Dow Theory Special Issue: Putting the Dow Theory under Stress-Test (IV)

Will future secular bear markets allow the Dow Theory to outperform buy and hold? Will future secular bear markets be so obliging to the Dow Theory as past ones?

The preceding two posts of this saga (here and here) dealt with the Dow Theory performance under secular bear markets. I concluded that I thought that future secular bear markets would resemble past ones in that the “swings” were going to be of sufficient magnitude so that to allow the Dow Theory to be profitable. Today, I will explain why I believe that the future will be similar to the past, and hence, secular bear markets will not be characterized by small swings (i.e. not reaching 20% from top to bottom) but rather ample ones which may include even 50% swings.

First of all, I believe in trends. Trends persist. It has been amply documented that the market is not a random walk (study, for instance, Michael Covel's book "Trend Following"). Trends exist because there is a tendency to overreact for psychological and fundamental reasons. Hence, trends based on fundamentals (i.e. economic crisis) will last longer than one expects and when coupled with psychology (bandwagon effect, etc.) there will likely be overshooting 

Secondly, the very rationale for pricing stocks warrants big swings. Basically, the price of stocks depends on two factors: The expected earnings and the discount rate (PER). An adverse economic environment, results in decreasing (or slowing at least) earnings. However, as a side effect, reduced earnings result in lower PER (high capitalization rates). In other words, people are less willing to pay for earnings. Thus, an earnings reduction of 50% may perfectly entail at the same time a PER reduction of 50%, a double whammy. Hence, if the stocks market was at a level of 100 with earnings at 5 units and PER at 20, an earnings reduction of 50% may result in the following stock market price:

            100 -50% earnings reduction = 50 units.

            50 – 50% PER reduction (PER of 10) = 25 units.

Which amounts to a total decline of 75%. This is precisely what happened in the 1930’s. There was a drastic decline of earnings, which at the same time triggered a massive PER reduction.

If you think it carefully, PER reduction makes fully sense. Less earnings means less money (wages too, as companies lay off) to be spent in the stock market (less demand). Furthermore, hard economic conditions increases the supply of stocks (people now in dire straits which is forced to sell, rich people getting less dividends who have to sell to maintain their lifestyle, etc.).

Furthermore, I feel that current and future times will encourage extreme swings, as central banking creates bubbles which subsequently pop (as it may be happening right now as a write these lines). Credit expansion and contraction further exacerbates the ebb and flow of earnings and PER.

Thus, it is not outlandish to predict an S&P 500 level of just 500. A dramatic reduction of earnings by 50% would see to that, as PER would also likely decline by 50%. However, I distrust those pundits predicting that it will occur tomorrow. I am not interesting in fundamentally calling the top of stocks; I have the Dow Theory to help me if such a dramatic decline à la 1930 happens again. 

Thirdly, on an empirical basis (which may not necessarily be a guide to the future, but helps), primary bear market signals as determined by Schannep’s Dow Theory entail, on average, a further -13% decline until a bottom is made. Since we trade, and live or die, by such primary bear/bull market signals, the past record seems to suggest that it is likely that the average swing (as detected by the Dow Theory) amounts to ca. 20% from top to bottom (-13% subsequent decline after the signal + ca. 6-7% from the top until the signal is flashed). Swings of an average magnitude of 20% are sufficient to be profitable traded according to the Dow Theory. More about the average decline following a primary bear market signal, with updated spreadsheet, here.

Forthly, even if we ignore the Dow Theory, and we just stick to a “bear market definition” consisting of a simultaneous decline of -16% both on the S&P 500 and the Industrials (more about it, on Schannep's website "thedowtheory.com", and his must-read, master piece book, "The Dow Theory for the 21st Century"), we know that in past instances, a subsequent -13.20% decline followed the declaration of a bear market.

For all this reasons, I feel it is very likely that future secular bear markets will “oscillate” with a range sufficiently ample to be profitably traded under the Dow Theory, especially “Schannep’s", which is very reactive.

However, in spite of all the foregoing, an astute reader could be asking himself: All this is nice and dandy. However, the right “overlay” for Dow Theory signals (especially , those of Schannep) are the cyclical bull and bear markets, not the secular ones. A secular bear market may easily “contain” several cyclical bull and bear markets, which at the same time “contain” primary bull and bear market Dow Theory signals. Will such cyclical bull and bear markets allow the Dow Theory to outperform, and more importantly, avoid big drawdowns?

The answer to this rather abstruse but important question will be given in the next chapter of this saga (with a clarifying graph to be provided). In the meantime, digest the present post, and ponder about this vital, question.

Sincerely,

The Dow Theorist.

Dow Theory Update for March 3: Primary bull market for SIL and GDX signaled today

Secondary reaction in US stocks continues unabated

US STOCKS

The primary trend is bearish, as explained here:

http://www.dowtheoryinvestment.com/2015/12/dow-theory-update-for-december-14.html

Here is an additional post concerning the likely decline to follow primary bear markets signals:

http://www.dowtheoryinvestment.com/2015/12/dow-theory-special-issue-additional.html

The secondary trend is bullish (secondary reaction against primary bearish trend) as explained here.

http://www.dowtheoryinvestment.com/2016/02/dow-theory-update-for-february23.html

No setup for a primary bull market signal has materialized yet.

GOLD AND SILVER

The primary trend is bearish as explained here.

The secondary trend turned bullish on January 26, as explained here

On February 16^th, GLD after having declined for two days, and going from a closing high of 119.06 to a closing low of 114.77, set up both precious metals for a primary bull market signal. GLD declined -3.6%, which in volatility adjusted terms, given the current volatility levels of the SPY and GLD, is a movement of sufficient magnitude. More about the rationale of volatility adjustments and how I perform them, here.

SLV did not even manage to decline for two days. However, to set up markets for a primary bull/bear market it suffices to have just one index. The principle of confirmation does not apply on this specific instance, as was explained in depth, here.

So now we have SLV and GLD set up for a primary bull market signal. If the GLD’S 2/11/2016 closing highs and SLV’s 2/12/2016 closing highs were jointly broken out, a primary bull market would be signaled.

On March 3, 2016, GLD managed to break above the secondary reaction closing highs (2/11/2016). However, SLV has not confirmed and, hence, no primary bull market has been signaled.

Here you have an updated chart:

SLV must better the closing high of the last secondary reaction (blue rectangle) for a primary bull market to be signaled

GOLD AND SILVER MINERS ETFs

Today, finally, SIL deigned to break up above the closing highs of the last completed secondary reaction (horizontal red lines on the charts). While the current secondary reaction did not even manage to have a pullback (tiny orange rectangles on the right side of the chart) of sufficient magnitude to set up both ETFs for a primary bull market, Rhea’s alternative definition of a primary bull/bear market comes in handy. More about this less publicized alternative primary bull market signal here (and in the linked post, you’ll find additional links, as it is a five chapter saga).

  

Please readers mind that I am not engaged in giving trading advice (see disclaimer at the footer of this Dow Theory blog). I am merely saying that according to my reading of the Dow Theory the primary trend for SIL and GDX has turned bullish today. Some traders may decide to take a long position. Others, may decide to stay on the sidelines. It’s up to each investor. I am just discerning trends; not advising anyone to act on my interpretation of the Dow Theory. This blog's aim is to instruct, and to prompt readers to think. I personally would have never "acted" on the opinions of a blogger (nor on the opinions of anyone, no matter how "expert", for this matter). This is why, many years ago, I decided to master as good as I could the Dow Theory so that I would never be dependent on anyone's else advice. There are no shortcuts.

Furthermore, I make this “additional” disclaimer, as I personally don’t take any trade suggested by the Dow Theory. I discriminate. Why? Because not all Dow Theory signals offer the same risk reward ratio. Like in baseball, I am not obliged to be batting all the time. If the “buy” signal (primary bull market signal) comes at a reasonable distance percentagewise from the primary bear market bottom, I’ll take the signal. If the signals occurs after a long and steep rally (with no breather, clearly overbought conditions) I may pass. So there are personal judgment calls.

SIL has rallied a whopping 57.49% from its 1/19/2016 closing low. GDX has rallied 58.94%. So clearly, this is not an easy trade to take. Each investor has different risk tolerances, and circumstances. If I were a fundamental investor convinced of the brilliant future for precious miners stocks (I am not, since I tend to dismiss any fundamental judgment), I’d maybe close my eyes and step in, since technically today things seem to have changed. Other traders may decide to take a smaller than usual position, as the Dow Theory stop loss (more about such a stop, here) is fixed at the primary bear market lows of 1/19/2016.

 

Other traders might wait for SIL and GDX to start a secondary reaction with a view to buying somewhat below the current price levels. However, there are no guarantees that we will see a pullback of moderate proportions.

Here you have an updated chart. The red horizontal lines display the relevant price levels to be broken out. 

Primary bull market for SIL and GDX signaled today

 

Sincerely,

The Dow Theorist

Dow Theory Special Issue: Why drawdowns matter

And why most investors should avoid them

Some weeks ago, one reader of this Dow Theory blog alleged that the focus on “timing” the market, and hence avoiding drawdowns was not a good idea, since in the long run US stocks (or at least US stock indices) end up being winners. Furthermore, no dividends are cashed by the investor while being out of the market as a consequence of “timing”. Hence, the admonition was: Buy and hold and know that eventually stocks will recover.

If we were certain that stocks will recover (this is the “mantra”), and we knew in advance that the drawdown length lies within our financial tolerance (in other words, we don’t need to tap into these savings while stocks remain underwater) then buy and hold could be ok.

Thus, if armed with a crystal ball we had known in 2008 that the precipitous decline was going to be erased in 4-5 years, people in no need of their savings during this time frame would have been well advised to just hold and don’t panic.

However, in real life, in real time, we really don’t know whether the drawdown is going to be of short duration (or at least of a duration that does not exceed our financial staying power) or, like it happened from 1929 to the mid Fifties, a drawdown in the vicinity of 25 years, which, more likely than not, will try everybody’s patience and staying power.

I recall vividly when stocks were falling in earnest by the end of 2008. I had a business meeting unrelated with the market with an aging lawyer. He was by then 70 years old. He was devastated and panicking as his life savings were invested in the stock market. He felt that the sky was falling under and hence told me that he had just ordered his broker to sell all of his holdings in order to sit in cash. He told me he was grieved as he had endured losses in the vicinity of 60% (yeah, stocks can decline more than indices), and to add insult to injury, this was the second time in his life to be wiped out. He told me that in the early 80’s we lost all his savings in real estate investments when real estate collapsed and he had to repay debt whose value exceeded that of the real estate he owned. His humble conclusion was that he was a lawyer, and hence “clobber stick to your trade”. He bemoaned that had he been cleverer in the early 80’s with real estate and had he avoided the stock mayhem of 2008 he would be a pretty rich person. He confided that the 60% realized loss in stocks in 2008 was tantamount to postponing his retirement as a lawyer for at least another 10-13 years (that is: NEVER). By 2008 I was already very interested in the markets, and investing, so I cannot say that the experience of that unlucky lawyer prompted me to study the markets. However, his financial predicaments confirmed me that I had to deeply understand markets, anticipate big declines (“timing”) and highly respect drawdowns. I also recalled in real time that Richard Russell had clearly signaled the existence of a primary bear market by the beginning of 2008, and hence, I was not caught unawares by the dramatic declines. I even cautioned about Russell's dictum to some investment acquaintances of mine, who disdainfully brushed off any thought concerning the bear market and ridiculed Russell. Well, the final "ridicule" was for those "fundamental" arrogants.

The take away is this: in real time, by the end of 2008, the 70 years old hapless lawyer did not know:

 (a) when to get out early (the "sweet" moment was the beginning of 2008); 

 (b) that we were nearing a bottom, and 

 (c) that after 5 years stocks would be making again higher highs. 

In real time nobody knows the future, and the mantra that everything will be ok in the long run, may be proven wrong (I insist: look at the drawdown that started in 1929 or go to other countries not so lucky as the US).

Under the Dow Theory, we cannot know letters "b" and "c" above (namely, whether we are nearing a bottom, or whether the big drawdown will be recovered in a few years). Let's remember Rhea: Nobody can predict the extent and duration of primary bear markets. However, what we can know under the Dow Theory (and this is very valuable, indeed) is the right moment to get out. Sometimes, our Dow Theory exits will merely avoid small drawdowns. However, sometimes, our exits will get us out of big trouble. More about the declines following the Dow Theory primary bear market signals, here.

Hence, a temporary loss may become permanent loss. Thus all good traders know when to run for the exits.

What about Buffet and other paradigmatic buy and hold investors? Well, their situation is quite different from the average Joe’s situation for the following reasons:

1) Firstly, their investments in a given stock are so sizable that “timing” is a losing proposition. In other words, they would move the market. Furthermore, given that they must make disclosure statements, they risk making the decline of the stock even more precipitous. For big investors is not so easy to get in or to get out, and hence they cannot sell a stock “next day at the open” and forget about it. Volume matters.

2) They are owners, not traders. As Minervini in his master piece “Trade Like a Stock Market Wizard”(p. 62)  says:

 

“Valuing a company on intrinsic value is not trading stocks; it’s buying assets. Your goal is to make money consistently, not accumulate a lockbox of assets that you really don’t own -just pieces of paper that were made for trade”.

Traders are not owners; we just own a digit or a piece of paper. Owners have control, and quite often perks (board meetings, etc.), and insider knowledge. We, traders, lack all of this. An owner should behave like an owner, that is accompanying the enterprise, selecting and controlling competent management, etc. Furthermore, owners quite often manage to derive extra benefits like providing incompetent relatives with cushy jobs, etc. We, as traders, given our minuscule commitment, don’t have any power, and the only compensation for our lack of power, is the ease of getting in and out. To each his own.  

Furthermore, as evidenced by this post, with proper timing (here the Dow Theory comes in handy) the investor can sport positive returns when the market is declining (see my studies concerning the Dow Theory outperformance during secular bear markets).

3) “Big investors” have huge staying power. The average trader does not. If Mr. Buffet’s holdings declined by 60% he would remain a billionaire. Furthermore, even a measly 0.5% dividend amounts to many million dollars, and hence, there is no need to tap into savings in order to keep up with daily expenditures. There is no comparison between the average saver and big, really big investors. Once again: To each his own. If I were Buffet, I’d be interested in ensuring that my companies perform well, and wouldn’t give a hoot about the Dow Theory, since it would be a distraction, and diminish my focus on the important thing: Being a company owner. Of course, the buy and hold crowd will vociferously say: “Buffet started small, and his ability to build a fortune from ground zero attests to the bounties of buy and hold. He’d never have achieved that by being a market timer”

My retort is as follows: First of all, many market timers find it terribly boring buy and hold. I don’t want to say that we crave for excitement (which is a bad thing in investing), but, certainly, God has not endowed us all with the same talents and inclinations. What works for Buffet does not work for the large majority of the population. Of course, the same applies to “timing”, since not all people are cut out for it. However, as Schwager’s “Market Wizards” saga makes clear, there are lots of market timers which have managed to amass some billions. Thus, it seems that market timing is no hindrance to grow a small stake into something bigger.

4) Personally, I feel that Mr. Buffet and the buy and hold crowd has had exceptionally good tailwind during the past decades, Thus, drawdowns have been never "life threatening" (at least for investors with a +20 years time horizon). Things can change, though. Buffet is fond of saying that he believes that US will continue to remain exceptional and hence continue to be a profitable investment for long term investors. As a foreigner, I deeply admire the US, its drive, ingenuity and reward for talent (albeit the clouds of envy and resentment begin to gather on the horizon in a manner that begins to resemble old Europe). I wish the USA “of olde” would remain forever. However, truth is that nobody knows the future and making an optimistic bet on the future of the USA is betting on “fundamentals”, and the skeptical “technical” dog that dwells in me tells me that this is a dangerous proposal. Hence, I personally hope that the US will remain a free market economy, and, if possible, become even a “freer” economy. However, if the US is to remain the beacon of free markets, I know that the charts will tell me so, as stocks will continue to go up. Why do I need to jump the gun and make a “fundamental” leap of faith? The Dow Theory will see to it.

Sincerely,

The Dow Theorist