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Dow Theory Special Issue: Putting The Dow Theory Under Stress-Test (III)

|Includes: DIA, IYT, SPDR S&P 500 Trust ETF (SPY)

Additional remarks concerning performance under secular bear markets

As a consequence of my second post concerning the Dow Theory stress-test, Alpha Dow posted this comment:

Hi there. First of all -- I love the site. I'm an 18yr disciple of Dow Theory and a subscriber to Schannep and a practitioner myself. There is a dearth of material out there about Dow Theory so you are doing the world a great service. I would like to say that although I agree with most of the article, it is at risk of sounding a bit facile. During the most recent decline from the May high to the October low (approx 14% on the Dow), I believe Schannep was at least 50% invested and most people are probably even more so. I may be wrong but JS himself says people use his service in different ways. I certainly don't just buy the ETFs that he does. I use it as a "regime filter" to know when to be aggressively long and when to play defense. I appreciate that this study is only for academic purposes and to elucidate the merit of the theory, but I think it risks sounding a bit pollyannaish to suggest a 6% loss is all that can be expected in a secular bear. We haven't even talked about transactions costs, slippage, emotions and taxes!

This post further elaborates on Alpha Dow's comment.

Schannep's mixes his Dow Theory with his proprietary "timing indicator", and hence signals derived from the Dow Theory just weight "50%". In other words, if one gets a Dow Theory "sell" (primary bear market) signal, whereas the "timing indicator" remains on a "buy" mode, he will only sell ½ of the position. This is why as of this writing Schannep remains invested at 50%.

This blog focuses exclusively on the Dow Theory, and does not use "Schannep's timing indicator". It is not because I find it defective, but, rather, because the "timing indicator" is not Dow Theory and the exclusive focus of this blog is the Dow Theory. The focus of my post was to assess what to expect under secular bear markets when exclusively applying the Dow Theory. I want to isolate its performance.

In the past, Schannep's timing indicator has quite closely mimicked his Dow Theory signals (i.e. 1987 crash). However, there is no guarantee that at any critical future juncture it will continue to do so. Hence, at certain instances, such as the current market environment, the Dow Theory may signal a "sell", whereas the "timing indicator" remains at a "buy". It is clear that when mixing both timing devices, there is a higher risk of enduring larger losses. If the current decline turns into a "big" decline, those remaining at 50% invested will endure a larger loss than those who only applied the Dow Theory, and run for the exits on December 11 (date of the primary bear market signal).

I am not saying that using the timing indicator is worse than just applying the Dow Theory. In real time nobody knows what is going to happen, and hence, should the current decline fizzle out, and a new powerful rally emerge, then it would have been wiser to remain invested at 50%. In other words, sometimes it is better to just use the Dow Theory; sometimes it is better to mix it with the "timing indicator" in order not to be so "reactive".

Of course, the downside of using the "timing indicator" will be a slighter greater tendency to larger losses when markets decline in earnest. So mixing the Dow Theory with the timing indicator will result in the following profile:

a) less whipsaws, as one remains partially invested when there is a failed Dow Theory sell signal ("failed" meaning that the next buy is at a higher level than the sell signal).

b) slightly higher losses, when the Dow Theory alone did not whipsaw (that is, when the next buy was at a lower level than the sell signal).

We should bear in mind that most Dow Theory sell signals are successful, that is, the next "buy" comes at a lower price level.

Schannep's own book, gives us an idea of the losses to be expected when using the "timing" indicator versus just using the Schannep's Dow Theory.

If we go to page 182 of his book (Table 14.2) we see that following a Schannep's Dow Theory primary bear market signal, the market has further declined -14.6%. On the other hand, the timing indicator further declined -12.5% (both figures were derived by Schannep with data until 2007). In other words, the Dow Theory signaled a "sell" (exit) ca. 2% points before than his timing indicator.

In other words, if I say that Schannep's Dow Theory tends to exit at ca. -6% from the top, it is reasonable to infer that the "timing indicator" will tend to exit at ca. -8% from the top. Please mind that we are talking about averages and not certainties.

The fact that the Dow Theory exits "earlier" than the "timing indicator" will result in a profile of more contained losses. I am not implying that this is better, since we have to also look at returns. Maybe the timing indicator endures higher losing trades but, at the same time, winning trades are larger. If we go to page 181 (Table 14.1) of Schannep's book we will see that the timing indicator does not outperform Schannep's Dow Theory. The combined use of the "timing indicator" and Schannep's Dow Theory (giving to each respective signal a 50% weight) results in a very similar performance to that derived from just using Schannep's Dow Theory. Thus, we can gather from Schannep's book that the combined use of the "timing indicator" and the Dow Theory:

a) Result in very similar performance to just using alone the Schannep's Dow Theory.

b) Losing trades will be slightly higher.

c) It may be convenient in some instances to keep a foot (50%) in the market and avoid whipsaws.

Personally, and here enters the psychological factor Alpha Dow mentions in his comment, I abhor overstaying weak markets, and hence I feel more comfortable just using the Dow Theory (and I keep it simple, less complexity). Furthermore, when looking forward, it is more unlikely that Schannep's Dow Theory be caught unaware by a sudden crash than the "timing indicator". The fact that the timing indicator avoided past crashes unscathed does not guarantee that it will continue to do so in the future. Of course, the same applies to the Dow Theory, but there is a difference: ca. 2% average more responsiveness (getting out earlier from the top) means that it is more likely for the Dow Theory to escape future crashes.

I have studied Schannep's Dow Theory whole record of buy and sell signals. Most of the buys and sell signals tend to be signaled at ca. 5-7% from the respective bottom/top. Of course, there are exceptions, but given the definition of secondary reaction given by Schannep (3% minimum movement) it is highly unlikely that buy/sell signals will be signaled at, i.e. 14% levels. This implies that even under very weak markets (2008, 1974) ) the Dow Theory will signal the exit at close levels from the top. Of course, nothing is carved in stone, and one day (hopefully very far from now) the markets will deliver us a bad surprise; however, Schannep's Dow Theory puts the odds on our favor, and hence it is not too optimistic to say that a loss of ca. -6% from the top is what we normally can expect. This is not true, if we mix the Schannep's Dow Theory with the "timing indicator".

It is true that real life investment is not easy. Somebody said that "trading is the hardest way to make easy money". It was not my intention to convey the idea that Schannep's Dow Theory is a panacea under secular bear markets. No, it is not. Investing is hard, and we have to keep emotions at bay. I can say in full sincerity, though, that, at least for me, is the only technical device I have found I fully confide, and which I am able in real life to fully respect and not outsmart. In other words: I pull the trigger when needed with no second-guessing. Of course, this need not necessarily apply to other investors. So if my post expressed the idea that investing with the Dow Theory is facile, it may partly be because to a large extent I do believe so. I regret that in the past I did not know about such a facile investing technique. For me it is like a puzzle that suddenly fits in. Of course, it took me many years of hard work to find it "easy" and have an almost blind confidence in its ability to deliver positive results in the future. I did not find it easy when I read Rhea's book for the first time.

There are other issues mentioned in Alpha Dow's comment:

a) Transaction costs: Yes, we have to keep an eye on them. Nowadays, though, brokers' commissions tend to be very low. Furthermore, the Dow Theory has low turnover. It is not day trading.

b) Slippage: This is an issue that affects all market timers. As to my experience it depends a lot on the broker and the issue traded (it is not the same to sell the SPY, than an illiquid stock). However, even under very adverse circumstances, slippage does not exceed 0.1% of the stock price. A round trade should not exceed 0.2%. Since, on average, the Dow Theory trades less than once a year, slippage, even outsized one, should not be so detrimental to performance. There is an additional "slippage" issue when using the Dow Theory. We know the buy and sell signals at the close but we act at the opening next day. Hence, there is a difference between the closing price, and the real fill at the open. This is the subject for a future post, but I can tell you that there is a negligible difference in performance between results calculated using the "close", and the "real ones" using the opening price next day. So waiting for next day's open does not degrade much performance.

c) Taxes. Well, all timing systems are afflicted by taxes (and even to some extent buy and hold). However, there is a good thing with the Dow Theory: The big winning trades tend to be made in time frames exceeding one year; the losing trades (which are not subject to taxation, as are "losses") tend to have shorter term durations. I am not giving tax advice, as the laws of each country are different. However, in many countries long term gains tend to benefit from a reduced tax rate or be tax exempt. The Dow Theory may capture a significant share of tax reduced capital gains. Please bear also in mind that the Dow Theory, unlike moving averages, is not prone to whipsaws (that is repeated contradictory signals flashed very often), and hence it is not so likely. More about the "built-in" advantage of the Dow Theory regarding whipsaws, here

Sincerely,

The Dow Theorist