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SPRING

1992

ISSUE

39

A PUBLICATION
71 BROADWAY,

OF THE MARKET
C/O NYSSA
l

TECHNICIANS

ASSOCIATION
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2ND FLOOR,

NEW YORK, NEW YORK 10006

(212) 344-l 266

MARKET

TECHNICIANS

ASSOCIATION

JOURNAL

Issue

39

Spring

1992

Editor James J. Bohan Merrill Lynch New York, New York

Associate John R. McGinley Technical Trends Wilton, Connecticut

Editors Michael J. Moody, CMT Smith Barney Harris Upham Los Angeles, California

Manuscript Frederick Dickson, CMT TDA Capital Westport, Connecticut Richard Orr, Ph.D. John Gutman Investments Lexington, Massachusetts

Reviewers David Upshaw, C.F.A., CMT and Reed Investment Management Shawnee Mission, Kansas Anthony W. Tabell Delafield, Harvey, Tabell Princeton, New Jersey

Waddell

Henry 0. Pruden, Ph.D. Golden Gate University San Francisco, California

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Publisher Market Technicians Association 71 Broadway, 2nd Floor New York, New York 10006

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ELIGIBILITY: REGULAR MEMBERSHIP is available to those whose professional efforts are spent practicing financial technical analysis that is either made available to the investing public or becomes a primary input into an active portfolio management process and for whom technical analysis is the basis of their decision-making process. AFFILIATE category is available to individuals who are interested in keeping abreast of technical analysis, but who dont fully meet the requirements for regular membership. are noted below. APPLICATION FEES: A one-time application fee of $10.00 for regular members, but is not necessary for affiliates. should accompany of the field Privileges

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STYLE

SHEET

FOR THE

SUBMISSION

OF ARTICLES

MTA

Editorial

Policy

The MARKET TECHNICIANS ASSOCIATION JOURNAL is published by the Market Technicians Association, 71 Broadway, 2nd Floor, New York, NY 10006 to promote the investigation and analysis of price and volume activities of the worlds financial markets. The MTA Journal is distributed to individuals (both academic and practitioner) and libraries in the United States, Canada, Europe and several other countries. The Journal is copyrighted by the Market Technicians Association and registered with the Library of Congress. All rights are reserved.

Style For The MTA


All papers submitted to the MTA Journal are requested to have the following items as prerequisites to consideration for publication:

Journal

ences should be put at the end of the article. Submission on disk is encouraged by arrangement. 4. Greek characters should text and in all formulae. be avoided in the

1. Short (one paragraph) biographical presentation for inclusion at the end of the accepted article upon publication. Name and affiliation will be shown under the title. 2. All charts should be provided in camera-ready form and be properly labeled for text reference. 3. Paper should be submitted double-spaced if typewritten, in completed form on 8% by 11 inch paper. If both sides are used, care should be taken to use sufficiently heavy paper to avoid reverse side images. Footnotes and refer-

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1992

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Assn.

4 MTA

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1992

TABLE

OF

CONTENTS

Instability in the Stock Market .. .. . .. .. . .. .. .. . .. . 9


There appears to be Richard C. On; Ph.D. recurring patterns in markets and just about every natural phenomenon. Patterns dont repeat in exactly the same way, however, and we need indicators to provide a warning when the market might be sensitive to external stimuli. Dick Or-r provides us with a technique, utilizing the concepts of volatility and instability, to judge the stock markets vulnerability to shock, based on the concept of fractal dimension from chaos theory.

Moving Stability Indicator

Window Correlation and its Use in Evaluation . . . . . . . . . .21

One way to determine the David Aronson usefulness of an indicator is to correlate the indicator with the future performance of the market. David Aronson carries the concept a step further by showing how the indicators relationship to the market changes over time and by providing an estimate of the indicators stability. A method of combining indicators that have a low level of correlation with each other is also suggested.

Railroad Track Charts: The Use of Trading Bands in Stock Selection . . . . . . . . . . . . . .13
Technical analysts often Michael Baum use chart patterns to determine the trend of a stock and oscillators show if an item is overbought or oversold. Trading bands, however, can provide the information at a single glance. Michael Baum shows how he interprets the performance of a stock from its fluctuations within a trading range.

The Barrons Confidence Index . . . . . . . . . . . . . . . . . . . . . . . . . .29 Revisited


For many years the Bruce M. Kamich Confidence Index was a tool employed by technicians to analyze the stock market. The indicator has declined in popularity in recent years, but Bruce Kamich has found a new use for the Confidence Index by relating it to the movement of bond prices.

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A Sealed Room and Only One Client.. . . . . . . . . . . . . . . .35


How many times Henry 0. Pruden, Ph.D. has news, fundamental information or for that matter the everyday mundane demands of the job distracted you at a critical juncture of the market? John Magee felt the need for a private place to help him focus on the market without distractions. Hank Pruden carries the concept a step further by providing some practical suggestions on how we can assimilate our own objectives with our clients objectives to provide the best possible service.

Membership Affiliate Information.

and . . . . . . . . . . . . . . . . . . . . . . . .2

Style Sheet for the Submission of Articles . . . . . . . . . . . . . . . . . . . . . . . . . . .3

The Impact of Commodity Prices on Bonds and Stocks: An Intermediate Term View . . . . . . . . . . . . . . . . . . . . . . . .39
For many years techniJohn J Murphy cians were content to analyze markets in isolation. In recent years, however, there has been a greater tendency to use information derived from other markets. John Murphy has popularized the use of inter-market analysis and shows the linkages between stocks, bonds and commodities.

MTA Officers Committee Chairpersons.

and . . . . . . . . . . . . . . . . . . . . . .4

Editors Commentary

. . . . . . . . . . . . . . . . . . . . . . .7

6 MTA

JOURNAL/SPRING

1992

Editors

Commentary

by James Bohan, Editor

The Journal has published an extra edition that you will find enclosed with the regular edition of the Journal. The extra is an index of all the articles published since January of 1978. Seminar editions issued in May were excluded. The index contains a summary of each article sorted by subject. An author sort is also included. The MTA would like to thank Shelley Lebeck and John Blasic for conceiving the idea for the index. John is also responsible for organizing the index by author and subject and for summarizing the articles. The members should find the index useful in their research. It could prove to be especially helpful for those preparing new articles for the Journal, especially those writing CMT papers. Back copies of the old Journals are available in limited supply and copies of individual articles are available from the MTA. A form at the back of the index should help expedite orders. The charge is to cover MTA costs. Members and afiliates may also borrow a back journal from the MTA library. The flow of articles to the Journal has slowed of late. Members and affiliates are encouraged to submit their manuscripts for publication. Keep in mind that CMT articles have more stringent requirements than regular Journal articles in terms of content. (See the CMT guidelines.) The index of past articles can be a source. Consider reviewing an old topic bringing it up to date and providing some new insights. The recent survey of members conducted by Phil Erlanger, chairman of the Long Range Planning Committee, showed that the members value the MTA Journal. To improve the content, however, we need wider participation. In addition to writing an article, consider passing on your views on an article or on a topic affecting the membership. Frequently letters to the editor can provide additional insight on a topic. Passing the Baton Editing the MTA Journal over the past two years has been a rewarding experience. I recommend it to anyone who wants to broaden their exposure within technical analysis. There is a tendency to stick with tools we are comfortable with and avoid areas where

we lack knowledge or have a bias towards. Reviewing manuscripts for the Journal, however, forces one to open up and consider all forms of analysis and approaches. Working with authors to qualify papers can be arduous at times, but most often leads to a new working relationship with a peer. An increase in knowledge of the publication process is another benefit. Mike Moody will take over as editor this summer. I am sure that Mike, who chaired the Library Committee the last two years and has been on the Journal Committee, will find the task rewarding. I will continue to handle the production end for Mike. The MTA is changing due to a broadening of the membership. An important part of the change is the CMT program that is an attempt to increase the level of professionalism by qualifying technical analysts. The CMT had been a two part process consisting of two examinations. The Journal became involved in the accreditation process because a paper could take the place of the second exam. All CMT candidates who started the process in 1991 will have to take a second exam and a Journal paper will be mandatory. Writing a paper on a technical topic can be a worthwhile learning experience for the candidate and it contributes to the base of research in the field. In May fifty candidates started the certification process and forty candidates took the second exam. In coming years, therefore, the number of papers submitted to the Journal will increase sharply. The flow could become a burden on the Accreditation and Journal committees. Various solutions to handle the increased workload are being discussed. The most obvious solution will be to increase the size of the committees. An alternative solution will be to grade the papers. Those who fail to pass will be able to resubmit the paper after having made the recommended changes. The Journal would then be able to select papers for editing and publication. This Issues Articles The MTA awarded three CMT designations for contributions to the current Journal to Michael Baum, John Murphy and Bruce Kamich. David Aronsons article fulfills the CMT requirement, but he

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1992

must fulfill the requirements to become a regular member before using the CMT designation. Technical analysis is becoming a fusion of different techniques and the current issue of the Journal provides a blending of new and old approaches. Dick Orr supplies us with a new indicator derived from his work on Chaos. David Aronson adds to the literature on selecting and combining indicators. Michael Baum provides us with his approach to trading bands while John Murphy gives insight to inter-market analysis. Hank Pruden shows the impact of psychology and remaining focused.

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Instability

in the Stock Market

by Richard C. Orr, Ph.D.

Introduction One of the problems facing all market modelers is the lack of a controlled environment in which to experiment. If an event occurs, we can only guess at its precise impact on coincident market behavior. The premise to be explored here is that there is an underlying structure to the market which determines to a large degree how it will absorb or fail to absorb shocks. A classic situation is that of the Kennedy assassination on November 22, 1963. Clearly the market had not discounted this event, yet within a week this very strong market had completely absorbed the tragedy and had resumed its long bull move. On the other hand, the market was so unstable in early October 1987 that a moderate decline became a crash. In previous articles (see 2 and 3), I have argued that there is a very subtle structure in the equity market which is chaotic, in the scientific sense of the word. More recently, a new book by Edgar Peters (see 4) makes the same point from a different perspective. The purpose of this paper is to demonstrate a technique based on the concept of fractal dimension from chaos theory, but involving only relatively simple calculations, that provides us with a way to measure the markets tendency to trend or to move in a trading range. This process can also act as an early warning signal for the occurrence of explosive moves in the market, either up or down. Instability and Volatility as Components of Range In general, the range of prices refers to the entire set of values taken on over someperiod of time: hourly, daily, weekly, et cetera. For our purposes, we will define the range over somespecific time interval to be:
(Percent) Range = lOO(High-Low)/((High+Low)/B).

of these extremes, for the eight days in question. In order to simplify terminology, volatility and instability are defined as follows:
Volatility Instability = Eight-day = Eight-day Moving Average of Daily Range. RangeNolatility.

Instability as defined above is inversely related to the approximate fractal dimension of an eight-day fractal thumbprint of the market, a concept discussed in a previous paper (see3). The actual calculation of the approximate fractal dimension can be rather overwhelming (see l), but our instability value serves the purpose quite nicely. The eight-day range is then just the product of its instability factor and its volatility factor. As Table 1 clearly demonstrates, larger ranges tend to have both larger instability and volatility factors. If we look at the eight-day range by decile over the period 1984-91, both the average instability and volatility factors are higher for each larger decile of eight-day range.

TABLE 1. GEOMETRIC AVERAGES OF INSTABILITY AND VOLATILITY FACTORS FOR A GIVEN DECILE OF &DAY RANGE (l/84-12/91) S-DAY
RANGE DECILE AVERAGE &DAY RANGE 1.790 2.363 2.659 2.951 3.261 3.633 4.096 4.688 5.529 0.232 AVERAGE INSTABILITY FACTOR 2.423 2.748 2.886 3.037 3.297 3.456 3.710 3.908 3.995 4.096 AVERAGE VOLATILITY FACTOR 0.739 0.861 0.922 0.972 0.989 1.052 1.105 1.200 1.383 2.006

:
3

2
6 ii 9 10

In what follows we will show that the daily range behavior for the past eight days affects the total range of prices for the next eight days. Using the above definition, the eight-day range of a series of prices is just 100 times the difference between the highest and lowest prices divided by the midpoint

A Dramatic Change in the Markets Stability In January 1984, the underlying structure of the market changed. If one looks at a graph of the B-day range values from 1979 to 1990 (see Figure I), the

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change is almost imperceptible. However if one looks at the two components of 8-day range, namely volatility and stability over the same period (see Figures 2 and 3), the shift is more obvious. What becomes clear is that very early in 1984 the market decreased in volatility and increased in instability. Whether or not this was the effect of the serious use of index futures by institutions is a matter of conjecture, but the timing suggests it may be so. Since

these two components nearly offset each other, their product which is the eight-day range did not show the change. Instability may be thought of as the tendency of prices to run in one direction, rather than moving in a trading range. The more unstable the market, the less a sequence of bars will tend to overlap each other on a bar chart. Since 1984, the market has tended to trend more, but with smaller average daily ranges.

40

30 --

20 --

-I l/79

I l/84

I-+ l/90

FIGURE 1. EIGHT DAY RANGE 7


6
7.4 6.4 a.4

5
4

6.4 5.4 4.4

3
2

3.4 24 1.4

ln9

1184

0.4

rns

1184

FIGURE

2. INSTABILITV

FIGURE

3. VOLATILITY

10

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Instability as an Early Warning Signal We now consider four specific examples of volatility and instability readings during market action of the past five years. In each case, distributions of volatility and instability values for the eight years prior to the year in question are used. This gives us a moving sample of approximately 2000 days. The values of volatility and instability for the period being studied are then ranked with respect to the distribution of the sample. For example, if the current value for volatility exceeds any volatility value in the sample, it gets a percentile ranking of 100 for volatility. If the current value for instability is smaller than any instability value in the sample, it is ranked 0 for instability. These readings tend to define market action over the subsequent eight trading days, so high readings signal the potential for unusually large moves, while small readings suggest the relatively quiet times over the next eight days.

Figure 4 shows the price action of the S&P 500 index during October 1987. Notice the extremely high instability readings even five days before the crash. By October 16th, volatility had also reached an extreme. This was hardly the time to assume that the bottom has been reached. After the crash, the market continued to ring. It moved sharply up and down, indicating a return of stability, but volatility remained high for weeks. While not as dramatic, the one-day plunge in October 1989 was more insidious than the drop two years earlier, in that it appeared to happen without warning. As Figure 5 shows, however, the extremely low volatility readings were matched by extremely high instability readings, suggesting the potential for a surprise. Volatility never did become higher than about average (a reading of 50), and by the end of the month the market had returned to a normal profile.

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3a5m360.99 -IQ I0 Qtt+ -1 Ii t,tt I it , Cr @ 35sm -It -. 3m.00 t t woo -mr 1 1 11 z 339.00 -. s%mVOLATlLrrY 90.1 40.9 104.0 1W.O 86.9 1987 THRU 18 NOV 1987 FIGURE CASE : 3 4 5. S6P DATE aocT99 6OCT89 13OCT69 26 OOT 99 500 INDEX:

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PERCEHTILES 1NSTASMJT-V 98.9 96.7 100.0 34.7 26.0 29 SEPT

PERCEMILES INSTABILlTY 98.1 99.9 W.6 6a.4 22 SEPT 1989 THRU

VOLATlLlTY 6.6 El 44.6 26 DCT 1989

4. S&P 500 INDEX:

w mm 3zQ.w 31ma 300.00 -. Yt -. -. CASE 1 : 4 FIGURE DATE 9 JAN 91 31 21 JAN 91 22 FEE 91 6. SLIP 500 INDEX: PERCENTILES INSTABILITY 90.8 94.1 95.4 0.8 26 DEC 1990 THRU VOLATlUrr 70.5 39.5 73.9 70.2 22 FEE 1991 0 qvpr I :: 370.00 -.t CASE : 3 DATE 19 DEC 91 14JAN92 23 DEC 91 t @ tttt ,tJ 39s.m 39am -3m.m -. -. -. t bl$

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PEFlCENTlLES INSTABlLrPl 69.1 94.1 2.5

VOLATILITY 13.4 30.9 47.9

FIGURE

7. SIP

500 INDEX:

10 DEC 1991

THRU

14 JAN

1992

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Figures 6 and 7 compare and contrast the market action in early 1991 and 1992, respectively. Notice that, in each case, very high instability eventually turned to very low instability, although the process took much longer in 1991. In addition, the volatility levels in 1991 portended a larger move than in 1992.
Forecasting Large Eight-Day Range Values. Instability and volatility values for the past eight days do have an effect on the range of prices for the next eight days. If we restrict our attention to large eight-day range values, those of at least 8 percent, we find that current low volatility and instability values imply that no large moves will occur within the next eight days, while high volatility and instability values imply a disproportionately high incidence of large moves within that same period. Table 2 shows the distribution of the 75 cases in the 2022 days from 1984 through 1991 in which the eight-day range was at least 8 percent. Note that in the vast majority of cases either the instability or volatility readings for the day just prior to the beginning of the eight days in question fall into the fourth or fifth quintiles. In no case do the instability and volatility readings both fall into the first or second quintiles. This result is actually even stronger than it appears, since in all nine cases where neither instability or volatility is in the fourth or fifth quintiles, a subsequent day reaches these levels before the 8 percent move begins. The bottom line is that high instability or volatility readings give a warning that the market is vulnerable to a shock, while low readings in both variables sound an all clear signal. TABLE 2.

Summary We have split eight-day range into two components, volatility and instability, each of which helps us forecast the range for the subsequent eight days. Volatility is the name we give to the eight-day moving average of daily range, while instability is then defined to be the eight-day range divided by volatility. We have investigated their behavior, both on macro basis and for specific memorable periods in recent market history. In addition, we have demonstrated that high values of one or both of these measures tend to be good predictors of high future eight-day range values, while low values of both of these measures suggest the absence of these high eight-day range values. For this reason, instability and volatility seem to be very useful measures for monitoring the likelihood of a dramatic move in the market.

BIBLIOGRAPHY 1. Mandelbrot, Benoit, The Fractul Geometry ofNature (Freeman, 1983) 2. Orr, Richard C., Chaos I: Time Series Forecasts in Markets, MTA Journal 33 (1989) 3. Orr, Richard C., Chaos II: The Fractal Structure of Markets, MTA Journal 35 (1990) 4. Peters, Edgar, Chaos and Order in the Capital Markets (John Wiley, 1991)

DI: Orr is president of Chronos Carp, a firm specializing in Chaos related research for financial markets. In addition to actively trading Stock Index Futures, he is a frequent contributor to the MTA Journal.

COUNTS OF FUTURE 8-DAY RANGES OF AT LEAST 8 PERCENT CORRESPONDING TO CURRENT INSTABILITY AND VOLATILITY READINGS BY QUINTILE (l/84-12/91)
INSTABILITY QUINTILES

TN I T

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Railroad

Track Charts

by Michael Baum

Overview Sharp movements of common stocks well above or below their trading ranges often provide excellent opportunities for profit. This occurs since most near term price moves have proven to be unsustainable and are usually followed by a counter-move that restores the prior periods price equilibrium. As a result of this observed phenomenon, an extensive list of indicators has been developed by market practitioners. A listing of some of these popular momenturn oscillators appears below. A variation on this work is spelled out in detail in this monograph. A caveat to consider, however, is that the over-bought/ over-sold approach to timing does not fit under all circumstances. A particular stock or market index may remain in an over-extended position for a very long period of time. This usually occurs when a powerful long term bullish or bearish wave of investor psychology over-rides the more typical pattern of an individual markets ebb and flow. Examples of this tendency will be explored in the article. Definitions An oscillator is. . . Any mathematically calculated line, or lines, that move up and down with price activity in such a way that over-bought and over-sold situations can be identified. (They). . . are often at their extremes at tops and bottoms, and visually illustrate the swings of the market from over-bought to over-sold. . . .I See Chart A. Over the years, an extensive list of oscillators has been developed and fine-tuned by market technicians. Most are now available in chart programs for personal computers. For example, the Dow Jones Market Analyzer PLUS chart program carries a variety of indicators such as Stochastics, WellsWilders Relative Strength, Williamss %R, Moving Average Convergence-Divergence, Commodity Channel Index and Percentage Trading Bands? Most oscillator charts are presented by showing an individual issue or market index and its momentum oscillator on the same computer screen. Two separate charts are constructed on the same monitor. To obtain market entry and exit signals an analyst

must constantly shift his or her attention between these charts. The Percentage Trading Bands are a set of parallel trendlines at a fixed percent above and below a particular moving average. Most technical analysts draw their parallel lines, delete the moving average used in the charts construction and then superimpose a closing price of the particular market under study. (See Chart B) This important innovation was developed by Ichu Cheng3 who integrated the separate price and oscillator charts into one. He suggested an actual price cross above or below the trading bands themselves could well generate suitable entry and exit signals. Ichu Cheng made the small, but all-important step, of integrating the price and oscillator charts to create one all-inclusive indicator. The oscillator featured here is based to a large extent on the original work of Ichu Cheng. To differentiate this approach from the general scholarship on momentum oscillators, the indicator discussed below will be referred to simply as Railroad Track Charts.

CHARTA

44

CHARTB

CHARTC IDEALIZED BREAKDCWN BREAKOUT

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Gerald Appel also demonstrated the judicious use of Percentage Trading Bands as a market forecasting tool before his colleagues at a regular Market Technicians Meeting in New York City? Christopher and Peter Worden have cleverly fashioned a succession of trading bands one and two standard deviations from the moving average itself? John A. Bollinger more recently added trading bands that expand and contract a pre-set number of standard deviations above and below a moving average.6 All of these analysts have contributed valuable innovations to the design of the Percentage Trading Band indicator work. Mechanical, Emotional and Psychological Rationales for Periodic Market Fluctuations Around an Arithmetic Mean William C. Garrett provided a mechanical rationale for market fluctuations around a mean.7 He suggested that the forces of supply and demand are constantly struggling for superiority. For example, following a period of price equilibrium, demand

overcomes supply thus enticing some longs to postpone their selling in the hopes of additional gains. As a consequence, selling volume diminishes and exaggerates the advance until it is carried to an up-side extreme. Once demand is exhausted, a counter-move follows. The selling that was deferred during the prior rise comes to market, creating a selling wave that drives the market lower. This decline is intensified as some potential buyers defer their purchases. As a result, buying volume dries up accelerating the speed and force of the down trend. Only after sell-side pressures carry the market to an extreme, and selling volume finally diminishes, does bargain hunting slowly emerge and the market begins to stabilize. At this stage, the market is positioned to begin its complete price cycle again. The late Michael G. Zahorchak suggested an emotionally-based positive feed-back loop to explain periodic price cycles that yield over- bought and oversold conditions.8 Here is a brief synopsis of his explanation. After an uptrend begins, sideline money flows into the market driving it higher. As

CHART

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the market becomes stronger, it continues to attract fresh funds. Motivation to rush in and buy a strong market stems from the emotional pressure within individual investors. As investment observers gain confidence from rising prices, a point is reached where some investors yield to greed. When all the capital available for investment has been drawn aboard the market, demand tires and prices turn down. Sagging prices then activate a bearish feedback loop within the personality of investors. Lower prices build the pressures to sell. As investors reach the point where they can no longer tolerate the stress of holding a deteriorating stock position, they close out their long positions. Finally, a sellhng climax occurs under the pressure of panic liquidations and a bottom is completed. The positive feed-back loop begins anew to push the market to its next peak. Paul H. Cootner introduced a model of market behavior in 1962.9 . . . Professionals . . . profit. . . from observing the random walk of the stock market prices produced by . . . (the) . . . non-professionals until the price wanders sufficiently far from the expected price to warrant the prospect of an adequate return . . . When prices have deviated enough from the expected price . . . (professionals) . . . can

expect future surprises to force prices toward their mean more often than not. Cootner referred to these springboards for a move back towards their mean as Reflective Barriers. (Many chartists refer to these barriers as support and resistance). Martin E. Zweig took Cootners model an important step further? He incorporated the Reflective Barrier model in terms of a general theory of investor expectations. Whenever non-professional investors become significantly one-sided in their expectations about the future course of stock prices, the market will move in the direction opposite to that which is anticipated by the masses. A Cyclic Framework for Railroad Track Charts: The Earnings Report Cycle Assuming the cyclic character of stock prices and the transient character of market extremes, the first task is to find the most suitable time frame for the moving average used to construct Railroad Tract Charts. Many timers refer to price cycles of three to six months as the intermediate-term rhythm. It has been observed that many stocks and stock groups have price cycles of different periods. Furthermore, some issues peak and trough ahead of the average issue, others score their highs and lows in harmony

CHART

D
OVER-EXTENDED CONDITION AFTER A LONG RALLY

80-

OVER-EXTENDED CONDITION AFTER A CORRECTION

-80

60-

- I I I I
19487

88

89

WEEKLY DATA DISNEY (WALT) 4% TRACKS PROJECTED FROM A 13 WEEK MOVING AVERAGE I 90

-60

I
91

7% 1

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with the average stock while some issues record their peaks and valleys later. The problem of cycle identification is further obscured because some price cycles of three to six months are distorted or overwhelmed by cyclic forces. For example, an intermediate term uptrend may be dampened by the bearish influence of a long term down wave. In addition, some price cycles have a tendency to vary widely and then return. Perhaps the most difficult roadblock to cycle identification is double-counting. In this instance, a stock may bottom, rally, peak and react within a six week period. Then the stock repeats the round trip in seven weeks leaving two cycles. When this occurs, the chartist must decide if the issue is running a shortened intermediate term cycle, or two near term cycles that make up one thirteen week movement. Recognizing the difficulties involved, the identification of the intermediate term cycle could well be considered within the reporting framework of corporate earnings which averages 13 weeks or 63 days. Actual reporting of income figures depends upon the accounting cycle for each firm. As a result, most interim figures are released three to six weeks after the end of the quarter. First quarter data appears from mid- April on, second quarter data begins appearing in mid-July and third quarter results are distributed beginning in mid-October. Firms with different fiscal periods report their earnings from three to six weeks after the end of their fiscal quarter. Year-end figures are usually delayed because of full year adjustments and full year numbers may take four to eight weeks or more before release. This stretch-out in reporting could well account for 73.56 days calculation for the complete intermediate term cycle of the Standard and Poors 300 Index. To fit within the reporting cycle, this monograph has selected the 63 day or thirteen week time period for determining cycles, but allowance is made for a longer cycle at year end. rhe Discounting Process As a general rule the market begins to discount i interim earnings figures a month or so before the 1release date. A stock usually moves higher in anticipation of favorable news. If results meet the expecta1 1 Lions of a majority of market practitioners, a peak iin the price cycle is soon evident. The profit-taking 1 ;hat usually follows generates an interim earnings (cycle trough. The situation is reversed when poor t:arnings are anticipated. Prior to the announce1ment, the stock is often subject to selling pressure Ind price weakness. Some further liquidation is possible after the release of earnings, but selling 1 1Jsually ends quickly, often marking an intermediate 1;erm cycle trough. The bargain hunting phase that
,

follows

initiates

the up phase of the next cycle.

Idealized Model of the Intermim Earnings Cycle (Chart 0 Starting from a period of price decline with the tracks in a down mode, the first price cross above the lower track is referred to as an Initial Rally Signal, (See Chart Version 1.0). This event marks the first evidence that selling dominance is beginning to exhaust itself and a market is moving toward equilibrium or possibly a new interim cycle of advance. Usually an up-side cross is followed immediately by a Basing Phase or trading range inside the tracks as the last of the selling by disappointed longs comes to market. In this pattern, the tracks themselves mark-off the extremes of price fluctuation. They are the Reflective Barriers discussed by Cootner and Zweig. In rare cases, the Basing Phase may be characterized by a succession of up-side and downside violations followed swiftly by counter-moves back inside the tracks (See Chart Version 1.5). In this erratic pattern, the forces of supply and demand are continually shifting their dominance. An Up Phase is illustrated on Chart Version 2.0. . It is marked by a market cross-over the upper track. This event is called an Initial Breakout Signal. When this occurs buying dominates the market and prices move swiftly above their upper track and may remain overextended. The Up Phase suggests that an opportunity to enter the market has already passed, and that existing positions should be maintained. In this phase, market prices may rise swiftly and create a pattern referred to as a Left Translation Bulge (see Chart Version 2.1). This configuration suggests an absence of supply combined with aggressive demand. In cyclic terms the pattern suggests the bullish influence of longer term waves upon the interim price cycle. Version 2.5 is marked by a succession of cross-overs and cross-unders while the track itself has an upward slope. In this instance, the track itself is playing the part of a center-line for a series of short term cycles. The investment strategy in this case is to hold all positions as the most ideal time to enter the market was seen at an earlier phase. Chart Version 2.6 reveals an erratic market pattern. This volatile pattern provides numerous short-term trading opportunities each time the market registers a cross-over or cross-under. Underlying the succession of these sharp movements is a conflict between the bullish influence of the Up Phase of the interim earnings cycle and the more bearish pressures of a longer term wave. Chart Version 2.9 is referred to as a Right Translation Bulge. It is a climactic buying surge after an overextended rise fueled by short covering. Selling opportunities often occur with the official

16

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release of earnings or other pertinent news items. A Topping Phase usually follows (See Chart Version 3.0). It is ushered in with a markets down-side cross below an upper track. This event is referred to as an Initial Reaction Signal. In this case the markets short term fluctuations are contained inside the tracks as a narrow trading range unfolds. Wider short term cycle swings within this phase are depicted by Chart Version 3.5. Every upside crossover above the lower track is a trading buy signalwhile each down-side cross below the upper track is a reaction or trading sell signal. This configuration and the one portrayed in the Basing Phase (version 1.5) represent a balancing between the longer term forces of supply and demand. This provides an environment for the weak but intense short term cycle influences to show themselves. If the balance of bullish and bearish forces are finally resolved on the down-side, the Topping Phase soon gives way to a Down Phase (See Chart Version 4.0). First evidence of this final phase in the Interim Earnings Cycle is a market cross-under of the lower track that is itself beginning to turn down. This indicator event is called an Initial Breakdown Signal. It is often followed by a free fall in the price of the stock. All short term rally peaks are contained below the lower

track so the lower track marks overhead resistance. This configuration is the mirror image of the Up Phase (Version 2.0) where the upper track provided support for every short-term cycle trough. If the Chart Version 3.0 Topping Phase Initial Reaction Signal was missed, the Initial Breakdown Signal in Chart Version 4.0 provides another opportunity to lighten positions or exit the market. During the Down Phase, new buying is best deferred until selling is exhausted. Following the initial breakdown, a sharp decline may occur. It is referred to as a Left Translation Bulge (see Chart Version 4.1), and reveals the sellers are dominant. When the lower track bisects the short term cycles a Chart Version 4.5 is seen. A timer could well look to the slope of the lower track for help in assessing if this phase is still in force or finally giving way to a more bullish Basing Pattern. Here again, the chartist is cautioned not to anticipate a bottoming pattern, but wait for the signals to show themselves. On occasion one may come upon a wildly erratic behavior pattern as seen in Version 4.6. In this condition, short term cycles penetrate the upper and lower tracks providing trading opportunities within a basically down market. Risks are higher under this condition when trading the long side because the

CHART E
OVER-EXTENDED A LONG RALLY CONDITION AFTER

95-

85-

OVER-EXTENDED CONDITION AFTER A LONG CORRECTION

-65

WEEKLY DATA MINNESOTA MINING 4% TRACKS PROJECTED

-55

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short-term-up-leg may be suppressed by the stronger interim earnings wave. If a stock or index crosses above a lower track, flashes a Rally Signal, and immediately reverses by crossing below the lower track again, the prior breakdown signal has been restored. A down market is evidently still in force. Trading strategy suggests quickly closing positions. The final and most devastating pattern for most investors is seen in Chart Version 4.9. It is called a Right Translation Bulge and usually appears as a climatic selling wave at the end of a Down Phase. The anatomy of Chart Version 4.9 is as follows: Selling begins to dominate in the 4.0 condition. As a decline proceeds, the ranks of bargain hunters become thinner until buying dries up. As a consequence, sellers overwhelm the internal balance of the market and liquidate at distressed price levels. This creates the Right Translation Bulge, and sets the stage for a counter-move that begins the Basing Phase, Chart Version 1.0 and the new Interim Earnings Cycle. Normally the cycle runs from chart 1.0 through 4.9 and then starts anew. The timer should be aware that the sequence may skip. In a bull market, the charts may run 1.0, 1.5,2.0,3.0 and then start over again at 2.0. In retrospect, it can be seen that 3.0 is a congestion period or narrow trading range prior to the resumption of the bull cycle. The opposite is the case in a bear market. A stock may end a 4.0 Down Phase, generate an Initial Rally Signal, display a Basing Phase only to quickly roll over and flash an Initial Breakdown Signal. In this case, the normal sequence was disrupted because the selling pressure from the bear market suppressed the Up Phase, overwhelmed the buy-side of the market and pushed the cycle from 4.0 to 1.0 and immediately into a 4.0 phase once again. Allowance should be made for the possibility of a back step to an earlier phase once evidence of such a pattern appears. Railroad Track Chart Construction: Real Life Examples Parameters are set from a review of past chart history. Chart (0) shows weekly data covering a three to four year cycle in the common stock of Walt Disney. Four percent tracks above and below a thirteen week moving average were drawn and a high-low-close chart was superimposed. This example illustrates some of the problems that must be overcome to find the most ideal parameters to measure over-bought and over-sold conditions. In early 1988, Disney shares broke down below its lower track on a few occasions. The issue subsequently snapped back towards equilibrium, and in early 1989 the issue took off on a long bull market surge. A positive long term wave of investor psychology over-rode the
18 MTA JOURNAL / SPRING 1992

normal rhythmic pattern. During the year-long rise, Disney shares remained in an over- bought condition. Reactions below the upper track proved temporary. The overbought periods may have prompted caution, but the fact that the lower band was not penetrated during this period should have kept the analyst constructive. By late 1990 a more rhythmic pattern was initiated by penetration of the four percent. Chart E, Minnesota Mining, provides a more typical example for railroad track identification. In this example, four percent tracks calculated from a thirteen week moving average are shown with the weekly bar chart. Every over-extended condition in this four year period proved unsustainable and was followed by a counter-move back inside the tracks. The Standard & Poors 500, with two percent tracks based on a thirteen week moving average, is shown in Chart (Fj. This example provides a combination of conditions found in Charts D and E. For example, in 1988, the index failed to break down below the lower two percent tracks. The performance shows the growing bullish influence of a long term wave. By 1989 these positive forces lead to a S&P Index rally of 35%. The first penetration of the lower channel in late 1989 indicated that the advance was exhausted and equilibrium was restored. To simplify the graphing, a chartist might find the weekly close easier to work with. In summary, two percent tracks have been found useful for the Dow Jones Industrial Average and Standard and Poors 500. The weekly advance- decline line and most blue chip issues work best with four percent tracks. In a study of about three dozen issues including many Dow Jones Industrial issues, several exceptions have been found. Included in this class special category are Eastman Kodak, Mobil and Procter & Gamble. Here, three percent bands match up quite well. Listed secondaries have been found to chart best with eight percent tracks. No exceptions have been found in this lower price group after study of about four dozen issues. Finally, a daily advance-decline line also works well with the eight percent parameters. Experimentation is needed to determine the best parameters for a particular market. Technical, Fundamental and Psychological Aids in Pinpointing an Intermim Earnings Cycle This monograph covers in detail the technical aspects of the Interim Earnings Cycle. The charts are a pictorial model (or representation) of where the stock has been and where it is positioned to go. Knowledge of the accounting cycle and the release dates for earnings is also required. Those are available in the Daily Graphs Chart Service? This

valuable listing reads EPS due, meaning the date when Earnings Per Share were released in the prior year. The assumption is made that the latest release will come on or around that date. The Value Line Publishing Inc provides an excellent forecasting service of upcoming sales and earnings figures.3 Many of the posted figures for interim figures come out close to or precisely at the Value Line estimates. This excellent showing suggests the service comes up with their own figures but may well obtain some confirmation from the reporting company prior to the release date. On occasion, reported figures are far from the estimates issued by Value Line and other analysts. The market had usually anticipated this development and discounted it in the market price before the news release date. When the interim figures are surprising to a majority of market practitioners, the market swiftly adjusts on or immediately following the news release date. A third aspect of this Interim Earnings Cycle is psychological. If the news is widely expected it will not upset the delicate supply-demand balance in the market place. Conversely, If the news is not anticipated, a dramatic move could follow. As a result, the true technical position of that market is suddenly revealed. It is necessary for the timer to quickly shift from the fundamental aspects of the earnings release

to the markets response. To a lesser extent, corporate news on backlog figures, contract awards, management changes or feature articles in the media are valuable psychological clues. It is indeed the markets behavior following these various media events that exposes the underlying supply-demand condition and where the stock or market stands in its cycle. Benefits to the Railroad Track Chart Approach Since stocks and the market spend most of their time meandering inside their tracks, the Railroad Track Chart Work frees the timer to focus upon an issue when it is at an unsustainable extreme. As a result, the analyst may be more alert to the significance of a cross-over or cross- under and the potentials of such a signal. This approach also insulates the timer from the emotions in the market place and the media helping one to become psychologically attuned to the possibilities of a stock or markets counter-move. Independence of thought, analytical focus and sensitivity to rapidly changing price conditions should not be underestimated. Furthermore, the cross-overs and cross-unders provide actual intraday market entry and exit signals. When the initial signal is followed by a succession of signals, it provides a valuable prompt to slowly accumulating

CHART

F
OVER-EXTENDED AFTER A RALLY CONDITION

380 -

340 -

OVER-EXTENDED CONDITION AFTER A CORRECTION

-260

WEEKLY DATA-S&P 500 2% TRACKS PROJECTED FROM A 13 WEEK MOVING AVERAGE

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stock in a Basing Phase or distributing stock during a Topping Phase. Divergence analysis is also possible. The market being measured may make a succession of lower price lows, but the lower track itself may well be falling at a faster rate. It is catching up to prices. As a consequence, the gap between lower tract and the market narrows. This pattern reveals a loss of downside momentum and a non-conformation is recorded. On occasion these signals are generated quite close to the actual peaks and valleys. Since moving averages are the heart of the Railroad Track Chart construction process, the Interim Earnings Cycle may be fit inside longer and longer moving averages to gain a summing of all the dominant waves impacting any market. Such a big picture analysis is a topic which might be investigated before a Railroad Track analysis is attempted. Limitsoto the Railroad Tract Chart Approach Without question, the major limitation to this work is the potential for false signals or whipsaws. To compensate for this limitation, the chartist is invited to look at the Railroad Tracks within a cyclic framework. Being cognizant of earnings estimates, the release dates of interim figures and the sensitivity of the market to the release of data should be an aid in interpretation. At least two exceptions will be encountered by an analyst running Railroad Track Charts. First, if a market replicates Chart Version 2.5 or 4.5 the track being crossed and recrossed is really a midpoint for short term fluctuation. Reliable entry and exit signals can not be obtained. In this instance, we would suggest trying new parameters. On another occasion, a timer may find a market low three or four points below a lower track. The issue may then rally slightly above an upper track, give a buy signal, and immediately reverse and give a sell and drop three or four points again. Here too the parameters have been incorrectly cast. The lower track should have been drawn perhaps five or six percent below its centered moving average. In addition to the earnings cycle, Bond and commodity cycles of different length may well effect particular common stocks. Examples include oil and natural gas issues as well as some credit-sensitve issues. This secondary impact could well distort the effected markets being run on the thirteen week time frame. Discussion The integration of line charts and oscillators into one composite indicator can not provide a perfect solution to investing and trading. None is implied. Periodic whipsaw signals and trading losses are part

of this timing approach. Still, the Railroad Track approach highlights important changes in a markets behavior. It spotlights those rare occasions when a market is at an historic extreme. This in turn opens the door to a profit opportunity. After all, what better moment is there to buy any stock or index than after an episode of selling finally spends itself and the issue lifts its head enough to cross above a fast closing lower track? Conversely, after a long rise what better time can be found for profit-taking or lightening up of positions than the instant a market falls below a fast rising upper track for the very first time?

REFERENCES 1. Walter Bressert, The Power of Oscillator/Cycle Combinations, Walter Bressert and Associates (Tucson, AZ) 1991 p. 3-1 2. Dow Jones Market Analyzer PLUS Version 2.03, RTR Software, Inc. and Dow Jones & Company, Inc (Princeton, N. J.) 1991 3. Ichu Cheng, Holt-Winter Channel: Taking the formula one step beyond, Technical Analysis of Stocks and Commodities, Technical Analysis, Inc. (Seattle, Wa.) August 1988, p.23-28 4. Gerald Appel,Timing the Market with Moving Averages and Trading Bands, Signaler-t Corp. (Great Neck, N.Y..) March 12,1966 5. Christopher and Peter Worden, Optioneer, Worden Brothers, Inc., (Chapel Hill, N.C.) 1991 6. John A. Bollinger, Financial News Network, (Los Angeles, Ca.) 7. William C. Garrett, Investing for Profit with Torque Analysis of Stock Market Cycles, Prentice-Hall, Inc., (Englewood Cliffs, N.J.) 1973, p. 25-28 8. Michael G. Zahorchak, The Art of Low Risk Investing, Second Edition, Van Nostrand Reinhold Company (New York, N.Y.) 1977, p. 25-30 9. Paul H. Cootner, Stock Prices: Random Vs. Systematic Changes, Industrial Management Review, Volume III, Spring 1962, p.24-45 10. Martin E. Zweig, Investor Expectations: Why they are the key to stock market trends, Zweig Advisors, (New York, N.Y.) 1973 11. Cycle Projections, Foundation for the Study of Cycles, Inc. (Irvine, Ca.1 Aug. 1990, p.1 12. Daily Graphs, William ONeill & Co, Inc. (Los Angeles, Ca.) 13. Value Line Publishing Inc, 711 Third Ave, (New York, N.Y.)

Michael Baum is a broker and analyst with Securities Corp., 919 Third Ave, New York, He also teaches a market timing course in lab setting at New York University School

Hampshire N.Y 10022. a computer of Continu-

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Moving-Window Correlation Stability Its Use in Indicator Evaluation


by David Aronson

and

Introduction As the discipline of market analysis becomes more quantitative there is a growing interest in objective ways to measure the predictive power of an indicator. One way would be to calculate the linear correlation coefficient (CC) between the indicator and subsequent market changes! In general CC is used to measure the strength of the linear relationship (i.e., dependence) between two variables, a predictor variable and a dependent variable. In the case of indicator evaluation, the indicator serves as the predictor variable while the markets subsequent change plays the role of dependent variable. For example, the dependent variable might be defined as the percentage change experienced by the market over the month following a given indicator reading. To the extent that their relationship is linear, CC measures how well the indicator is able to predict the markets future change. CC can assume any value from a maximum value of + 1.0, indicating a perfect positive relationship between the two variables, to minimum value of - 1.0, indicating a perfect negative relationship. A negative relationship implies that high indicator readings forecast a bearish market. If the two variables are plotted against each other in a scatter diagram, a perfect linear relationship is indicated when all observations lie on a straight line. Magnitude is the important quantity when measuring predictive power so indicators displaying either significantly positive or negative CC values would be useful predictors. CC values close to zero indicate no linear relationship. The minimum CC required to evidence a statistically significant relationship depends upon the number of historical observations used in its calculation and the level of confidence desired by the analyst? Prior indicator research has focused on measuring CC over entire spans of historical data? For example, given twenty years of weekly observations, the CC would be calculated for the full twenty years. However, such studies have ignored the stability of the CC over shorter time intervals. Clearly, stability is an important property, if the indicator is to be of

practical use. Consider an indicator which has a significantly positive CC of +.50 when measured over an entire twenty year period, but when measured over one year sub-periods its value is so variable that its sign occasionally reverses to negative. During such sign reversals the indicator provides false predictions. For example, high indicator readings, which should be followed by rising prices, as implied by the positive full span CC, would in fact be followed by a falling market. High CC instability renders an indicator far less useful than another whose average CC over the full span is lower, but more stable. Our thesis is that CC stability is an important characteristic that should be incorporated into indicator evaluation. We propose a method for measuring and using CC stability. Our method measures CC stability by employing a moving data window. The concept of a moving data window is common in time series analysis and is used, for example, when constructing moving averages. In contrast to a typical full span CC, the moving window correlation coefficient (MW-CC) computes the CC value only for those observations contained in the data window, whose length, N, is defined by the analyst? After each calculation, the window is moved forward in time by one observation, and the CC is recalculated. The MW-CC operation produces a fluctuating time series that itself can be measured in terms of its average, its standard deviation and its trend. The standard deviation gives an indication of the stability of CC. The average and standard deviation are combined into a ratio which I have named SACC (Stability Adjusted Correlation Coefficient). Our thesis is that SACC is an informative measure that adds a useful new dimension to indicator correlation analysis. The Correlation Coefficient: An Intuitive Explanation The statistical theory behind the CC can be found in any basic statistics book. It is not our purpose to review that material, however, for readers not familiar with the concept, a brief description and some diagrams will provide an intuitive notion of its

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basis. Readers already familiar with this material may wish to skip to the next section. Suppose we have a set of historical data based upon two variables. One variable is an indicator whose predictive power we wish to determine, while the second variable is a measure of the markets future return. Imagine plotting this data on a 2-dimensional plane, usually called a scatter plot. On the plane are two mutually perpendicular axes. By convention, we assign the markets future return to the vertical axis, while the indicators values are assigned to the horizontal axis. The location of each point on the plane represents the values of the two variables at a particular point in time. Depending on the strength and nature of the relationship we get a cloud of points that will resemble, to some degree, one of the seven diagrams below.

What is a Significant Correlation Since even the best market indicators carry scant amounts of predictive information, they dont produce tight cigar-like patterns such as b or e, but rather scatter plots that resemble loose rotund ovals such as c and d. These typical point clouds are often hard to distinguish visually from round point clouds ( e.g. g) which are produced by indicaters with little or no value (i.e., CC = 0). Therefore we need an objective way to distinguish indicators with and without statistically significant forecasting information from those lacking it. This can be accomplished by applying a statistical test to determine if the magnitude of the CC is significantly different from zero. The logic for interpreting the significance test of CC is as follows. We start off with the hypothesis that the indicator has no forecasting

DIAGRAM 1
l . . . 9.

t .

-.~
. C::!:!=:::::!C . . .-

l . . . mm..
9.m. *;;;;.; l mm 9 . .. 9 9. 0~. . l . 0 . ?f;;.:+ . . ..=.. -.=

..

~-

l . ((=tJl
t Positive
.

..=

((=+I.0
Positive

.=:.
(b) Strong

. 9. . l mm.. .
l . . l

l.

.*.

K=+.2S

(0) Perfect

f (c) Weak Positive

9 l
.... .

.~.
mu l

.
mm

.
l l

.. lm:. i. l 0 mm .... rn. * -~.I .


l . . . . l t . urn. . l

vedicol oxis is fufure ma&t return horizontal axis is indicator value

m
.

K=O

(g) No Relationship .
mm.

l
.

.
mm 9.. l . l . .

. . .

l *. l .= ...m..-*m
l

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.

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mm .
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.=

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...I:mmm 8 .

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mm.

(d) Weak Negative

l&-.25

h-.70

(e) Strong

Negative

(1) Perfect

Negative

22

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value (i.e., that the CC=O). This is known as the null hypothesis. Statistical inference proceeds on the basis that if you can reject the null hypothesis you are entitled to believe its opposite, (i.e., that the indicator has some predictive value). The burden of proof is on the indicator to show it has forecasting information. The significance test tells us how confident we can be that CC, does not equal zero. The test, which takes into account the number of data points used, is based on the statistical principle that many repeated measurements of the CC between two uncorrelated variables, produces a normal distribution. Moreover, the standard deviation of this distribution is equal to: l/square root of the number of data points. The area bounded by one standard deviation above and below the mean is equal to 68% of the area under the entire distribution. For example with 200 data points the CC has a standard deviation of 0.071. This means that even if two variables are unrelated and their true CC=O, there is a 68% chance that the CC will take on a value between -.071 and +.071. The region enclosed between -2 and +2 standard deviations (i.e., between CC values of -.142 and +.142) is 95% of the area under the normal distribution. Therefore, CC values can occur within this range with a 95% probability even if the true CC=O. Continuing this logic, if an indicator has a CC value greater than +.142 or less than -.142, which will occur by chance only 5% of the time when the true CC=0 we can be 95% confident that CC does not equal zero and the indicator has some forecasting value. CC values beyond +3 or -3 standard deviations give us confidence that our indicator has some value with 99.7%. Below we give some key values whichCC must exceed to be significant at the 95% and 99% levels of confidence.
Number Data # weeks/years of data Points CC magnitude 95% Signif for 99.7% Signif

techniques, such as non-linear pattern recognition and multi-layer neural networks can.5 These advanced methods are beyond the scope of this article. Moving Window Correlation Coefficient & SACC Our approach to measuring CC stability is the MW-CC which employs a moving data window. The window length is a parameter specified by the analyst. MW-CC computes CC only for the data contained in the data window. After each computation, the data window is moved forward by one time period and CC is recomputed. In this study the data window length was specified as 208 weeks, or approximately four years. There is nothing magical about this window length and it was chosen simply because it corresponds roughly to a major cyclic period in stock market fluctuations. We could have just as easily used 100 or 50 weeks. Because of the windows 208 week length, four years of past weekly data were required to generate the first MW-CC value. For example, to produce an MW-CC value for the first week of January, 1965, data back to January 1961 was required. Moreover, the value computed for January 1965 would not have been knowable until some later date, when the value of the markets future change became known. In this study the future return variable required one year of future data. Thus the MW-CC for January 1965 would not have been knowable until January 1966 even though on our plots the value is posted as of January 1965. This is simply a convention we have adopted for this study and there is nothing sacrosanct about this choice. This explains why our plots end on 6/30/89 even though our available data extended through 6/30/90. Also, to reduce computation, the data window was moved forward by 13 weeks instead of one week each time a new MW-CC value was computed. Our indicator figure of merit is derived from the statistical characteristics of the time series generated by the MW-CC technique. Specifically we measure its average value and its standard deviation over a period 24.5 years. From these two statistics we created a ratio that called the SACC (Stability Adjusted Correlation Coefficient) using the following formula: (note the vertical lines indicate the absolute value of the ratio is used).
SACC= IMW-CC AverageMW-CC Standard Deviation1

104 208 520 1040 1300

2 4 10 20 25

yrs yrs yrs yrs yrs

.20 .14 .09 .062 .055

.30 .21 .13 .093 .083

As pointed out above, this article is confined to a discussion of the linear CC which measures how closely the point cloud hugs a straight line. Although linear relationships are the type most often explored in statistics, significant non-linear relationships may exist. While the standard linear CC will fail to detect them, more sophisticated statistical

Either a low value for the numerator, or a large value in the denominator will produce a low value for SACC. Indicators with stable predictive power will tend to have small denominators resulting in higher SACC values. It is our contention that SACC

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23

provides greater insight into an indicators utility as a market predictor than CC alone. For example, suppose we have two indicators. Indicator #l has an MWCC average of + 50 and indicator #2 has an MW-CC average of + .25. Knowing nothing else about them we would be tempted to rely on indicator #l over #2. But if the MW-CC of indicator #l has a standard deviation of .50 while that of indicator #2 is 0.125, #2 is substantially better in terms of the SACC criterion. Indicator Indicator #l SACC=.50/.50=1.0 #2 SACC=.25/0.125=2.0

with the dependent variable. Therefore we defined the indicator as the inverse of the ratio (i.e., the ratio of the 26 TWMA to the 4 week TWMA). Indicator Descriptions 1. CPRM (COMMERCIALPAPERRATEMOMENTUM) The data series used was the weekly interest rate on 3 month high grade commercial paper (CP3). The indicator is the log of the ratio of the 26 week TWMA of CP3 to the 4 week TWMA of CP3.

CPRM = log(26 weekTWMA

CP3/4 weekTWMACP3)

The Tested Indicators We have applied SACC analysis to a number of indicators which are defined below. Each indicator was correlated with a measure of the markets future change using the MW-CC technique. The definition of future market change is defined below. A plot of the MW-CC for each indicator is presented along with a table comparing the SACC values. Each plot has superimposed on it a regression line that depicts the trend of the MW-CC over time and gives an indication of improvement or deterioration in predictive power. An upward sloping regression line indicates improvement while a downward sloping line indicates deterioration. All indicators were derived from weekly data and were calculated for the period l/1/61 through 7/20/90. Indicators that involved moving averages were generated using a triangular weighted moving average (TWMA). In contrast to the simple moving average that assigns equal weight to all observations in the moving data window, TWMA assigns the greatest weight to the observation in the middle of the window and smaller weights assigned to observations at the end points of the window. For example the weights in a 5 period TWMA would be: 1,2,3,2,1. Each datum in the window is multiplied by its respective weight, these products are summed and then divided by the sum of the weights (9=1+2+3+2+1). The advantage of the TWMA over ordinary moving averages is that of it is less sensitive to large differences between the latest addition and deletion from the data window. All indicators are based on the natural log. To permit easier graphical comparison, all indicators were defined so as to have positive correlations with the dependent variable. This involved defining the indicators in a manner that is the reverse of what might make the most common sense. For example the commercial paper rate momentum indicator might typically be defined as the ratio of a 4 week TWMA to a 26 week TWMA . This would produce an indicator that is negatively correlated

2. FFRM (FEDERALFUNDSRATEMOMENTUM) The data series used was the weekly federal funds rate quoted on Friday (FFR). The indicator is the log of the ratio of the 26 week TWMA of FFR to the 4 week TWMA of FFR.

FFRM = log(26weekTWMAFFR/4weekTWMAFFR)
3. PRM (PRIME RATE MOMENTUM) The data series used was the weekly Prime interest rate quoted on Friday (PR). The indicator is the log of the ratio of the 26 week TWMA of PR to the 4 week TWMA of PR.

PRM = log(26 week TWMA PR/4 week TWMA PR)


4. DIVYLD (DIVIDEND MELD ON ~8~~500) The data series used was the weekly yield on the S&P500 stock index as quote in Barrons. 5. DIVBILL

(DIVIDEND YIELD s&p500/3 MONTH TBILLS YIELD)

The data series used were the weekly yield on the S&P500 stock index (DIV) and the yield on 3 month tbills (BILL). The indicator is the log of the ratio of dividend yields divided by tbill yields.

DIV/BIL

= log (DIVBILL)

6. MFACR (MUTUALFUNDCASHTOASSETSRATIO) The data series were those published by the Investment Company Institute. Cash were divided by assets and lagged by five weeks to compensate lags in reporting the figures.

MFCAR=(MUTUALFUNDCASH/MUTUALFUND ASSETS)LAG5 7. HILO (HILO LOGIC INDEX)


Weekly number of new highs and new lows as reported in Barrons were used to construct an indicator developed by Norman Fosback of the Institute for Econometric Research. The indicator is the total number of issues traded for the week divided by the lesser of weekly new highs or weeky new lows. This ratio was smoothed with a 13 week TWMA.

HILO=13WEEKTWMA(TOTALISSUES/LESSEROF (NEW HIGHS, NEW LOWS))

24

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CPRM VS S&P500
208 so .40 z+s oz a 0 cl v 1 3 5 .30 .20 .lO 0.00 ,

FUTURE

RETURN
I .00 .70 n -I t > n 0 0 i = .60 .50 .40 .30 .20 .lO 0.00 -.lO

DWLD
208

VS. S&P500

FUTURE

RETURN

WK MOMNG WINDOW CORRELATION QUARTERLY DATA

WK MOVlNG WINDOW CORRELATION QUARTERLY DATA

-.20 -.lO

FFRM VS. S&P500


208 .60 _I

FUTURE

RETURN .a I
-I -

DIV/BIL
200

VS. S&P500

FUTURE

RETURN

WK MOVlNG WINDOW CORRELATION QUARTERLY DATA

WK MOVlNG WlNDOW CORRELATION QUARTERLY DATA

I CY LL LL c-l y 3 I

.40 .30 .20 .lO 0.00 -.lO -.20 -.30 -.40 5


10 15 FFRMM 8

.6

m \ > cl

PRM VS. S&P500


208 .60 j

FUTURE

RETURN
.60

MFACR VS. S&P500


208

FUTURE

RETURN

WU MOilNG WINDOW CORRELATION QUARTERLY DATA

WK MOilNG WINDOW CORRELATION QUARTERLY DATA

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8. PSSR (PUBLIC TO SPECIALISTS RATIO)

SHORTS SALES
SO .40

YCM VS. S&P500


208

FUTURE

RETURN

Weekly values for public short sales (PUBSS) and specialists short sales (SPSS) were obtained from Barrons. The indicator is the ratio of PUBSS to SPSS smoothed with a 13 week TWMA which is lagged by two weeks to compensate for reporting lags.

WU MOVING WINDOW CORRE!vATlON QUARTERLY DATA

z >

JO
.20 .lO

PSSR = 13 wk TWMA (PUBSSISPSS) lagged 2


rates for three month commercial paper (CP3) and the weekly rates for Moodys AAA Corporate Bonds (AAA) obtained from Barrons. First the yield curve (YC) is calculated as the log of the ratio: YC=CP3/AAA. The

0
0

9. YCM (YIELD CURVE MOMENTUM) The data series used were the weekly

$ 0.00
Z -,,.
-.20 -.30

indicator
TWMA

is the difference

between the 52 week


of YC. Definition of Dependent Variable: S&P 500 Future Change The definition of the dependent variable is critical in correlation analysis. A particular indicator may have significant correlations with changes over the next five years while being uselessfor the next three

of YC and the 4 week TWMA

YCM = 52 week TWMA YC -4 week TWMA YC

HILO VS. S&P500


208 .60 SO 0 .40 .30 .20 .lO WK MOVING

FUTURE
WINDOW

RETURN

CORRELATION

months. In this research, the dependent variable is an


average of several time horizons to overcome a pro-

blem with a single horizon pointed out by Walter C.


Revis in an earlier MTA Journal article. Quoting from that article . . . focusing on one particular period of

_I

v 3 r

time can result in seriously distorted

impressions

of

y 0.00
-.lO -.20

-JO
-.40

LO Y

PSSR VS. S&P500


208 .60 SO

FUTURE

RETURN

WK MOVlNG WINDOW CORRELATION QUARTERLY DATA

K VI v, a 0 0

.40 .30 .20 .lO

i 2 0.00
-.lO -.20

an indicators accuracy. An extreme example of this would be comparing an indicator to the DJIA one year in the future for the dates October 16 and October 19, 1986. Since adding a year to these dates would bring us to the day before and the day after the Crash, the difference in the yearly return would be dramatic One year from October 16, 1986 would show a return of over 22% in the Dow Industrials. One year from October 19, 1986 would show a loss of over 5%, even though the DJIA was higher on over 97% of the trading days in between. Would it be fair to say that an indicator that was bullish on both dates in 1986 was only right half of the time? Obviously not.6 In this study the dependent variable is defined as an average of future change over six different time horizons; 1 month, 2 months, 3 months, 6 months, 9 months and 12 months. First the annual compounded price change on S&P500 was computed for each of the time horizons. For example, supposeat a certain point in time the S&P500 stands at 200 and one month later it is 210, two months later it is 207, three months later it is 225, six months later it is 240, nine months later it is 245 and twelve months later it is 220, the annualized changes for each time horizon would be: 1 month annualized compounded return = (210/200)2 = 80%

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2 month annualized compounded (207/2OOY = 23% 3 month annualized compounded (225/200)4 = 60% 6 month annualized compounded (240/200)* = 44% 9 month annualized compounded (245/200)1.33 = 31% 12 month annualized compounded (220/200) = 10% The dependent returns = 41.16% variable

return return return return return

= = = = =

is an average of the six

Results Below, in Table 1, we present the results of our analysis for the period l/65 through 6189. Each indicator was correlated with the dependent variable, the markets future return asdefined above. For each of the nine indicators listed along the right hand side of the chart the following five columns of information are provided; Co1 l-Average value of the MW-CC Co1 2-Standard deviation of the MW-CC Co1 3-Minimum value of the MW-CC over the historical period Co1 4-Maximum value of the MW-CC over the historical period Co1 5-SACC, a ratio of Co1 1 to Co1 2 Table 1.

5
Indicator CPRM FFRM PRM DIVYLD DIV/BIL MFACR HILO PSSR YCM Average 0.26 0.26 0.24 0.45 0.38 0.26 0.19 0.34 0.21 St. Dev. 0.14 0.17 0.14 0.16 0.25 0.17 0.20 0.17 0.17 Min -0.25 -0.34 -0.40 -0.12 -0.34 -0.20 -0.32 -0.19 -0.21 Max 0.46 0.52 0.52 0.74 0.74 0.52 0.53 0.58 0.47 SACC 1.86 1.53 1.71 2.81 1.52 1.53 0.95 2.00 1.23

Conclusion & Future Research The stability of an indicators forecasting power is an important consideration in evaluating its utility and the MW-CC technique is one way to measure it. The SACC criterion incorporates stability and average correlation and thus identifies indicators whose forecasting power is high relative to variability. Researchers who wish to pursue this area should consider investigating several facets . First, other window lengths should be looked at to seewhich are most informative for particular future time horizons. Second, correlating the MW-CC curves of various indicators could provide useful information as to which indicators might usefully be combined to form multivariate forecasting models. The idea would be to combine indicators whose MW-CC curves are least correlated. This suggestion is in the spirit of Modern Portfolio Theory7 that seeks to maximize portfolio return while minimizing return variance. It does so by combining investments that display low levels of correlation in their return streams. In a like manner, MW-CC data streams might be fed into an MPT optimizer to find a combination of indicators that maximizes MW-CC while minimizing MW-CC variance. The optimal portfolio of indicators discovered could then serve as input to a multivariate estimation technique which derives the functional relationship between the indicators and a dependent variable. This step is necessary because MPT does not generate a functional mapping. Conventional multiple regression could be used as the estimation method, though more advanced non-linear methods could provide better results if the relationships are non-linear. The application of MPT optimization to MW-CC curves give needed attention to indicators time varying predictive power and their intercorrelations. The benefit of introducing this type of information into the multivariate modeling process could be models with more stable predictive power.

FOOTNOTES 1. For a general introduction to correlation analysis see Jerome L. Valentine and Edmund A. Mennis, Quantitative Techniques for Financial Analysis, C.F.A. Research Series, Richard D. Irwin Inc., Homewood, Illinois, 1971 pp 85-86 or any introductory text on statistics. 2. James T McClave and F? George Benson, Statistics For Business and Economics, Dellen Publishing Company, San Francisco, 1985, p. 420 and Biometrika Tables for Statisticians, Vol. 1 (2nd edition), Cambridge University Press (1958); edited by E.S. Pearson and H.O. Hartley, pp 332-333. 3. For example, Norman G. Fosback, Stock Market Logic, The Institute for Econometric Research, Fort Lauderdale, Florida, 1985. In this work, Fosback measures the CC of numerous indicators using the time span 1942 through 1975. 4. N should be greater than 30 observations to prevent small sample size problems, but not so large that it loses sensitivity

Plots of the MW-CC It is instructive to look at the plots of MW-CC from which the SACC was derived. It becomes clear just how volatile forecasting power is. We also fit a trend-line to the data with linear regression. The slope of the regression trend-line shows whether the CC is getting better or worse over time. MW-CC plots for each of the nine indicators described above are shown in Diagrams #2 through 10.

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to short-term changes in predictive power. 5. For a general introduction to non-linear modeling methods see Shaolom M. Weiss & Casimir A. Kulikowski, Computer Systems That Learn, Morgan Kaufmann Publishers, Inc., San Mateo, California, 1991, or Ross M. Miller, Computer-Aided Financial Analysis, Addison-Wesley Publishing Company, Reading, Massachusetts, 1990, Chapter 10. 6. Walter C. Revis, A Methodology for Creating a Master Indicator, Market Technicians Association Journal, Winter 1989/1990, pp. 25-30. 7. Andrew Rudd & Henry K. Clasing, Jr., Modern Portfolio Theory-The Principles of Investment Management, Down JonesIrwin, Homewood, Illinois, 1982, Chapter 1.

David

Aronson is president of Raden a firm that develops and licenses

Research predictive

GFOU~, model-

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The Barrons
by Bruce M. Kamich

Confidence

Index Revisited

Investors and technicians are forever interested in indicators that will help forecast the markets or anticipate turning points. Some indicators lead, others are coincident and others may lag the averages or the instrument that one is following. This paper focuses on the Barrons Confidence Index as a leading or coincident indicator of the bond futures market. We will explore the history of the Confidence Index from its uncertain beginnings, its ?-e-discovery in 1959, its overuse in the 196Os, and the subsequent fallow years. Finally, we will look at a way to use the indicator to time the bond market. The Confidence Index first appeared in Barrons on January 8,1932. It is reported each week in the Market Laboratory section. The Confidence Index became popular in the 1960s when Joseph Granville introduced it as a stock market timing tool. In the mid-1960s, it was published by a number of market services in both line and point and figure form. In conversation, Jim Alphier, the late chairman of Argus Investment Management said that Col. Leonard I? Ayres originated the Confidence Index in 1926 or 1927. Jim Alphier also said that Ayres was involved in the founding of a company called Standard Statistics that was later merged in 1941 with Poors becoming the famous Standard & Poors Corporation. I was unable to unearth the original ideas behind the Confidence Index and found no citations regarding its use. In Leonard I? Ayress, Turning Points in Business Cycles, we can find some of his early thinking on the topic of confidence and interest rates that may have inspired formulation of the confidence index. A sample is quoted below.
It has long been a commonplace of financial comment that business confidence increases, and business sentiment becomes more optimistic, when stock prices are advancing? Throughout this book the thesis has been developed that there is a special significance in the fact that security prices and the volume of new capital issues have turned downward shortly before the downturns of most business cycles, and that they have turned upward before the business upturns. The argument has been that the downturns of the security prices have created market

conditionsthat were unfavorable for the saleof more capital issues,and that the upturns of prices have restoredfavorable market conditions.Thesechanges of direction in the trends of security prices and in the volumes of new capital issueshave resulted in cyclical fluctuations in the amounts of new money flowing into corporate enterprises. There is one simple test which should throw considerable light on the degree of regularity with which such changes of direction in the trends of security pricesand the volumesof capital issues have in fact precededthe downturns and the upturns of the business cycles.That test can be carried through by computing the data of a single line representing in the earlier years of the long period under review a smoothed average of the coursesof the security prices, and for the years sincethe early 1860sa line representing a smoothed average of the security prices and of the capital issues? According to theory the indicator line should be moving downward as it crosses each light vertical dashedline, and it should be moving upward as it crosses eachof the heavy ones.In nearly all the cases it behaves in that way, but in a few instances its changes of direction are made too sluggishly to render that possible? Despiteall its shortcomings the
indicator line reflects the high degree of regularity with which stock and bond prices have turned downward before the downturns of our business cycles and by doing so have created unfavorable market conditions for the further marketing of new securities, and the regularity with which they have turned upward before the upturns of the cycles and brought about favorable market conditions for floating new issues. For the past 75 years the line includes the data of the new issues as well as those of the bond and stock prices, and it continues to turn

upward and downward with almost unbroken


regularity shortly before the upturns of the business cycles.4 and downturns

The staff at Barrons, nor a conversation with Joseph Granville shed any light on the early history and uses of the Confidence Index. In the 1960s, the Confidence Index was constructed from the ratio of the average yield on Barrons 10 highest grade corporate bonds to the yield on the Dow-Jones 40 Bond Index. Today the Index is the result of Barrons index of 10 high-grade corporate bonds divided by Barrans index of 10 medium-grade corporate bonds.

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Barr-ons explains the Confidence Index in their own literature as the ratio of the yield on the best grade bonds relative to intermediate grade bonds. A falling ratio means that bond buyers are willing to accept a much lower yield on the better-quality bonds that suggests that they are losing confidence in lesser-quality issues. The cautious element in the market is thereby implying that it doesnt favor lowquality in general. A falling Barrons Confidence Index is viewed by many as a harbinger of weakness for the stock market. The reverse is also believed to be bullish for stocks. A rising Confidence Index suggests that astute investors are becoming more willing to tolerate higher risk (since they are willing to accept lower yields on lower-quality bonds relative to what theyll accept on the higher-quality issue.)? The use of the Barrons Confidence Index as a stock market forecasting tool is associated with Joseph E. Granville. When Mr. Granville was writing a daily market letter for E.F. Hutton & Co., Barrons published on September 7, 1959 his article Market Forecaster? The Barrons Confidence Index has Compiled an Uncanny Record. In this article, Mr. Granville tells us how to use the Index:
The ratio is high when investors demonstrate confidence by buying lower-grade liens, low when they take refuge in top-grade issue. Correlated with the movements of the stock market, the Index becomes a highly sensitive forecasting instrument, predicting the extent as well as the timing of price advances and declines. Generally speaking, changes in the Confidence Index precede those in the stock market by two to four months. . . . Repetitive bottoms or tops in the Confidence Index usually signal very important near-term lows or highs in the Dow-Jones Industrial Average. . . . Major tops for the market are signaled when the Confidence Index makes a sharp weekly upswing to a new high and then retreats immediately the following week. . . . The low in the Index following an unbroken series of declines is often more significant than subsequent lows made after intermittent rebounds.

pertaining to this indicator was found. Reference to the Confidence Index is not complete without an appreciative nod to Lawrence Zeiberg for first calling the authors attention to the Index by lucky accident, both of us completely unaware at the time of its significance.5 The 1960 Granville book goes on to explain that the Index is simply pointing out the direction the smart money is moving in. When the Confidence Index moves up it means that important money is moving away from the safest bonds toward more speculative bonds. When the Confidence Index declines it means that the smart money is gravitating back toward the safer issues and away from the speculative bonds. Correlation with the stock market becomes obvious. A series of advances in the Confidence Index is going to result in more money flowing into equities (gravitating toward risk) and a series of declines in the Confidence Index is going to result in money flowing out of equities (gravitating toward safety). The flow of smart money shows up in the bond market before it shows up in the stock market.
Smart money can be identified in retrospect by anybody. If the stock market goes into a sustained advance the smart money was that money which flowed into equities just before the rise. Conversely, if the stock market goes into a sustained decline the smart money jumped out of stocks first. Therefore; see what the smart money is doing in the bond market and you will know in advance what it will do in the equity market, either come in or go out. The Barrons Confidence Index tells you in one weekly figure whether the smart money is gravitating toward safety or risk. The time lag between the changes in the Confidence Index weekly readings and the stock market average movements is subject to various durations, but the correlation theory is sound enough to underscore this indicator as one of the most sensitive and accurate market timing devices. To emphasize this in the broadest possible sense, the stock market has never gone down following a lengthy series of Index advances and the market has never continued to rise following a series of Index declines. In the positive sense, the market has always risen following a rising trend in the Confidence Index and has fallen following a declining trend in the Index. The lead time is generally two to four months.

Granvilles, A Strategy of Daily Stock Market Timing for Maximum Profit, added little to his article, but it served to publicize the Confidence Index. In the preface Granville tells us more about the background of the Confidence Index. The Barrons Confidence Index is treated at some length as a primary feature, not only because of its very newness as an applied stock market indicator, but because of its high degree of timing accuracy, which has immediately placed it in the forefront of the major market indicators. Other than the writers brief article on the subject (Barrons, September 7, 1959, entitled Market Forecaster?), no other literature

Granville also suggests we need not get too close to the Index in that It would be possible to compute the Confidence Index on a daily basis but in the light of past performance the added degree of accuracy would not be commensurate with the effort. Granville also reminds us to trust our 10 indicators and try to ignore the news reports - It has been found that when the Confidence Index is in disagreement

30

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with majority opinion, the record of past performance favors the Confidence index as being the true indicator in the majority of cases. Granville presents 15 rules to guide you in interpreting the Confidence Index. 1. Whatever the Index is doing is usually reflected in the stock market between 60 and 120 days later. 2. The Index is primarily useful in determining market timing, but not necessarily amplitude as measured by the Dow-Jones Industrial Average. 3. The Index is simply pointing smart money is moving in. out the direction the

significant, especially if the new high or new low is only maintained for that one week. 14. When overlapping 60-120 day signal time areas exist, the transitory nature of the shorter duration C.I. swing is stressed. 15. While the Confidence Index is important, it is still only one indicator. It is the collective use of all the indicators that constitutes the most enlightened market forecast? By 1963, in his next book, Granvilles New Key to Stock Market Profits, Granville gives only passing mention to the Confidence Index. At this juncture it is interesting to note what some of the other indicators were pointing to. The Barrons Confidence Index called for a new high in the Dow-Jones Industrial Average sometime between June and August.O For the next 25 years the Barrons Confidence Index slowly collected dust and became a forgotten sentiment and stock market timing tool. There is one study in the 1965 revised second edition of the Encyclopedia of Stock Market Techniques (we are unsure when it was written, but the last price entry is March 1965). This article by Paul S. DellAria, was titled Confidence Index - Stock Selection and in the summary the author points out, To date, taking into account the reappraisal of its lead time, the Confidence Index has performed satisfactorily. The lead-time curve is offered as a tool that can enhance the usefulness of the Confidence Index. The thrust of the article was to refine the lead time of the Confidence Index. The author found that, Although there is no doubt that the lead time varies, the range does not necessarily fall between two and four months, but can be greater. In fact, it can vary from as little as zero lead time to as much as a year. The Barrons Confidence Index has not been widely used in the last twenty years and there have been few references to the index in writing. In 1984 Granville co-authored a kind of autobiographical book with William Hoffer. In The Book of Granville, Reflections of a Stock Market Prophet, he notes that it became overused. If I really have unlocked the secrets of the stock market, why has not everyone followed my lead, effectively undermining my theories? In some cases they have. Some of my early indicators, such as the Dow Jones Rail Average and the Barrons Confidence Index, became so widely followed that they were no longer valicl.12 As traders and analysts we have come to accept that bullish developments for the stock market can be bearish for the bond market. A strong economy can translate into higher earnings and higher equity prices, but for bond traders a stronger economy can mean increased demand for money and higher

4. Whatever the Confidence Index does not foresee is not important. If the Confidence Index is declining and the market is rallying the market offers a selling opportunity. If the Confidence Index is rising and the market is declining it offers a buying opportunity. 5. Major tops for the stock market are often signalled when the Confidence Index makes a sharp weekly upswing to a new high and then retreats immecliately the following week with an equally sharp decline. 6. Repetitive tops or bottoms in the Confidence Index usually signal very important near-term lows or highs in the Dow-Jones Industrial Average. 7. The low in the Confidence Index following an unbroken series of declines is often more significant than the subsequent lows made after intermittent rebounds. 8. The start of long bull swings in the stock market are more likely to be signalled by the first rises in the Confidence Index following a long period of previous declining moves in the Index. 9. Lead measurements in the case of double, triple, or four-way Confidence Index bottoms, should be measured back to the last of the multiple Index bottoms. 10. When the phenomenon of divergent Index penetrations is encountered, it is the most recent penetration that determines the direction of the Confidence Index trend. 11. Regardless of what weights the Index grade rails, etc.), the validity of the stock signal is not distorted. (second market

12. When the Confidence Index is in disagreement with majority opinion, the record of long past performance favors the Confidence Index as being the true indicator in most cases. 13. A penetration of a tenth of a point in the Confidence Index is not looked upon as being too

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31

Weekly

Bond

Futures

Prices

Weekly

Bond

Futures

Prices

66

66

51 85

57 85

Barrons Confidence
1977 1978 1979

Index 1960 1982

Barrons Confidence
1983 1984

Index 1986

interest rates. Thus, some indicators that work for the stock market may need to be reversed or inverted to generate signals for bonds. Granville found that bottoms or low numbers for the Confidence Index preceded lows in the stock market. In my research, however, I found that high confidence numbers were closer to bond market price lows while low numbers for the index tended to preceed highs for the debt markets. It looks as we have come full circle. Can we accept a new use of the Confidence Index? I present my findings above and on the next page. Examining the extreme readings in the BCI for the past 15 years we came up with the revealing results shown in Table I.

From Table 1, (see page 34) note the distinct change in the data from the 1977-1983 period to the 1984-1992 period. The extreme readings marking the bottoms in bond prices (high BCI readings) are in the 93.7 to 98.7 region in the latter period. In the early period bond market bottoms occurred when the index fell between 91.7 and 94.1. The difference in levels might be attributed to the fact that the early phase in the bond market had a bearish bias while the latter phase had a bullish emphasis. Another possible explanation for the difference in levels between the periods was that the issues used to compute the Confidence Index were changed. In 1984, Randall Forsyth revised the index as one of his first

32

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Barrons
1987 1988

Confidence
1989

Index

1990 1991

n ID

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33

jobs on the Barrons staff. It is quite possible that the issues in the Index will be revised again since some of them have been called. In interpreting the indicator in future cycles, consideration should be given to the downward sloping channel that has lead to higher levels for the Confidence Index at market bottoms. Table I as a Tool Market
Index at Tops 88.6 90.1 89.2 84.0 86.0 85.2 87.0 90.8 91.3 89.9 91.3 91.5 92.2 93.4 92.9 92.8 89.8 87.2 91.8 Nearby Futures Prices N/A 97-22 81-24 72-07 69-23 76-06 77-11 64-00 85-07 98-31 99-24 93-14 97-02 96-21 99-28 105-20

BIBLIOGRAPHY Ayres, Leonard I?, Turning Points in Business Cycles, The MacMillan Company, 1940 DellAria, Paul S., Confidence Index - Stock Selection, Encyclopedia of Stock Market Techniques, (Revised Second Edition), Investors Intelligence, Inc., 1965 Granville, Joseph for Maximum Granville, Joseph fits, Prentice-Hall, Granville, Joseph ville, RefZections 1984. Krasner, Joel H., E., A Strategy of Daily Stock Market Timing Profit, Prentice-Hall, Inc., 1960 E., Granvilles New Key to Stock Market ProInc., 1963 E. with Hoffer, William, The Book of Granof a Stock Market Prophet, St. Martins Press, Confidence Galore, Barrons, June 4, i990

The Confidence Index for Timing the Bond


Index at Bottoms 92.8 94.1 93.3 93.6 93.9 91.7 93.7 96.3 95.7 93.7 96.9 97.7 97.4 98.7 96.0 95.0 95.0 93.3 96.4 Nearby Futures Prices 101-20 91-24 90-22 69-00 59-16 62-09 70-22 68-21 68-15 94-29 77-23 84-14 86-19 90-23 93-02 96-28

Date 10131/77 10130/78 07123179 03117180 09114181 07109182 10128183 03/02/84 03/01/85 06113/86 10116187 08126188 03/10/89 04l30190 06124191 03/16/92 avg 77-92

Date 01/03/77 03113178 12124179 12/29/80 02/02/81 lo/29182 03104183 07127184 12127185 11128186 01102187 01129188 08/04/89 12/10/90 10/07/91 01/06/92

FOOTNOTES 1. Leonard F? Ayres, Turning Points in Business Cycles, 1940, p. 162. 2. Ibid., p. 156. 3. Ibid., p. 157. 4. Ibid., p. 161. 5. A promotional booklet by Barrons showing how to use various indicators and data contained in the weekly. 6. Market Forecaster? The Barrons Confidence Index Has Compiled an Uncanny Record: Barrons, September 7, 1959, p. 9. 7. Joseph E. Granville, A Strategy of Daily Stock Market Timing for Maximum Profit, 1960, p. 114. 8. Ibid., p. 116. 9. Ibid., p. 122-123. 10. Joseph E. Granville, Granville$ New Key to Stock Market Profits, 1963, p. 270. 11. Paul S. DellAria, Confidence Index - Stock Selection, Encyclopedia of Stock Market Techniques, 1965, p. 59. 12. Joseph E. Granville, with William Hoffer, The Book of Granville, Reflections of a Stock Market Prophet, 1984, p. 140.

avg 77-83 ave 84-92

Conclusion After examining the 1977-1992 history of the Bar-rods Confidence Index and bond futures prices, I believe the Index is at least a good coincident or confirming indicator of tops and bottoms for bond futures. Committing funds to the market or raising cash gradually as the indicator changes should be given consideration. One possible way to use this data would be to go a third long when the Confidence Index reaches 95, the overall average. Another third long position could be purchased if the Index rose further to 96.4 or higher, the average of the more recent years. A final position could be acquired when the earlier purchases become profitable. More work needs to be done in refining entry and exit points in the market. Smoothing the Index with moving averages and formulating rules to reduce the level of subjectivity would be one area for investigation.

Vice President with MCM, Inc., Bruce M. Kamich is responsible for the technical commentary and analysis on MoneyWatch, a technical and fundamental information/advisory service covering the U.S. Treasury market and delivered over Telerate. Before joining MCM, Bruce was employed as a futures and options hedging specialist at Oppenheimer & Co., as Director of Research at Alto Commodities, as a technical market analyst at Merrill Lynch, and covered risk management trading at a regional government securities dealer. He has held various positions on the board ofthe Market Technicians Association and currently serves as the President of this 600-member organization. Bruce has had several articles published in the MTA Journal on specialized bond market indicators.

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A Sealed

Room and Only


Ph.D.

One Client

by Henry 0. Pruden,

In this article, I propose to offer you some opinions and conjectures on the following thesis: to do his or her finest work, a technician must have a sealed room and only one client. A Sealed Room We must travel north to near Boston and travel back in time to the early 1950s so as to observe John Magee seated in his famous sealed room. John Brooks, author of The Seven Fat Years: Chronicles of Wall Street, found Magee there and then. From the pen of Brooks the fable, the myth or was it the fact of the sealed room came to be accepted as the symbol of the pure technician working in a pure technical world. This is how Brooks told the story of his first meeting with John Magee:
Hanging on the wall nearby was a bulletin board, on which were posted several notices, written in symbols too esoteric for me, and a motto, not so esoteric, that read, MY MIND IS MADE UP, DONT
CONFUSE ME WITH THE FACTS.

from here, where I had nothing but a table, a chair, a telephone, a ticker and an air-conditioning machine. I sealed up the windows with boards and putty, so there would be no outside sights and sounds to distract me. I had no fundamental information at my disposal whatever, which left me free to make up my mind solely on the basis of my charts. Magee continued, Ive still got a lease on the Worthington Street Office-keep a lot of my private files there. Ive always hung onto it as a place where I can go every now and then and think-a kind of safety valve, you might say. . I

Magee gave me an owlish glance and pointed to the motto on the bulletin board. So, you see, in a sense theres as much truth as humor in that, he said. Of course, the sign is just a gag and is intended as a rebuke to know-it-alls, but to the technician the last part of it has a special significance and in a peculiar way means what it says-Dont confuse me with the facts. Facts, as used here, are the daily outpouring of newspaper stories and radio news bulletins dealing with announcements of mergers, reports of earnings, decisions in tax cases-all that sort of thing-to say nothing of a great variety of opinions and predictions and just plain scuttlebutt. Even if you could separate the hard core of fact from the chaff of scuttlebutt, you would find that much of it is irrelevant-information that is either trivial or, more often, has already been noted, evaluated, and acted on, and thus has been reflected by the market, days, weeks, or even months before it reaches you. Discounted in advance, as Wall Street says. It is simply so much confusing dross to the technician, who therefore does his best to avoid it. Let me give you an example, said Magee. Before I came to work here, I was on my own, making my charts and operating in the market out of an office at 350 Worthington Street, a few blocks

Like Wyckoff, like Schaboacker and like Neil1 before him, Magee ran a pennant up the flag pole emblazoned The Tape Tells All! To tell the truth, to interpret the true message of the market, all Magee required was the price, volume and time of transactions, all of which were available from the ticker tape. With price, volume and time, Magee could create daily charts and weekly charts, he could then go on to draw trend lines, mark levels of support or resistance, and, then, finally, elevate all into a fantastic geometric typology-wedges, triangles, head-and-shoulders, saucers and so on and on. But why has the metaphor of the sealed room lingered for so long? Why do the words sealed room evoke such warm and knowing familiarity among some technicians and vivid mental images among others? The answer to these questions lies, I believe, in the allegorical qualities of the story of the sealed room. An allegory is a story in which figures and actions are symbols of general truths. It is a method of indirect representation of ideas as truths. The upshot of the story of the sealed room is that you need your own private space, your own sealed room, free of the noise, interferences, competitions and expectations of the external world, so that you can do your best technical thinking. You can best organize yourself for effective decision-making by first creating for yourself in your own mind your own version of the sealed room. That you can achieve superior technical results by retiring to the treasure chest of your own sealed
room is no small accomplishment. It promises you

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an opportunity to shift your state of mind into that zone where superior performance is naturally fostered. In his article on Finding The Zone (NY Times, April 9,1989), Lawrence Shainberg recounts how Denise Parker, a diminutive, world-class archer finds her zone. According to her coach, Keith Henschen, an applied sports psychologist: . . . athletes who do best are the ones who get into
the zone most easily. (Her coach asked Denise) . . .to create for herself what he called a happiness room, a place to which she could withdraw in her imagination in order to visualize an upcoming meet. Of all the exercises this was the one to which Denise brought the most enthusiasm. The room she created (in her mind) was primarily a replica of her bedroom, but it had its magical dimension, and it was anything but austere. Theres stairs leading up to it and these big doors you go through, she explains. It has brown wall-to-wall carpet, a king-sized waterbed, stack stereo, a big screen TV and a VCR, posters of Tom Cruise and Kirk Cameron on the wall, and a fireplace thats always blazing. Thats where I go when a meets coming up. I drive up to it in a Porsche, go inside, lie down on the waterbed and watch a tape of myself shooting perfect arrows. Later, when I get to the tournament, everything seems familiar. Even at the Olympics I was calm as soon as I began to shoot.

technical
clients,

analysis, to create wealthy


a better world.

and happy

to make

Its not what the vision is, its what the vision does: Truly creative people use the gap between vision and current reality to generate energy for change. As Somerset Maugham once said, Only mediocre people are always at their best! Everyone has had experiences when work flows fluidly; when he feels in tune with a task and works with a true economy of means. Someone whose vision calls him to a foreign country, for example, may find himself learning a new language far more rapidly than he ever could before. You can often recognize your personal vision because it creates such moments; it is the goal pulling you forward that makes all the work worthwhile. But vision is different from purpose. Purpose is similar to a direction, a general heading. Vision is a specific destination, a picture of a desired future. Purpose is abstract. Vision is concrete. Purpose is advancing mans capability to explore the heavens. Vision is a man on the moon by the end of; the 1960s. Purpose is being the best I can be, excellence. Vision is breaking the four-minute mile. It can be truly said that nothing happens until there is a vision. But it is equally true that a vision with no underlying sense of purpose, no calling, is just a good idea-all sound and fury, signifying nothing!3 Let us wend ourselves more deeply into an exploration of your purpose and your clients. At the bottom there may well exist a curious love-hate rela-

Like Denise, your sealed room can be your happiness room; like Denise, you can create your sealed room in your mind; like Denise, you can outfit your sealed room with all the modern gadgetry and wizardry you wish; like Denise, you can retire to your sealed room at any time, but particularly before major events; like Denise you can run movies of yourself making the perfect market calls time after time after time, or, if you prefer, you can run mental movies of those times in the past when you made your best calls, you did your best work, you felt you were in sync with the market. Only One Client Within your mind there should exist a vision of yourself achieving your defined purpose. Such a vision has magnetism, it has the power to pull you toward its fulfillment. To be most magnetic, such a vision should depict you accomplishing your hearts desire-for example, imagine seeing yourself receiving the MTA Award, feeling the congratulatory handshakes from Bob Prechter and Marty Zweig, and exchanging messages of trust, respect and mutual admiration with your clients. Such a vision engenders commitment, raises standards, enlivens a creative search for better solutions to problems, be they technical, personal or monetary. Such a vision generates the creative tension you need to call forth
your best efforts, to push forward the frontiers of

tionship between you and your clients. You are the expert, they are novices, or so the reasoning goes, for otherwise why should they buy our advice? Your superior knowledge presumably gives you power, yet modern marketing philosophy states that the consumer, your client, is king! You want to be rational,

your clients too often are emotional!? You want to focus and concentrate your energies, but too many
diverse clients are always scattering your attention

and efforts. You may have a solid track record and a method for generating reasonable, consistent
results, yet potential clients clients leave you as they flock the latest hot hand. You are clients, but you may prefer avoid you and current around the guru with dependent upon your to affiliate with your

peers; you may wish to stand tall in the timer ratings.


Now let us walk into a bookstore and purchase a

copy of a forward-thinking management text, The Fifth Discipline: The Art and Practice of the Learning Organization, by Peter M. Senge. Between its covers can be found an assortment of nuggets of wisdom. Take purpose for instance. The author implores you to extend the boundaries of your ego
and function, you end up widening your circle of

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compassion. By expanding your boundaries of compassion you end up seeing clearly how you and your client are enmeshed in the same system of mutual dependence. Out of this sense of expanded boundaries also springs a commitment to the whole, which will make your sense of purpose a real motivating force. As Senge goes on to say, . . . genuine commitment is always to something larger than ourselves. The sense of connectedness and compassion characteristic of individuals with high levels of mastery naturally leads to a broader vision. . . . Individuals committed to a vision beyond their self-interest find they have energy not available when pursuing narrower goals. Viewing your technical efforts from the clients perspective is a commitment to the truth. It means a relentless willingness to root out ways we limit or deceive ourselves from seeing what is, and to continually challenge our theories of why things are the way they are. It is broadening our awareness, it is expanding our boundaries, it is taking another observation of our work from the outside looking in. But how do we reconcile what is, the culture of the client-customer relationship on Wall Street, with what should be, a wider, deeper sense of purpose which incorporates your client as a partner in your progress? Ipropose that you simplifjl your life down to %nly one client. Then incorporate that bne client into your personal vision of achievement, and into your statement of purpose. You are the customer, you are the Company, exclaimed Paul Hawken in the title to a chapter in his book, Growing a Business. Hawken went on to make the following observations:
In order to develop a good business idea and earn the permission of the marketplace, yoou must be the market. You should want to shop at the store you run, to receive the services you offer. Every expression of the business, its ads, decor, service, packaging, pricing, and selling techniques should be 100% credible, respectable, and acceptable to YOU.~

And further

on Hawken said that:

While you approximate the customer, you can know only yourself. So stay close to the person you understand, and market products for yourself. This takes the guess work out of it.5

Hawkin is calling our attention to the fact that we too are the clients of your own technical products, that we too should shop, critically, at the windows of our technical enterprises. We should repeatedly ask ourselves: would I buy that? does it meet my standards as a client? If it does not, then change it. You, yourself are that one client. You, yourself,

or at least the customer-client part of you, are the proxy for all of your other clients. That is a responsibility. Consistently serve that one client very well over the long-term and youll serve all of your other clients. Think of it this way. If you are by yourself, trading for your own account, you are, in the final analysis, doing it for some larger purpose. That larger purpose is fulfilling the needs of the consumption side of your business, the customer. Your larger purpose is inextricably tied to fulfilling broader client needs, be they safety needs fulfilled by money in the bank, affiliation needs met by caring for your loved ones or even philanthropic needs satisfied through charitable donations. Cut a corner, cheat your customer and you cheat yourself. So much for the duality of yourself as customer and company. But your vision of yourself as your best and most worthy client will only enhance your decision making if it becomes an internal part of you. Writing down, I am the customer, I am the company as a motto, then placing that affirmation everywhere along your daily path is not a bad idea. But the really good idea, the idea which will give that motto some punch is to have it installed in your mind, in one or more of your primary senses of seeing, hearing and feeling. Lets do a simple exercise to get this point across. At this moment create a mental picture of an ideal client in your minds eye. Focus on the head and shoulders. Now center this picture of your ideal client as though it was appearing on a onemillion dollar bill. Can you make the client look a little more like you? Can you place that image of your ideal client in your upper visual field alongside an image of yourself? If you did those exercises, you were creating an internal visual representation. On the other hand, if you were unable to make mental images or if you were unhappy with this picturemaking process, then try words or feelings instead. Develop somewords to represent your client, like he is a jolly good fellow. These words, like your conscience speaking, will come up to remind you of your purpose, your vision. Or maybe youll be reminded of your vision by how you feel, by a tingling sensation in your arms or a thrill through your solar plexus. Best of all, develop all three internal representations of your only one client-see him, hear him, feel him. The next facet of your vision calls for constantly, continually maintaining a vivid image of your growing, thriving client or client-self. A hallmark of effective decision-makers/successful people is a capacity to sustain their vision, to have it as a handy reference against which to check their decisions. Their vision is both now in the present and out there

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in the future; it is focused on ends and results rather than upon ways and means. An effective decision-maker is so bound to fulfilling his larger mission he will make the needed adjustment in ways and means. For example, if reversing a market opinion is needed to fulfill the vision of a prospering client, the opinion will be amended; if abandoning a pet technical approach is required to reach the future vision, so be it; if different time-frames or styles of trading or even if a bullish bias must be surrendered to fulfill the vision, appropriate change will be made. And the effective, visionary decision-maker will accept these and numerous other mistakes in stride; hell accept them as learning opportunities along the path to the fulfillment of his compelling future. Any decision you make should be tested against that vision. If the contemplated action leads toward the fulfillment of that vision, it is an effective decision; if the contemplated action leads away from the fulfillment of that vision, it is an ineffective decision. Your vision of you and your client on the face of a $l,OOO,OOO bill can serve as the trigger which causes you to generate multiple options of the future, your vision can be the standard against which you measure those options, your vision can be the motivator which pulls you into action. The stronger and richer the image of your only client, yourself, and the more deeply rooted, the more pure and the more single-minded your purpose, the more likely that this entire decision-making process will become automatic for you. Maintaining the image of only one client will work to harness the immense powers of your unconscious mind. Conclusion Reflecting back upon this discourse may bring to light some insights worth considering. There may be some truth to the picturesque notion of making a habit of slipping away to your own special redoubt, your own sealed room. From there you can sally forth with the foremost technical forces which you and your myriad of technical resources can muster. And the direction you choose is determined by the vision in your minds eye, namely only one client. The vision I see for you is you as the best technician or trader or investor you aspire to become. I see you doing this by serving to your utmost capacity a vision of your client or both of you together. If you find merit or even hope in the notions of a sealed room and only one client, then you might wish to consider two helpful hints: 1. Identify an exclusive place for yourself that you can call your sealed room. This place can be located a few feet away from your computer screen

or several hundred miles away from your city, or both. Remember to have a positive mental attitude; remember to relish the creation of your sealed room. 2. Focus your attention on only one client. Imagine this client growing wealthier and living a thriving lifestyle. Commit yourself to the enhancement of this clients welfare. Develop an image of yourself as this ideal client or being with that client. See you or both of you moving along a path of continual growth and thriving. Use this image as a benchmark for the choices you make. Each day renew this vision until it is there for you always and automatically.
This article is based upon a paper delivered Market Technicians Association Seminar, fornia, May 3, 1991. at the 16th Annual Santa Barbara, Cali-

FOOTNOTES 1. Brooks, John, The Seven Fat Years: Chronicles of Wall Street, Harper and Row, 1958, pp. 1466147. 2. Shainberg, Lawrence, Finding The Zone , lVew York Times, April 9, 1989, p. 1. 3. Senge, Peter M., The Fifih Discipline, Doubleday, 1990, p. 153, p. 207. 4. Hawken, Paul, Growing a Business, Simon and Schuster, 1987. 5. Ibid.

BIBLIOGRAPHY Bandler, Richard and Grinder, John, Frogs into Princes: linguistic Programming, Real People Press, 1979. Edwards, Robert D. and Magee, John, Technical Analysis Trends, John Magee, 1966. Neuroof Stock

DI: Pruden is a speculator and an educator He is a member of the MTA and of the TSAA of San Francisco. Dr Pruden frequently teaches classes on technical analysis at Golden Gate University in San Francisco, California.

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The Impact of Commodity An Intermarket View


by John J. Murphy

Prices on Bonds and Stocks-

The intent of this article is to explore relatively new ground in the analytic process-intermarket linkages among the various financial markets-and to study the logical sequence of events that often moves from commodities to bonds to stocks. The value of intermarket analysis to a trader or investor is to aid him or her in seeing and understainding the world of markets in a broader, more revealing fashion. Although other analysts have applied a more rigorous statistical approach to this subject, this article will rely on price charts to present a visual analysis of the relationship between commodities and bonds, and then between bonds and stocks. Inasmuch as this is a new and exciting area for technical analysis, it is regarded as both pioneering and exploratory. Hence the assertions made in the following text are believed to be true. Further historical research and real time experience will strengthen some links, weaken others, and reveal many other heretofore unsuspected links among markets. The author encourages other students of technical analysis to join him in the never-ending process of creating and testing hypotheses concerning intermarket analysis, and to share those insights and findings with fellow technicians through the pages of this Journal. Traditional technical analysis has an inward focus in the sense that analysis is usually performed on a single market basis. That approach treats each market as a separate entity. Stock market technicians focus their attention on the market itself to determine its probable future direction. Bond traders naturally concentrate their technical analysis on the bond market. Commodity traders study the charts of gold, oil, soybeans or whatever commodity theyre trading. Each group usually limits its analysis to the particular market it is following. Intermarket analysis takes a more outward focus by suggesting that there is value added by combining the analysis of all three sectors. Intermarket work pays close attention to the price action in surrounding markets. It suggests that stock market technical analysis should be supplemented by a corresponding analysis of the bond market, since the bond market often acts as a

leading indicator of stocks. It further suggest that bond prices are heavily influenced by the action in the commodity pits. Because bonds are so sensitive to inflation, there exists a generally inverse relationship between bond prices and commodity prices. That being the case, the intermarket analyst studies these three market sectors together. This article attempts to show how closely related these three sectors are, and why its useful for stock market technicians to keep an eye on bonds and commodities. The Strong Link Between Commodities and Bonds A strong link exists between commodities and bonds. The bond market is extremely sensitive to inflation. Rising inflation usually produces lower bond prices and higher yields. Falling inflation pushes bond prices higher and yields lower. Commodity prices are generally regarded as a leading indicator of inflation. Since commodities traded on the various commodity exchanges represent raw materials at their first stage of production, it stands to reason that thats where the first hint of inflationary trends will usually emerge. One of the commodity indexes that is widely-utilized to measure the direction of the general commodity price level is the Commodity Research Bureau Futures Price Index. The CRB Index includes 21 commodity markets, all of which are traded on commodity exchanges. Virtually all actively-traded commodities are included in the CRB Index. Although the 21 markets are equally weighted, the three groups that have the greatest impact on the CRB Index are the metals, the oils, and the grain markets. For that reason, its especially important to monitor the activity of those three sectors. At certain times, any one of these three sectors can dominate the commodity scene and will play a crucial role in the inflation picture. During 1988, the grain markets dominated because of the drought in the midwest. During 1990, the oil markets were dominant because of the Persian Gulf war. For longer range intermarket comparisons, however, its best to use the CRB Index or some other composite index as the proxy for commodity price

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trends instead of relying on the movement of any one commodity market or sector. It should be noted that one of the criticisms of the CRB Index is its heavy weighting of agricultural markets. Many analysts prefer to use a commodity index that measures only the direction of industrial commodities, such as the Journal of Commerce Index or the CRB Industrials Index. Although I prefer to utilize the CRB Index, its important to monitor all commodity indexes for confirmation. At times, when the intermarket relationship between the CRB Index and bonds, for example, appears to be out of sync it pays to emphasize other indexes. An example of one such situation that occurred during the summer of 1991 will be discussed later in the article. Visual Comparison of Bonds and the CRB Index Figures 1 and 2 provide a visual comparison of the CRB Index and Treasury bond futures prices. The intent is simply to show the inverse relationship that usually exists between the two sectors. When commodity prices are rising, bond prices are usually falling. Conversely, falling commodity prices are usually bullish for bonds. Figure 1 shows the five years from 1987 through March of 1991. The vertical lines pinpoint the important turning points. Line 1 shows the collapse in bond prices during the spring of 1987, which was accompanied by a bullish breakout in the CRB Index. During the summer of 1988, the peak in the CRB Index (coinciding with the end of the midwest drought and a major top in the grain markets) helped launch a major rally in bonds (line 2). Lines 3 and 4 show two other turning points during the second half of 1989 and in March of 1991. In all four instances shown on the chart, turns in the bond market were accompanied by turns in the CRB Index in the opposite direction. Figure 2 provides a closer look at the related market action from the summer of 1989 to the first quarter of 1991. Once again, the inverse relationship can be seen. Line 1 shows that a CRB upturn during August of 1989 coincided with the beginning of a double top in bonds. A CRB peak during May of 1990 coincided with a bond bottom (line 2). Line 3 shows two important pieces of information. The first is simply that the downturn in the CRB Index during the fall of 1990 coincided with an upturn in bonds. The second has to do with divergence analysis. During September of 1990, bonds dropped below their spring lows. The rally in the CRB Index, however, was well below its spring high. That bearish divergence by the CRB Index provided an early indication that the move to new

lows in bonds was suspect. In this case, technical analysis in one sector (commodities) is used as a check on technical analysis of another (bonds). Bearish readings in the CRB Index during the fall of 1990 (line 3) provided an early bullish warning for bonds. Line 4 shows the beginning of a downturn in bonds during March of 1991, which coincides with an upturn in the CRB Index. Long Term Rates Versus the CRB Index Since bond prices usually trend in the opposite direction of commodity prices, it follows that bond yields usually trend in the same direction as commodity prices. Figure 3 shows the positive correlation between the CRB Index and long term interest rates (30-year bond yield) that existed form early 1989 to early 1991. Notice how the CRB Index led turns in the bond market at the end of 1989 (line 1) and at the 1990 peak (line 2). The divergence between the CRB Index and interest rates, described in the preceding paragraph, during the fall of 1990 (line 2) can be seen more clearly on this chart. Bond yields set new highs while the CRB Index didnt. Clearly, bond traders (and economists) would have benefited at that point by glancing at their commodity charts. Line 3 in Figure 3 shows the upturn in long term yields during March of 1991, which coincides with a corresponding upturn in commodity prices. Bonds Versus Stocks The stock market is sensitive to interest rate trends. Figures 4 and 5 reveal an apparent positive correlation between bond and stock prices. Visual analysis also suggests that bonds led stocks, at least during the five years under study, That being the case, technical analysis of bond prices can be an important ingredient in an analysts outlook for stocks. Figure 4 compares Treasury bond futures prices to the Dow Industrials from 1987 to the first quarter of 1991. While both markets usually trend in the same direction, serious divergences between the two should be noted. In order to understand the significance of a divergence between bonds and stocks, it is necessary to recognize the strong tendency for bonds to change direction well before stocks, sometimes by several months. That being the case, it is possible for bonds and stocks to periodically have divergent trends. That apparent decoupling is usually nothing more than bonds changing direction before stocks, and providing an early warning of a similar turn in stocks. A dramatic example of bonds turning down before stocks, forming a bearish divergence in the process, was seen in 1987. Figure 4 shows that the stock market peak in

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igure 1
s-year comparison of the CRB index (solid line) to Treasury bond ltures prices (dotted line). Bonds and commodities UsuallY trend I opposite directions. The verticle lines how that turns in bonds re accompanied by opposite turns in the commodity markets.

Figure

A P-year comparison of the CRB Index (solid line) to Treasury bond futures (dotted line). The inverse relationship between bonds and commodities can be clearly seen, especially at turning points.

:igure

3
of the CRB Index (solid line) to long term inline). A strong positive correlation can be seen prices and Treasury bond yields.

Figure 4
A strong correlation can be seen between stocks (solid line) and bonds (dotted line) during these 5 years. The bond market usually leads important turns in the stock market.

/ l-year comparison erest rates (dotted metween commodity

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August of 1987 was preceded by a bond collapse in April of the same year. What appeared to some to be a decoupling turned out to be an early warning to others. Both markets rallied together from late 1987 to late 1989. The double top in bonds at the end of 1989 marked the actual top in several broader stock averages. However, the divergence during the summer of 1990 (line 2) is especially striking as the Dows rally to new highs was unconfirmed by the bond market action. Figure 5 provides a more detailed comparison from the end of 1989 to the beginning of 1991. The second peak in the bond market (line 1) in December of 1989 led a selloff in stocks by a week. A more serious bearish divergence between stocks and bonds was seen during the summer of 1990 (line 2). Figure 5 also shows that the stock market upturn in October of 1990 was preceded by an upturn in bond prices (which, in turn, was accompanied by a falling CRB Index). To the upper right of the chart, a divergence can be seen developing between rising stock prices and falling bond prices during March of 1991 (accompanied by a rally in the commodity markets.) CRB/Bond Ratio Versus Stocks The interplay between the CRB Index and bond prices tells us a lot about the inflation picture and provides a useful indicator for stock market direction. Figure 6 is a relative-strength ratio between the CRB Index (numerator) and Treasury bond prices (denominator). When the CRB Index is outperforming bond prices and the ratio is rising, inflation forces are building and long term rates are nudging upward. That scenario usually has a bearish impact on stocks (see lines 1, 2, and 4 in Figure 6). A falling CRB/bond ratio has the opposite meaning, and has a positive influence on stocks (see lines 3 and 5 in Figure 6). Arrow 6 in Figure 6 shows the ratio line rising during March of 1991, suggesting the likelihood of some bearish pressure on the stock market. The Summer of 1991 Revisited As in the application of any indicator or analytical technique, there are times when usually reliable relationships appear to break down. Admittedly, even the most reliable intermarket relationships seem to disappear for short periods of time. At such times, the analyst has little choice but to rely on more traditional analytical methods until the more normal intermarket relationships come back into line. At other times, the apparent discrepancy can be resolved by deeper investigative work. One such situation developed during the spring of 1991 when

the usual inverse relationship between commodity prices and bonds seemed to disappear. Figure 7 compares the CRB Index to bonds during the spring and summer of 1991. A peak in bonds during February of that year coincided with a trough in the CRB Index which is the normal pattern. However, the CRB Index and bonds then dropped together into the June/July bottom, contradicting their usual tendency to trend in opposite directions. The analyst knows that both markets rarely trend in the same direction for very long, but isnt sure which one to trust. At such times, its a good idea to consult other commodity indexes to see if they are confirming the trend in the CRB Index. A glance at Figures 8 and 9 immediately clears up the apparent mystery. Both charts employ two industrially-weighted commodity indexes which give a very different picture than the CRB Index. Figure 8 compares the CRB Industrial Futures Index to bonds. That index includes copper, cotton, crude oil, lumber, platinum, and silver. Notice how that commodity index maintains a clear inverse relationship to bonds. Figure 9 compares the Journal of Commerce Index to bonds with the same result. The JOC Index includes 18 raw industrial prices. Like the CRB Industrial Futures Index, the JOC doesnt include any agricultural markets. During the spring of 1991, activity in the agricultural markets distorted the CRB Index, causing the usual relationship to bonds to be disrupted. This is one example of why its so important to monitor all commodity indexes for confirmation. The upward spike in the grain markets during the summer of 1991 also caused a misleading blip in the CRB Index. Notice, however, that the peak in both industrial commodity indexes during the summer of 1991 coincided with the upturn in bond prices. This raises the natural question of why one would use the CRB Index at all. My work suggests that over a long period of time, the CRB Index has the closest correlation to the bond market and bond yields than either of the industrial-based indexes. The CRB Index has also on many occasions led turns in the industrial markets by several months. Nonetheless, its important to monitor all commodity indexes. An International Dimension Theres another explanation for that spring slump in U.S. bond prices, which introduces another aspect of intermarket analysis-the need to monitor global markets. During the summer of 1991, economists and analysts were puzzled by the bond market slump. The American economy was in recession, inflation wasnt a concern, commodity prices

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Figure

Figure

A comparison of stocks (solid line) and Treasury bonds (dotted line) during a %-year span. Bond led stocks at most important turning points.

The CRB Index/bond ratio (bottom chart) compared to the S&P 500 Index (upper chart). A rising ratio is bearish for stocks (points 1, 2, and 4). A falling ratio is bullish (points 3 and 5).

3c USC

99024

283

Figure

7
of 1991, the CRB Index and bonds contradicting their normally inverse

Figure

During the spring and summer trended in the same direction, relationship.

During the spring and summer of 1991, the CRB Industrial Futures Index maintained its inverse relationship to the bond market and was more useful than the CRB Futures Price Index for intermarket comparison with the bond market.

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were slumping. Bond prices should have been rising. However, an analysis of global bond markets revealed that the U.S. bond market was simply participating in a major global bond correction. Figure 10 compares U.S. Treasury bonds to British bonds. Notice how closely the two markets resemble each other. By placing the U.S. market into a global perspective, a different picture emerges. The major bond market rally in the U.S. during the summer of 1991 occurred simultaneously with most other world bond markets. The Rotation Between Bonds and Stocks During 1991 Market events during 1991 provide an example of the rotation that normally takes places between bonds and stocks and the need to understand their normal relationship. (See Figure 11). Arrow A shows bonds turning up slightly before stocks during the fourth quarter of 1990. Arrow B shows the dip in both markets that preceded the outbreak of the Mideast war in January, 1991 and the subsequent rally in both markets shortly after the war broke out. Arrow C shows that the February peak in bonds corresponds roughly with the beginning of a ten month consolidation period in the Dow Jones Industrial Average. The second half of 1991, however, provides an excellent example of why its so important to understand the rotation that normally takes place between stocks and bonds. Bonds rallied in July of 1991 but had little immediate impact on stocks. Six months later, however, stocks moved to record highs. It is at such times that an understanding of the rotation between bonds and stocks becomes vitally important. Bonds and stocks didnt decouple during the second half of 1991 as many analysts argued. Bonds were simply performing their normal role as a leading indicator of stocks. During recession, bonds usually turn up months before stocks. During the bond rally, interest-sensitive stocks do especially well. At some point, traders begin to sense an economic rebound, and money flows from bonds to stocks. During that second stage, stocks play catch up with bonds as asset allocators switch from interest-sensitive stocks to cyclicals. The Effect of Discount Rate Changes Arrow E in Figure 11 shows bond futures clearing long term resistance at 101 in December of 1991, registering a 4-year recovery high. That bullish breakout in bonds and the accompanying surge by the Dow Industrials to record highs were caused primarily by the full point discount rate cut by the Federal Reserve Board on December 20 of that year. Many analysts have published research showing the

positive effect successive discount rate cuts have had on the stock market. Successive hikes in the discount rate have ultimately proven to be bearish for stocks (witness Edson Goulds Three Steps and a Stumble Rule). Given the tendency for short and long term rates to trend in the same direction, the impact of discount rate moves on the stock market is just another way of stating the link between interest rate direction and the stock market. Martin Prings Six Stages An excellent explanation of the chronological rotation between bonds, stocks and commodities is given by Martin Pring in his work entitled Asset Allocation and the Business Cycle (published by the International Institute for Economic Research, PO. Box 329, Washington Depot, CT 06794). Pring describes six stages of the business cycle and what happens to each asset class during each stage. Stage 1 (during recession) sees rising bond prices. Stage 2 is characterized by rising stocks. Stage 3 sees rising commodities. Stage 4 has bond prices peaking. Stage 5 shows stocks peaking. Stage 6 is identified by falling commodities (during the onset of recession). That analysis suggests a rotation where bonds turn first at peaks and troughs, stocks second, and commodities last. Viewed in that way, bonds become a leading indicator for stocks, stocks become a leading indicator for commodities and, to complete the circle, commodities become a leading indicator for bonds. That rotational sequence is also supported by the work of Dr. Geoffrey H. Moore, Director of the Center For International Business Cycle Research at Columbia University. Business Cycle Research In his book entitled, Leading Indicators for the 1990s (Dow Jones-Irwin, 19901, Dr. Moore, one of this countrys leading authorities on the business cycle, presents research supporting the chronological sequence between bonds, stocks and commodities described in Prings six stages that forms the basis for intermarket analysis. In the eight business cycles since 1948, Dr. Moore tracked the performance of bonds, stocks and commodities as leading indicators of turns in the business cycle at peaks and troughs. What he found was that bonds turn first at peaks and troughs (with an average lead time of 17 months), stocks are second (with an average lead time of seven months), while commodities, measured by the Journal of Commerce Index, turn third (with an average lead time of six months). Dr. Moores research supports one of the basic premises of intermarket analysis, namely that bonds, stocks and commodities are not only

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Figure 9
The Journal of Commerce Index of 18 raw industrial prices also maintained an obvious Inverse relationship with bonds during the first half of 1991. The July peak in industrial commodities coincided with a ma)or trough in bond prices.

Figure 10
The downward correction in U.S. Treasury bond prices during the first half of 1991 and the subsequent recovery during the second half of that year coincided with similar activity in global markets such as the British bond market.

linked, but peak and trough in a predictable, rotational sequence. Conclusion An extension of this discussion on intermarket analysis could include many other subjects. The impact of the U.S. dollar and overseas currencies, as well as the activity in global bond and stock markets are other subjects for consideration. The link between certain stock market groups and commodities, such as oil and gold shares to crude oil and gold, as well as the relationship between interest-sensitive stock groups, such as the utilities, and bonds could also be considered. Intermarket analysis should play an important role in the asset allocation process.
John Murphy has been a MTA member for 10 years, having served on the Board of Directors for 6 of those years. He is the author of Technical Analysis of the Futures Markets (Simon & Schuster, 1986) and Intermarket Technical Analysis (John Wiley & Sons, 1991). This article is based on research published in the latter book. John is president of JJM Technical Advisors which is based in Oradell, N.J. He is also the regular technical analyst for CNBCYFNN-TV where he does daily broadcasts on the financial markets.

Figure 11
L comparison of bond prices and the Dow Industrials during 1991. he bond peak in February marked the beginning of the IO-month :onsolidation in stocks. The bond rally during the second half of 1991, followed by the stock market rally in December (sparked my the December 20 discount rate cut), demonstrates the tendency or bonds to lead stocks.

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