psychologist and work hard with your subconscious, or you know your investment strategy inside out. Of course, the best way is to both know your subconscious and know your strategy inside out.

Well, now I will give my readers a surprise.

I have the Dow Theory versus buy and hold (of the Industrials) record from 1896 to 2011. So we can compare on a year-to-year basis (year-end end figures) how buy and hold fared versus the Dow Theory. Thus, in a given year, buy and hold may have delivered +10% whereas the Dow Theory merely returned +3% and vice versa. We take as our reference for a buy and hold investor the Dow Jones Industrials.

Out of these +115 years, do you know dear readers how many years the “classic'” Dow Theory outperformed “buy and hold”?

Do you expect the Dow Theory to outperform every single year?

Do you expect, at the very least, the Dow Theory to outperform 60% of the time? Seventy percent of the time, perhaps?

Make your guesses…...

…..

…..

I want you to think it over…...

Well, here is the answer:

29.4% of the years the Dow Theory equaled “buy and hold” in performance. These are years when the Dow Theory was invested throughout the year (thus overlapping with buy and hold). The average annual performance in these years was 16.89% for both the Dow Theory and buy and hold.

29.4% of the years (I checked for a typo or math error and there is none) the Dow Theory outperformed buy and hold. The average annual out performance is 15.77%. The Dow Theory returned -0.95% whereas buy and hold returned -16.72%.

However, 41.2% of the years the Dow Theory underperformed buy and hold by 8.54%. In these years, the Dow Theory returned 6.35% whereas buy and hold returned 14.89%.

I am indebted to one reader of this Dow Theory blog for inputting the Dow Theory classic record into a spreadsheet on a yearly basis in parallel with the annual closing price of the Industrials thereby allowing me to filter out the resulting figures and elaborate these statistics. Thus, we can draw the following conclusions:

1.      The “classical'” Dow Theory underperformed “buy and hold” most of the time. So the criticism that Schannep is “great," especially when it works, is misleading. All timing systems, and all Dow Theory “flavors” undergo rough patches. Under performance spells also affect the canonized “classical” Dow Theory.

2.      However, in spite of such underperformance most of the time, over the long term the classical Dow Theory achieves greater returns with a much lower risk.

3.      Interestingly, the Dow Theory underperforms when there is no danger out there. In good years for the stock market, the Dow Theory, while remaining solidly positive, returns less than buy and hold.

4.      The Dow Theory outperforms buy and hold when it is most needed: When stocks go down. The average annual performance of the Dow Theory when it is outperforming is -0.95%. However, buy and hold returned in those years a dismal -16.72% on average.

The reader may be puzzled to learn that the Dow Theory underperforms when the stock market is in a “good” year (namely when it goes up solidly). However, this has an easy explanation. As with any market-timing  system, the Dow Theory never gets us “aboard” in real time. At the risk of oversimplifying we can say that ca. 10% of any new bull market is always lost as the bull market signal comes some time after the inception of the new bull market. When the market goes up in an almost straight line, by definition the Dow Theory will lag in returns. Furthermore, if you do the math you can see that the Dow Theory under performance in “good” years for the stock market was ca. 8%. In other words, 8% of market action was lost to the Dow Theory as it was “late” in getting in.

However, what results in under performance in “good” times, is out performance in “bad” times. When the market heads south and buy and hold gives away all the unrealized gains, the Dow Theory does an excellent job in getting the investor out of the market close enough to the top.

Of course, the best environment for the Dow Theory is a long and sustained bull market where the primary bull market swing lasts more than one year uninterrupted. These are the years when the Dow Theory gets aligned with buy and hold as it remains fully invested along the never ending primary trend. However, such blissful environment (for both Dow Theorists and buy and hold investors) occurred only 29.4% of the time. Furthermore, if markets were always in such a perfect bullish mood, there would be no need for the Dow Theory or any other market timing system for this matter. Investing would be a piece of cake.

As the market tends to have more “good'” years than “bad" years, it is not surprising the Dow Theory under performs most of the time. However, its value lies in out performing when it is most needed: When the going gets tough.

Conclusions:

1.      The Dow Theory smooths out performance. It tends to deliver less than buy and hold in “good” years, but delivers much more in “bad” years. All this is accomplished with a higher average annual return. Such smoothed performance implies less risk for the investor and in technical jargon, we would say it has a higher Sharpe Ratio.

2.      Such smoothed performance is the closest thing to a free lunch. I am sure most seasoned investors would settle willingly with 2% less annual performance (i.e. 8% instead 10%) in exchange for reducing volatility, and draw downs. This is why bonds are successful in the first place. Or to put it differently, if there was an insurance that covers draw downs most investors would be willing to pay a premium of, say, 2% in order to protect themselves against the unexpected. This is why “puts” and derivatives are successful too. The Dow Theory provides us with ca. 2% annual average out performance while reducing dramatically volatility. It is like the insurance company paying us to buy its insurance. Not bad at all.

3.      Investors get blinded by performance. However, in real life, the investor is killed by draw downs. A 15% average performance is worth nothing if, somewhere along the road, there is going to be a draw down of -50%. Buy and hold is nice in theory, and it may work provided the investor has deep pockets (staying power) and psychological fortitude. However, in real life, very few investors possess both attributes at the same time. Thus, the publicized return figures of many investing strategies are not attainable in real life because the investor cannot endure the draw downs. If the average retiree needs to draw 4% off his capital annually (and this is a very realistic and even modest assumption), a draw down of 50% in any given year, will force him to draw 8% if he wants to keep his expenditures intact. Of course, he can cut with expenses, but as we well know, this is not an easy feat. Even if the retiree manages to reduce expenditures by 25%, this implies a withdrawal of 6% while being in the midst of the draw down. As a result total equity would be reduced by 50%+6%, thereby remaining only 44% of his original capital. A draw down of such magnitude is akin to a black hole. It is very difficult to escape from it. In most instances, the retiree will finish by eating up all of his capital. Game over for him!

4.      Therefore, the Dow Theory by strictly limiting losses in the “bad” years (remember in “bad” years the Dow Theory lost -0.95% versus -16.72 for buy and hold) clearly helps the normal investor lacking unlimited funds and/or mental fortitude. Furthermore, average returns don’t give the exact picture. Buy and hold lost on a year-end  basis more than 30% six years, whereas this never happened with the Dow Theory. 

Dow Theory’s performance during the secular 1966-1981 bear market

In my post “How often does the Dow Theory outperform buy and hold?”, which you can find here, I started a series of articles dedicated to examining the classical/Rhea Dow Theory “flavor” under all market environments and across time.

In that post, we made some interesting findings.

We found out that the Dow Theory outperformed buy and hold. Both in raw terms (average returns) and risk-adjusted returns (much lower standard deviation of returns).

However, it was also ascertained that 41.2% of the time the Dow Theory severely underperformed buy and hold. Only 29.4% of the time managed the Dow Theory to outperform buy and hold. Therefore, the overall Dow Theory outperformance was made in relatively few, but critical, years. I encourage you to read that post and absorb all its details.

 

Whilst in such a post, I made clear that the Dow Theory tended to outperform buy and hold during bear markets, I didn’t provide the readers of this blog with specific figures relating to secular bear markets. This is what we are going to do in this post.

We are going to focus our attention on the 1966-1981 bear market. How did the Dow Theory fare?

Well, as you can imagine, the answer is:

The Dow Theory did indeed fare very well during such secular bear market and trounced buy and hold.

Let’s look now at the fine print.

All figures that follow are exclusive of dividends.

During these 16 years, the Dow Theory outperformed buy and hold (the Industrials) six years or 37.5% of the time.

Three years or 18.75% of the time, the Dow Theory matched buy and hold (it was fully invested all year long).

Seven years or 43.75% of the time, the Dow Theory underperformed buy and hold.

So, during this secular bear market, the figures for out and under performance closely resemble those for the whole +115 years.

The average annual performance for the Dow Theory was 2.97%. Buy and hold only managed to scratch 0.77%. Please mind that the ca. 2% publicized Dow Theory outperformance for its +115 years track record also holds true during this secular bear market. Such “outperformance stability” is worthy of praise and is to be studied more in depth in a future post in this Dow Theory blog.

The standard deviation of annual returns clearly favored the Dow Theory. Buy and hold experienced a standard deviation of 17.43% whereas the Dow Theory had a more modest 10.99%.  Once again, the Dow Theory excelled by reducing significantly risk.

Buy and hold had seven losing years. The Dow Theory only six. However, the comparison between losing years gets more interesting when we look at the average loss in each losing year. Buy and hold lost -15.42% on average, whereas the Dow Theory significantly contained losses by losing only -7.56% on average. Hence, in bad years, the Dow Theory outperformed on average buy and hold by 7.85%.

True to its underperformance in good years, the Dow Theory managed to make only 9.28% in winning years, whereas buy and hold made 13.65%.%. Hence, in good years, the Dow Theory underperformed buy and hold by -4.08%. However, we shouldn’t get greedy. When the market is behaving nicely, there is no need to squeeze 13.65%. I’d rather prefer to make 9.28% in good years and containing my losses to only -7.85% (instead of -15.42% for buy and hold) in bad years. The investor’s long-term survival demands fewer stellar years and fewer horrible years. We don’t want a roller coaster; we just like a gentle smooth ride. Furthermore, it should be born in mind that the Dow Theory managed to outperform buy and hold by more than 2% when the whole period is considered (1966-1981).

But averages are misleading. Let’s take a look at the deepest drawdown suffered by the buy and hold investor during that secular bear market. Measured on a year-end  basis between 1973 and 1974 buy and hold lost -44.16%.

Do you want to know how much did the Dow Theory lose in 1973-1974? Make your guess….

The Dow Theory only lost -5.89% because it managed to keep the investor in cash (out of the market) during the great bulk of the devastating 1973-1974 bear market.

In real life, very few investors could survive such -44.16% devastation. Especially those nearing retirement. In my humble opinion, such draw down is an indictment of buy and hold.

By contrast, the Dow Theory worst draw down during the secular bear market amounted to only -15.26% in 1975.

Thus, we can notice that the Dow Theory is very dependable. The figures you are reading right now are very close to the statistics I posted here.

All the statistics I have just given deserve your careful attention if you are really serious about protecting your capital. Please mind my insistence in protecting capital. Take care of your equity and returns will take care of themselves. What you have in front of your eyes is the closest thing to a free lunch. Of course, it does not come for free. To believe in the Dow Theory takes work, hard work. At the risk of repeating myself, I always say that the Dow Theory looks deceptively simple. It is not so simple or at least not simple enough so that investors stick to it during the inevitable and frequent underperformance spells. Furthermore, and this is the subject for a future post in this Dow Theory blog, being a market timer takes an emotional toll on most investors. Not because of the stress of trading in and out of positions, since, as you can see from frequently reading this blog, the Dow Theory signals occur very sparsely, but because psychologically not being “buy and hold” has social and mental repercussions which not everyone is apt or willing to bear. Everything in life has a price, and the Dow Theory’s free lunch may not be so free after all. This is why I am pretty convinced that technical analysis and more especially the Dow Theory will not self destruct due to mass following. It spite of its simplicity (or because of it), it becomes psychologically intractable for most folks.

Dow Theory’s performance during the secular 1982-1999 bull market

We are going to focus our attention on the 1982-1999 bull market. How did the Dow Theory fare?

It fared well, but its performance was slightly less stellar than that delivered by buy and hold. So, once again, it is confirmed that the Dow Theory comes really in handy when the going gets tough. There is no need for protection when the market is in a smooth ride. And as explained here and here, timing devices rarely outperform bull markets.

During these 18 years, those that bought and hold the Industrials made an average gain of 15.94% annual.

Those following the Dow Theory (in its classica/Rhea “flavor”) made an average gain of 14% annual.

So the Dow Theory underperformed buy and hold by 1.94% on an annual basis during the secular 1982-1999 bull market.

This is fully in line with the findings we made in the first post of this saga. The Dow Theory underperforms when markets go up. However, true to its “protector” function, the Dow Theory managed to make +24.21% in 1987 (the year of the crash) whereas buy and hold made a  meager +2.26% for the year.

Hence, in such fateful year, the Dow Theory managed to outperform buy and hold by almost 22%. Not bad, I think!

But year end figures are only part of the story. If you read my post concerning the 1987 stocks market crash, you will learn that the loss experienced by Dow Theorists from the top amounted to only -13.49% whereas buy and hold endured a loss of -36.13% from top to bottom.

An image is worth more than thousand words, I encourage you to read the 1987 crash post and, more importantly, look at the chart. It says anything you need to know.

1990 was not a particular good year for the stock market. Buy and hold lost -4.34%. The Dow Theory made a somewhat modest loss of -4.28%.

Now let’s break down the out and underperformance of the Dow Theory versus buy and hold.

In only 2 years, the Dow Theory managed to outperform buy and hold. As you can guess such years were 1987 and 1990, namely when there is trouble in the air.

In 8 years the Dow Theory equaled buy and hold. Those were typical secular bull market years when the Dow Theory remained fully invested along the primary trend during all the year. Thus, the Dow Theory remained fully invested from 1993 to 1997, that is five consecutive years. This gives you a measure of the strength of the secular bull market.

In 8 years, the Dow Theory underperformed buy and hold.

Now let’s take a look at the standard deviation of returns. If you go back to my post “DowTheory’s performance during the secular 1966-1981 bear market," you’ll see that the standard deviation of annual returns for buy and hold during such a vicious bear market amounted to 17.43% (the Dow Theory had a much modest standard deviation of only 10.99%).

During the secular 1982-1999 bull market, things were different. It was such a bountiful period that the standard deviation of returns for buy and hold declined to only 11.45%, which was slightly lower than the standard deviation for the Dow Theory at 11.60%.  I do think that such secular bull market was the closest thing to nirvana for buy and hold investors, which perversely, resulted in blinding them as to the realities and hidden dangers of buy and hold when one doesn’t have the privilege of having permanent tailwind (something similar doomed famed Dow Theorist Schaefer).

The slight underperformance of the Dow Theory during the 1982-1999 secular bull market may disappoint investors. However, what I wrote here remains fully applicable and should be fully absorbed by all investors really intend on protecting their capital:

 

1.      The Dow Theory smooths out performance. It tends to deliver less than buy and hold in “good” years, but delivers much more in “bad” years. All this is accomplished with a higher average annual return. Such smoothed performance implies less risk for the investor and in technical jargon, we would say it has a higher Sharpe Ratio.

2.      Such smoothed performance is the closest thing to a free lunch. I am sure most seasoned investors would settle willingly with 2% less annual performance (i.e. 8% instead 10%) in exchange for reducing volatility, and draw downs. This is why bonds are successful in the first place. Or to put it differently, if there was an insurance that covers draw downs most investors would be willing to pay a premium of, say, 2% in order to protect themselves against the unexpected. This is why “puts” and derivatives are successful too. The Dow Theory provides us with ca. 2% annual average out performance while reducing dramatically volatility. It is like the insurance company paying us to buy its insurance. Not bad at all.

3.      Investors get blinded by performance. However, in real life, the investor is killed by draw downs. A 15% average performance is worth nothing if, somewhere along the road, there is going to be a draw down of -50%. Buy and hold is nice in theory, and it may work provided the investor has deep pockets (staying power) and psychological fortitude. However, in real life, very few investors possess both attributes at the same time. Thus, the publicized return figures of many investing strategies are not attainable in real life because the investor cannot endure the draw downs. If the average retiree needs to draw 4% off his capital annually (and this is a very realistic and even modest assumption), a draw down of 50% in any given year, will force him to draw 8% if he wants to keep his expenditures intact. Of course, he can cut with expenses, but as we well know, this is not an easy feat. Even if the retiree manages to reduce expenditures by 25%, this implies a withdrawal of 6% while being in the midst of the draw down. As a result total equity would be reduced by 50%+6%, thereby remaining only 44% of his original capital. A draw down of such magnitude is akin to a black hole. It is very difficult to escape from it. In most instances, the retiree will finish by eating up all of his capital. Game over for him!

4.      Therefore, the Dow Theory by strictly limiting losses in the “bad” years (remember in “bad” years the Dow Theory lost -0.95% versus -16.72 for buy and hold) clearly helps the normal investor lacking unlimited funds and/or mental fortitude. Furthermore, average returns don’t give the exact picture. Buy and hold lost on a year-end basis more than 30% six years, whereas this never happened with the Dow Theory.

Sincerely,

The Dow Theorist