Contrary Opinionvisionaries will give keynote speeches. Conference speakers will include Avinash Persaud, Dr Adam Posen and Stephen Roach. ... COMMITMENTS OF TRADERS REPORT LONG-TERM

Looking at sentiment indicators

5002

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/feb

.technicalanalyst.co.uk wwwThe publication for trading and investment professionals

Contrary Opinion

Outlook for USD/NOK Capturing market extremes

Applying Bollinger Bands

to the RSI

Software featureThe Bank of New York’s

portfolio flows monitorSeveral indices

come together

T H E 1 1 t h E U R O M O N E Y

I N V E S T O R S C O N G R E S SBOND

Q U E E N E L I Z A B E T H I I C O N F E R E N C E C E N T R E , L O N D O N . 2 2 – 2 3 F E B R U A R Y 2 0 0 5

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SSponsors to date: ABN AMRO - BankTuranAlem - Barclays Glo bal Investors - Bond Exchange of SouthAfrica - BondVision EuroMTS Indices - Dresdner Kleinwo rt Wasserstein - Fitch Ratings - MDM FinancialGroup - Morgan Stanley - Nykredit Realkredit A/S - Reuters - Trust Investment Bank - WestpacInstitutional BankExhibitors to date: Cantor Market Data - CFA Institute - Chicago Board of Trade - eSpeed Inc - Eurex -GovPX inc. - International Securities M arket Association - Moody’s Investor s Service - Standard &Poor’s - SWX Swiss Exchange - Thomson Tradeweb

Topics at the Congress will include:

Calling the bond market turn: why everyone got it wrong in 20004 and why they won't

get it wrong in 2005 Credit spreads: is the only way up? Hedge fundds: How they

expect to make money in fixed income in 2005 Structured products Adding valuue:

how forex can beef up your fixed income portfolio Emerging markets: is the party

finally oover?

Now in its 11th year, the Euromoney Bond Investors Congress is the world’s premier fixed

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WELCOME

January/February 2005 THE TECHNICAL ANALYST 1

© 2005 Clements Biss Economic Publications Limited. All rights reserved. Neither this publication nor any partof it may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic,mechanical, photocopying, recording or otherwise, without the prior permission of Clements Biss EconomicPublications Limited. While the publisher believes that all information contained in this publication was correctat the time of going to press, they cannot accept liability for any errors or omissions that may appear or loss suffered directly or indirectly by any reader as a result of any advertisement, editorial, photographs or othermaterial published in The Technical Analyst. No statement in this publication is to be considered as a recommendation or solicitation to buy or sell securities or to provide investment, tax or legal advice. Readersshould be aware that this publication is not intended to replace the need to obtain professional advice inrelation to any topic discussed.

CONTENTS 1 FEATURES

USD/NOKIs the tide turning?

Anders Soderberg, chief technical analyst atSEB Merchant Banking, reveals his reasons

for predicting a USD correction

Building a better RSI usingBollinger Bands

Alex Douglas explains how Bollinger Bands can be used to calibrate RSI

with prevailing market conditions

Sentiment indicatorsSentiment indicators are essential tools for

the contrarian trader. The Technical Analystpresents an overview of the best

JAN/FEB

>06

>12

>20

Repeat patterns in historical stock prices inevitably lead to hopes that a potentially profitable market cycle exists. We look at the theory that years

ending in ‘5’ signify a positive return to US stocks. Can forecasting Dow direction this year really be that easy? In the world of FX, we ask if the

Norwegian Krone will signal an important turn in dollar direction. We also take a look at contrary opinion, a well established area of technical

analysis, and offer an overview of the key sentiment indicators that gauge how the majority are positioned in the markets.

The Technical Analyst wishes you a happy and prosperous 2005.

Matthew Clements, Editor

>

> >

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INDUSTRY NEWS

MARKET VIEWS USD/NOK: Is the tide turning?Brent crude in 2005UK gilts: An uncertain year ahead

TECHNIQUES Building a better RSI using Bollinger BandsDo years ending in '5' really signal a bull run for stocks?Sentiment indicatorsFive Fibonacci studies

THE TECHNICAL ANALYST TALKS TO…Adam Sorab, chairman, Society of Technical Analysts

SUBJECT MATTERS Gold and the Kondratiev CycleComparing moving average envelopes & Bollinger Bands

SOFTWAREThe Bank of New York's Interactive Portfolio Flow Monitor

BOOK REVIEW & LETTERSThe (Mis)behaviour of Markets by Benoit Mandelbrot & Richard Hudson

COMMITMENTS OF TRADERS REPORTLONG-TERM TECHNICALSTRAINING AND EVENTS DIARY

04

060810

12182025

30

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CONTENTS 2 REGULARS>

32 42

Reuters's is to acquire fellowinformation providerMoneyline Telerate for $175million. The agreement ismade up of $100 million incash and $75 million inReuters-owned shares in the

Savvis CommunicationsCorporation. Telerate hasaround 30,000 users worldwideand full integration intoReuters is expected to take 18months.

Charting provider, eSignal, haslinked up with broker Spear,Leeds & Kellogg's (SLK) andtheir REDIPlus trading plat-form. eSignal will providecharting, formula studies andback testing features toREDIPlus. SLK deals in USequities, options, electronicfutures and European equities.

Meanwhile, As part of itsplan to broaden its business inEurope, eSignal’s latest release(version 7.8) now includes

London Stock Exchange (LSE)Level 2 data, EuronextEquities Level 2 data, OFEXdata and Bern Stock Exchangedata. In addition, eSignal hascompleted an agreement withAFX News Limited - aEuropean provider of interna-tional economic news - thatwill expand eSignal's set ofcurrent AFX offerings toinclude services such asGerman language news.

4 THE TECHNICAL ANALYST January/February 2005

ESIGNAL LINKS UP WITH US BROKER

Reuters to buy Telerate

Industry News

SINGAPORE BONDS TRADE ON BLOOMBERG

The Monetary Authority ofSingapore has chosenBloomberg to provide the inter-dealer trading platformfor the Singapore governmentbond. Starting in 2005, all pri-mary dealers in Singapore willuse the Bloomberg platformto transact bonds electronical-ly and will be able to viewcomplete trading informationfor the market which has adaily volume of around SGD2.6 billion.

DEMARK SIGNALSLONG-TERM SELL FOR DOW

In a New Yearresearch note,Tom DeMark,creator of theDeMark indi-cators, saidthat his annual SequentialIndicator is signalling a long-term 'countdown' sell signalfor the Dow. This is the firstsuch signal since 1972 afterwhich the Dow fell nearly 50%over the following two years.

DeMark's indicators areavailable on Bloomberg andCQG.

Industry News


Telerate has announcedenhancements to the technicalanalysis functions available onits series of market data servic-es. To its A8 1.2 system hasbeen introduced new studiesincluding theaccumulation/distributionoscillator, a directional oscilla-tor, divergence, RSI andKeltner channels. Version 2.0has new instrument displayswhich now include the GannSwing. 'Advanced Active8Charting' also features newRandom Walk indices, a doublesmoothed moving average andFibonacci projection lines.Meanwhile, Telerate's newWebStation 3.0 now includesIchimoku Kinko-Hyo charts,

fast and slow stochastics, andthe directional movement indi-cator (DMI). Telerate plan to

include open interest datawhen its 3.1 version becomesavailable.

Telerate updates charting features

E X C H A N G E N E W S :

EUREX volume reaches record high

Eurex, the exchange for euro-denominated derivatives, tradeda record 1.07 billion contracts in 2004 (up from 1.014bn in2003) making it the world's largest derivatives market. InDecember volume increased 21% on December 2003 to 80.1million contracts while open interest rose 35% to 61 millioncontracts. The Euro-Bund future enjoyed the greatest tradingvolume of all Eurex products. The most traded equity deriv-ative contract was the DJ Euro STOXX 50.

CBOT trading volume hits record in2004

The Chicago Board of Trade has also reported record trad-ing volume for 2004. A total of almost 600 million contractswere traded on the exchange last year, a 32% increase on2003 and an all-time high for the CBOT.

Market Views


Although nothing suggests that the four-year beartrend is coming to an end soon, there are severalsigns which indicate a longer pause or greater reac-

tion may be imminent.

The dollarBoth sentiment as well as technical factors signal anincreased risk of a US dollar correction during the early partof this year. As the old saying goes "When it's made it to thefront page, there's not much left to go" and the greenbackhas certainly been front-page news during the last quarter2004. Significantly, reportable positions of non-commercialaccounts on the Chicago Mercantile Exchange appear con-sistent with this observation. They have decreased their longcurrency holdings, especially in CAD and EUR contractsagainst the dollar.

In fact non-commercial accounts are currently carrying ashort EUR position for the first time since reporting a smallshort position in November 2001. Furthermore, addition ofthe six largest currency contracts (CAD, CHF, GBP, JPY,EUR and AUD) to provide a broader understanding of dol-lar positioning also suggests we have passed the point atwhich sentiment was most bearish. In recent years, a diver-gence between a falling dollar index future and a decreasingshort dollar position by non-commercial accounts has pro-vided a particularly accurate early signal of a forthcoming

dollar correction. On average the market has retraced 7.1%under those conditions. In fact, the market does at presentreflect such divergence (Figure 1).

USD/NOKConcerning USD/NOK, we begin by examining its weeklychart (Figure 2). Firstly we notice a significant probability ofa forthcoming correction once the pair has traded outsideand then returned into its 13-week +/-5 percentage pointprice channel. Also, the multi-RSI shows a special patternoften seen ahead of corrections where different RSIs flattenout below 30 in order to create a base prior to any reaction.A buy signal will be triggered once the shortest RSI (blue)turns around, penetrating longer RSIs, and once the pairtrades outside its price band. Such a signal has already beentriggered.

Turning to Elliott waves for further guidance, we detect acomplete or almost completed wave pattern down from ahigh point in October 2000 (Figure 3). However, even aftertaking this into account, it still remains unclear if the finalwave five has terminated yet. Ideally the final low should befound around 6.0000, although a temporary over-run cannotbe ruled out at this stage.

Once a low is confirmed the market should begin to cor-rect its entire decline from a high of 9.6520 in 2000. Such acorrection should last many months and ultimately target the

USD/NOK IS THE TIDE TURNING? by Anders Soderberg

Figure 1. Dollar index future and net non-commercial dollar posi-tioning on the CME (inverted scale).

Figure 2. (USD/NOK weekly and multiple RSI)

Market Views


7.42/7.85 area (7.42=38.2%, 7.49=wave 4 high, 7.85=50%reaction). However, since the market will encounter verystrong resistance around 6.70, the former triangle floor, weexpect wave (a) of the correction to end there. Wave (b) willretrace lower (to around 6.40) before wave (c) brings thepair upwards towards the correction target area to completethe total correction. Subsequently, the long-term trend willresume with new lows likely. In addition, our dailyUSD/NOK scorecard*, which acts as an indicator of indi-cators, reveals a clear and bullish divergence between priceand score (Figure 4). The scorecard's refusal to move lowerdespite fresh price lows is a clear warning sign that the mar-ket is overdone. A scorecard reading of -6.00/-7.00 is nor-mally followed by a reaction higher during the followingmonth. (*Our scorecard includes indicators such as RSI,

stochastics and rate of change. Each indicator is given a+/- score based upon them being overbought /oversold byour definition. The scores are then summed up to a totalscore, which can gyrate between +/- 7).

As we have already shown, several indices already suggesta forthcoming USD/NOK correction. We believe the cor-rection has already begun and that the pair will reach the6.70 area during late Q1 or early Q2. This view reflects ourexpectation of a forthcoming general dollar correction,especially as we remain bearish concerning EUR/NOK.

Anders Soderberg is chief technical analyst at SEBMerchant Banking in Stockholm.

Figure 3. (USD/NOK weekly wave count) Figure 4. (USD/NOK and daily scorecard indicator)

“NON-COMMERCIAL ACCOUNTS ARE CURRENTLY CARRYING A SHORT EUR POSITION FOR THE FIRST TIME SINCE

NOVEMBER 2001.”

Market Views


Using the same indicators that per-formed well last year could provide aclearer picture of what lies ahead for

Brent crude.Figure 1 shows prices since April 2004

along with a group of moving averages: the13-, 21- and 34-day, all members of theFibonacci sequence. Over this period movingaverage crossovers have done a good job inconfirming strong trends in the market.

Figure 2 shows that over the past year a 10-day RSI was an effective indicator of markettops, well in advance of the eventual highwatermark. For example, the RSI exceeded90 (significantly overbought) at the beginningof October last year, anticipating the eventualhigh of 51.56 on October 26th. In this case,the overbought signal did indeed foresee aretracement of prices.

The RSI also proved an excellent indicatorover intermediate market bottoms when thevalue fell below the 30 level. This proved truein early February 2004, early April, lateAugust, mid-November and once again at thebeginning of December. Presently, the indi-cator is in the middle of the range and is giv-ing no clear directional information.

Figure 3 shows that the stochastic indica-tor, like the RSI, has also been a harbinger ofmarket tops and bottoms. Recent marketmovement puts the stochastic indicator inthe middle of its range but it must be notedthat a higher low was put in just above theoversold level of 20, indicating the potentialof the market to reverse its current down-ward trend.

Figure 4 shows the most recent months oftrading in IPE Brent, drawn with a 10-daymoving average and standard BollingerBands. Whenever the price of the crudemoved through its 10-day moving average, itthen made a subsequent move to the oppo-site band where it found support or resist-ance. Most recently, Brent crossed below its10-day average on December 22nd and even-

BRENT CRUDE IN 2005 by Jim Garland

Figure 1.

Figure 2.


Market Views

tually found support on the lower band justabove $39 on January 4th. Prices are nowmaking their way back towards anotherassault on the 10-day moving average which,if crossed, would indicate a move toward theupper band currently around $43.67.

In terms of Fibonacci, the Brent crudecontract retraced 62% of the total annualrange when it found support at its lows inDecember around $37.30 (Figure 5). Themarket then advanced and found resistanceback at the next level around $43. It is now ina sideways range inbetween the retracementslevels. This gives us more reason to believewe are poised for a significant breakout.

We are currently in a downtrend that hasfollowed an unprecedented advance to alltime high levels. Although the RSI is offeringno clear buy or sell signals, the lagging indica-tors suggest a reversal or pending breakout.Furthermore, the higher lows being made bythe stochastics, in conjunction with the con-vergence of the fast and slow moving aver-ages, could imply the market is poised for astrong move to the upside.

Looking at the fundamentals: Given theinternational oil market's relationship to polit-ical events, it would take a brave speculator toignore developments in the Middle East,demand from fast growing China, rebuildingof tsunami-hit Southeast Asia and decisionsby OPEC. As a result, any technical analyststudying his charts must keep a close eye onthese fundamental factors and other worldnews.

Jim Garland is senior vice-president atGlobalView software

Figure 3.

Figure 4.

Figure 5.

Market Views


UK gilts enjoyed a successful second half of 2004following the strong and well-supported recoveryoff the June low at 104.86. The concerted break

back above the March lower high at 110.46 in Decemberhas spilled over into 2005, and is set to continue towards112.45 (38.2% retracement of the 124.77 June 2003 peak to104.86 decline) and the key 114.55/115.00 area in the firsthalf of 2005.

Long-term outlookConcentrating on the wider continuation chart, for 10-yeargilt futures (Figure 1), price action has been tracing out anear 7-year equilateral/ascending triangle since peaking at126.53 in March 1998 (actual traded peak of a formerbenchmark), and is consolidating the impulsive 8-yearadvance off the April 1990 major reaction low at 66.69.This lateral consolidation has surpassed the 5-yearFibonacci time target (.618 of the 8-year advance) and willextend to at least match the 8-year advance which maturesin March 2006. However, if there are two more legs of thetriangle to be completed then a base beyond March 2006 isanticipated, and therefore action is expected to remainbetween 104.86 and 126.53 for 2005. A possible alternativefor labelling this near 7-year consolidation off 126.53 would

be a regular 3-3-5 flat correction, but either way, the 104.86June 2004 reaction low is likely to remain a significant turn-ing point.

From an Elliott Wave point of view on the monthly con-tinuation chart, the March 1998 high at 126.53 can belabelled the peak of Wave 3, with the triangle Wave 4underway (Elliott Wave theory states that a triangle is mostlikely to be found in this position as a Wave 4). The 8-yearadvance off the April 1990 bottom at 66.69 peaked at126.53. Despite the current triangle low point at 104.29(October 1999) having already been set (marked "A"), theterminal low has yet to be made ("E"), and as mentionedearlier, it is expected to appear sometime beyond March2006. The "B" wave off 104.29 showed promising signs oftesting the 126.53 Wave 3 peak, yet it never delivered as the3 ½ year advance did not break down into 5 waves. The"C" wave decline to 104.86 was comparatively sharp andincisive - common with many corrective "C" waves, andtook a mere 11 months. The "D" wave is currently under-way off 104.86 and should last the length of 2005 andbeyond. "D" waves share certain characteristics with firstimpulsive waves. One of these properties is evident here asthe wave is becoming gradually more constructive after anuncertain beginning.

UK GILTSAN UNCERTAIN YEAR AHEAD by Francis Bray

Figure 1.


Market Views

Medium-term outlookMoving in from the monthly chart to the weekly (Figure 2),the focus is on this recovery off the June 2004 low at104.86. The weekly RSI and slow stochastics are all bullish- moving steadily above previous peaks inside overboughtterritory whilst the higher %K line on the stochastics isincreasing its lead over the rising %D. This is a sign of mar-ket strength and strong underlying support, backed up bythe momentum indicator's ability to set a higher low abovethe zero line and setting fresh 18-month highs. Theprospect of further gains above 112.45 is hence lookingfavourable at this stage, opening room for a Fibonacci pricecluster just below the psychological 115.00 level. 50% ofthe 124.77/104.86 decline ("C") lies at 114.79, and takingthe values of the converging triangle support and resistancelines at 105.00 and 124.10 respectively, 50% of this differ-ential comes in at 114.55. This highlights how importantthe 115.00 level will be, and should be enough to prompt anoticeable downside correction. It will also establishwhether a return to the key highs in the 124.77/125.53 areais possible in the longer-term. For now, a steady progres-sion towards this 114.55/115.00 area is expected in the firsthalf of this year before the risk of a significant setback.

Any significant decline will provide an opportunity forbears to threaten a retest of the range lows at104.29/104.86. However, it will also give overbought tech-nical indicators (both monthly and weekly) an opportunityto unwind and for longs to take profits after a multi-monthadvance. Layers of support at 108.85 (minor pivot area),107.54 and 106.42 (rectangle congestion) will look todefend the 104.86 low, although as in a Wave 2 correctionof an impulsive Wave 1, there is a risk of a near completeretracement. Formation of a higher low above 104.86would prompt renewed bull pressure on the 115.00 area,

and ultimately force a break through there to open up theupper end of the triangle around 124.77/126.53.

Other factors The gilt market will have to face some uncertainties thisyear with the General Election probably in Q2 (althoughmany investors will already have pencilled in a foregoneconclusion), the widening fiscal deficit (PSNCR) and theprospect of slower growth forecasts for 2005. In addition,continuation of a split between Prime Minister Blair andChancellor Brown could also weigh near-term. TheChancellor has been the architect of the "prudent" UK fis-cal stance since assuming power in 1997 with the goldenrule to balance current government spending over thecourse of the economic cycle. While this is looking some-what frayed, it has nonetheless been one of the drivingforces behind the UK fiscal stance over the last 8 years andany change may have a detrimental effect on the attractionof long gilts. A breakdown below the 104.50/104.86 lowswould negate the equilateral/ascending triangle theory andmean the "C" wave is still ongoing. This would leave adeeper 3-3-5 corrective flat pattern as the likely scenariofrom the March 1998 126.53 top.

Next on the agenda for a potential turning point wouldbe the corrective bear channel support line, currently near102.00 but steadily falling towards the base of the previousWave 4 low of one lesser degree, at 98.44 (September1994). The timing for reaching this point is the first half of2006.

Francis Bray is fixed income technical analyst atInforma Global Markets in London.

Figure 2.

Techniques


BUILDING A BETTER RSI

Techniques


Improving upon a concept such

as the RSI (Relative Strength Index)

is no easy task. This indicator has

clearly stood the test of time,

becoming one of the most

ubiquitous of all tools available to

the technical analyst. This article

presents an overview of the

indicator and looks at how its

performance may be enhanced

with Bollinger Bands.

USING BOLLINGER BANDS by Alex Douglas

Techniques


Amomentum oscillator such asthe RSI is constructed to giveus an indication of the velocity

of the market being studied, the ideabeing that momentum will often beginto turn before the actual price of themarket turns and certainly never after areversal in the price. Consider throwinga ball up into the air. At some point itsupward trajectory will begin to slow,even though the ball is still movinghigher. During this phase the momen-tum of the ball will already be indecline despite the ball having not yetmet its zenith. The same is true forprice trends. The velocity of the trendis likely to turn before the actual pricetrend turns and certainly no later thanthe change in prices.

Construction of the RSITo smooth out the impact on momen-tum of erratic price movements, Wildersuggested looking at the past 14 tradingperiods to find the average of gainsmade in 'up' periods and the averagelost during 'down' periods. Regardlessof the number of up or down periodsposted, the cumulative gains and lossesare averaged over 14 periods to give ameasure of Relative Strength (RS).

Once this figure is determined theindex can be created with the followingformula:

This creates an oscillator with a rangeof 0 to 100 that allows for meaningfulcomparisons of the momentum of aparticular market at different price lev-els as well as allowing comparisonsbetween different securities.

InterpretationWilder noted that moves in the RSIeither above 70 or below 30 often sug-gest the imminent appearance of a topor bottom respectively. Although he

Figure 1. Carlton Communications: The firm bull trend sees the RSI holding toward theupper end of the range with plots failing to probe into oversold territory, below 30.

Figure 2. Carlton Communications: Manually shifting the oversold/overbought bands from30/70 to 40/80 during a bull trend provides a slightly better result.

periodsdowninlossesofAverageperiodsupingainsofAverageRS =

⎥⎦

⎤⎢⎣

⎡+

−=RS

RSI1

100100

Techniques


does not specifically refer to the areaabove 70 as 'overbought' or the areabelow 30 as 'oversold', Wilder did men-tion these terms in relation to oscilla-tors in general at the beginning of thesection on the Relative Strength Indexin his classic book "New Concepts InTechnical Trading Systems". Whilesome would disagree, it has becomecommon market practice to refer to thearea above 70 as the overbought zoneand the area below 30 as the oversoldzone. A probe outside of the 30 to 70band followed by a modest correctionand then a subsequent return toward(but not exceeding) the previoustrough/peak outside of the 30 to 70band sets up a strong indication ofmarket reversal - the failure swing(Figure 1). This signal is triggered on abreak of the previous low/high estab-lished by the correction.

The concept of divergence, commonto many technical indicators, is particu-larly useful when interpreting RSI. AsWilder notes, "Although divergencedoes not occur at every turning point, itdoes at most significant turning points.When divergence begins to show upafter a good directional move, this is avery strong indication that a turningpoint is near. Divergence is the singlemost indicative characteristic of theRelative Strength Index." An excursioninto overbought or oversold territorywhich is accompanied by divergence isseen as a particularly noteworthy signal.

Analysts can also employ classic pat-tern analysis on the RSI as well as tak-ing note of areas of support and resist-ance using the same methods as appliedto price charts. In fact, due to thepropensity of the RSI to turn beforeprices change direction, it is notuncommon to find signals appearingon RSI before they appear on the pricechart. However, for the purposes ofthis article we should investigate theconcept of overbought and oversold alittle more thoroughly.

Overbought and oversold In a market that is broadly moving side-ways, the parameters of 30 and 70 aregenerally adequate to give an indi-

Figure 4. Carlton Communications: In order to make it easier to see when the RSI has movedoutside of the Bollinger Bands into oversold or overbought territory we need to flatten out thebands and re-plot RSI in such a way as to represent the position of the RSI in relation to theBollinger Bands. This is achieved by plotting %b(RSI).

Figure 3. Carlton Communications. Bollinger Bands can be placed on the RSI to create auto-matically adjusted levels of oversold/overbought based on market activity

→→

Techniques


cation of the overbought or oversoldstatus of the market. However, in afirmly trending market it is not uncom-mon for an oscillator such as the RSI togravitate toward one end or the other asdictated by the direction of the pricetrend.

A market rallying firmly may rarelysee an RSI plot fall below 30. Similarly,a bearish market may rarely see an RSIplot above 70. As the best signals areoften given by the RSI falling into over-sold territory during a bull trend or anexploration into overbought territoryduring a bear trend, it has become com-mon practice to shift the bands delin-eating oversold and overbought territo-ry, based upon the prevailing marketdirection.

During a bull trend the bands areoften adjusted so that the oversold areaincreases to be any level below 40,while the overbought area contracts tobe any level above 80 (Figure 2). In thecase of a bear trend it is common tolower the band to 20-60.

ProblemOn first glance this manual adjustmentof the bands seems like a reasonablygood solution to the problem of the

oscillator gravitating toward one end orthe other depending on the direction ofthe price trend. But the bsic problemremains - Exactly how do we knowwhen is the right time to be manuallyadjusting these bands?

SolutionAn elegant solution to this problemthat automatically adjusts the over-bought and oversold levels was dis-cussed by John Bollinger in his epony-mous book, "Bollinger on BollingerBands". Quite simply, this approachinvolves plotting Bollinger Bands onthe RSI with the upper and lower bands(Figure 3).

The basic theory underlying BollingerBands when applied to price action isalso valid when the bands are used withindicators. Thy provide a measure ofthe volatility of the instrument beingstudied through the use of the statisti-cal tool of standard deviations. Thesestandard deviations are plotted bothabove and below a simple moving aver-age to create a dynamic band whichcontracts when volatility is low andexpands when volatility increases. Dueto the requirement of the standarddeviation calculation to square varia-tions from the mean, Bollinger Bandsare very quick to react to sudden sharp

Figure 5. Carlton Communications: Placing the regular RSI and the normalized RSI, or%b(RSI) on the same chart we can see that %b(RSI) gives us signals that would otherwise havebeen missed.

Techniques


moves in the instrument (price or indi-cator) being studied.

When applying Bollinger Bands to anindicator, Bollinger suggests changingthe standard parameters for both thetime period and number of standarddeviations. In general terms it is sug-gested that longer time periods shouldbe used when applying Bollinger Bandsto indicators, with 50 periods suggestedfor a standard 14-period RSI. Thenumber of standard deviations is onlyslightly increased from the default of 2to 2.1.

Instead of using 'fixed' levels to indi-cate the overbought and oversoldzones, the upper Bollinger Bandbecomes the marker of overbought ter-ritory and the lower Bollinger Bandmarks the oversold zone. The dynamicnature of Bollinger Bands removes theneed to make manual adjustments tothe overbought/oversold zones andensures that these levels are appropriatefor current market activity whether theunderlying instrument is moving side-ways or is bullish or bearish.

Obviously, plotting Bollinger Bandson the RSI and then attempting to usethe upper and lower bands as indicatorsof overbought and oversold territorymakes life difficult when the BollingerBands are continually expanding andcontracting, thus causing the absolutelevel of overbought and oversold to becontinually shifting. Again, Bollingerhas suggested a very elegant and simplesolution to this problem.

When using the 'fixed' levels of 30and 70 we are interested in where theRSI is in relation to these bands. Is theRSI below 30, above 70, or somewherein between the two? Once we replacethe 30/70 levels with Bollinger Bandsour interest shifts to where the RSI liesin relation to the Bollinger Bands. Inorder to make this relationship easier tosee we need to flatten out the BollingerBands so that they become horizontallines on our indicator, just as the 30 and70 levels were (Figure 4).

The following formula shows where

RSI lies in relation to the BollingerBands with the lower band representedby a horizontal line at 0 and the upperband represented by a horizontal line at1. An excursion below 0 or above 1represents the RSI moving outside ofthe Bollinger Bands. Given the similar-ities to the stochastics indicator (whichuses the terms %d and %k) this indica-tor has been given the name %b(RSI).

Interpretation methods for this newindicator are the same as for the regularRSI. During a bull trend the most pow-erful signals generated by RSI are likelyto be failure swings and signs of diver-gence following probes into oversoldterritory. As seen in Figure 5, the firmrally in Carlton Communications dur-ing 2003 had the RSI gravitating towardhigher levels, failing to return below 30once the rally got underway in mid-March. During this same time period,%b(RSI) did manage to probe intoboth overbought and oversold territory,giving us valuable clues as to the likelydirection of the market. The mostnotable difference visible between RSIand %b(RSI) in Figure 5 is in the waythese two indicators reacted to the lowsof September/October.

RSI fell to a low of 37.5 on 29-Sep-03, failing to reach the oversold regionbelow 30 and thus failing to reach thelevel Wilder stipulated as a requirementfor a significant bottom or failureswing. If we had had the foresight tolift the oversold/overbought levels to40/80 in reaction to the bull trend, theslip below 40 to 37.5 would have givena bottom signal and even a minor diver-gence signal. However, the %b(RSI)indicator required no manual adjust-ment and gave a very clear indication ofan imminent turn higher as it hit its low11-Sep-03, the same day as the pullbacklow in price. Subsequent activity in%b(RSI) saw the appearance of a clas-sic failure swing as the indicator liftedfrom -0.18 to 0.42 before slipping backto -0.08. The failure swing was con-firmed on 06-Oct-03 as %b(RSI) liftedback above 0.42, the same day thatprices took their first significant steptowards resuming the underlying bulltrend. In this particular example we

cannot claim that %b(RSI) also gave adivergence signal as the price low of11-Sep-03 was marginally lower thanthe price low of 01-Oct-03.Nevertheless, divergence is commonlyseen on the %b(RSI) while the regularRSI is giving no hint of divergence oran imminent turn. In this instance%b(RSI) was clearly indicating a bias tothe upside.

SummaryPlacing Bollinger Bands on RSI to gen-erate dynamic oversold/overboughtregions helps to overcome the tenden-cy of an oscillator such as RSI to grav-itate towards one end or the other dur-ing protracted trending moves.Examining the position of the RSI inrelation to the Bollinger Bands with%b(RSI) will often reveal noteworthydivergences that are simply not revealedwith RSI while other signals such astops/bottoms and failure swings oftenappear slightly earlier on %b(RSI).

Alex Douglas is a consultant and co-founder of G7FOREX.com. He is aboard member of the InternationalFederation of Technical Analysts.)(

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BBadRSILowerBBandRSIUpperBBandRSILowerRSIRSIb

−−

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Techniques


DO YEARS ENDING IN '5' REALLY SIGNAL A BULL RUN FOR STOCKS?

Five is the magic number for USstocks according to some market

commentators in the popularpress. Many recent stories have

drawn attention to the fact thatyears ending in '5' (1905, 1915,1925, etc) have seen the Dow

end higher in every decade since1880 (Table 1). Is this part of a 10-year stock cycle or simply coinci-

dence? No other year in thedecade has equalled this

performance which has seenreturns in '5th' years averaging

around 32%, far exceeding theaverage returns of other years

(Figure 1).

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Larry Williams, CEO ofCommodity Timing, a consul-tancy, says the 5th year perform-

ance may be due to the US presidentialelection cycle which has shown a strongtendency for stocks to rally in the yearprior to the election year and the yearafter an election where the incumbentretains his presidency. If this is so, thenyears ending in 5 rallied because of thepresidential election cycle in eleven outof the twelve decades.

However, the presidential electioncycle could apply equally to other odd-numbered years in the decade sinceelections always take place in evenyears. Yet years ending in 1, 3, 7 and 9show no exceptional returns whencompared to years ending in 2, 4, 6 and8. In fact, most explanations offeredfor the 5th year phenomenon - which

includes references to interest ratecycles, the weather, and a psychologicalpropensity for humans to think in tenyear blocks - remain unconvincing. JeffHirsch of The Stock Traders Almanactold The Technical Analyst, "I've yet tofind anything other than coincidence toexplain the phenomenon."

The 5th year phenomenon is also lessnoteworthy when you consider whathas happened to the Dow since 1885.The general trend upwards (whichincludes the effect of inflation), hasmeant the Dow has seen more 'up'years than 'down' years. In the 120years from 1885 to 2004, 76 years havebeen 'up' and only 45 have been 'down'.In other words, 'up' years account for63% of the total.

This means that each of the ten year-endings can, on average, be expected to

have been 'up' in 8 out of the 12decades since 1885 (12 x 63%). And thelikelihood of any one of those year-endings being an 'up' year on all 12occasions is 4% (63%12 x 10). This isanalogous to asking ten people to tossa coin that is weighted 63% in favour ofheads, 12 times in a row. The probabil-ity of one person throwing 12 heads insuccession is small but not unreason-ably so.

Finally, while it remains difficult todismiss the phenomenon outright, itshould be remembered the sample sizeupon which the observation is made issmall. There are only 12 decades ofdata available for analysis, meaningthere are only 12 observations for eachyear-ending. As such, it is probably bestto look elsewhere for guidance on stockmarket direction in 2005.

Year 1st 2nd 3rd 4th 5th 6th 7th 8th 9th 10th

Up 7 7 6 8 12 7 6 10 9 4

Down 5 5 6 4 0 5 6 2 3 8

Table 1. Up and down years 1895-2004

-10

-5

0

5

10

15

20

25

30

35

1 2 3 4 5 6 7 8 9 10

% r

etu

rn

years ending in

Figure 1. Dow average returns (%) for each year-ending since 1885

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Techniques


Contrary opinion holds thatwhen the vast majority of mar-ket participants are bullish or

bearish, then a reversal in trend isimminent. In other words what themajority think is assumed to be wrongso it's best to position yourself on theopposite side of the market. To quoteWarren Buffet, "Be brave when othersare afraid and afraid when others arebrave."

The following sentiment indicatorsare widely used tools for following hisadvice.

The VIX In 1993, the Chicago Board OptionsExchange (CBOE) introduced theVolatility Index (VIX). Since volatilityoften signifies financial turmoil, VIX isoften referred to as the "investor feargauge". The VIX is based on real-timeoptions prices and so reflects investor'schanging expectations of future market

volatility. Option prices tend to rise asmarket volatility increases. Options arepriced using a derived 'implied volatili-ty' measure, the expectation of futurevolatility during the life of the option.

The original VIX was constructedusing the implied volatilities of eightS&P 500 (OEX) options thereby repre-senting the implied volatility of a hypo-thetical at-the-money OEX option withexactly 30 days to expiration. In 2003,the CBOE introduced a new VIXmeasure. This uses options on the S&P500 index and uses a wider range ofstrike prices rather than just at-the-money series. This measure is consid-ered more representative since it incor-porates information from option pricesover the whole volatility skew not justfrom at-the-money options.Historically, the VIX rises during peri-ods of investor fear and falls as panicsubsides. This effect can be seen in theVIX behaviour isolated during theLong Term Capital Management and

Russian Debt Crises in 1998 (Figure 1).The VIX is a contrary indicator which

means that high readings suggest themarket is oversold and may be near abottom while low readings indicateoverbought conditions and marketcomplacency. The average level of theVIX since 1995 has been around 20. Assuch, high readings indicated a buy sig-nal and low readings a sell signal.However, the VIX is rarely used in iso-lation and is most useful when used intandem with traditional technical tech-niques such as RSI and moving aver-ages. Bollinger bands and moving aver-age envelopes can also be applied toVIX charts in order to identify theunderlying trend and establish extremelevels.

Commitment of Traders Report The COT report was first published foragricultural commodities in 1962 andexists because the Commodity FuturesTrading Commission (CFTC) requiresthat traders report their daily positions.The COT report, released every Friday,provides a breakdown of eachTuesday's open interest for markets inwhich 20 or more traders hold posi-tions equal to or above the reportinglevels established by the CFTC. What isimportant is the change in the net trad-er position for each category fromweek to week. The net trader position isthe long contracts less the short con-tracts

The CFTC classifies traders into threegroups: commercial traders (hedgers),non-commercial traders (large specula-tors), and small traders (small specula-tors). Commercial hedgers are institu-tions and individuals who operatein the cash market of the underly- →→Figure 1.

Sentiment indicators are used for gauging market opinion and, as such, are effective tools for contrariantrading and investing. We present ten of the most widely used indicators.

SENTIMENT INDICATORS

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ing commodity. The non-commercialsare speculative traders who are general-ly classified as fund managers. Smallspeculators include all speculators withpositions below reportable limits asspecified by the CFTC.

To some extent, opinion is divided asto what category to look for in theCOT report. For comparison, we pres-ent commercials' and non-commercials'positions for the S&P 500 future inFigures 2 and 3. Most text books sug-gest paying most attention to the com-mercials. This is because larger hedgers

are assumed to be the smart money andhave access to superior market infor-mation. The idea therefore is to posi-tion oneself on the same side of themarket as the commercials. In practicehowever, most professionals tend tolook at the non-commercials or largespeculators. George Slezak of websiteconsultancy Commitments ofTraders.com says COT data should betreated as an overbought and oversoldindicator but commercials tend to holdtheir positions longer than non-com-mercials as so their net positions may

be later in indicating market reversals.Michael Krauss, global head of fixedincome technical analysis at JP Morgan,says, "I have always used the large spec-ulator positions and looked forextremes in long or short positions".Craig Ferguson, chief technical analystat ANZ Bank agrees, "We look at thenon-commercial speculative positionsbecause these positions really are theswing factor in most markets. Webelieve that commercial positions aremore long-term in contrast with thespeculators who constantly changetheir position according to the underly-ing trend". The COT report is availableat: www.cftc.gov.

The SentixThe Sentix indicator was established inGermany in 2001 by Manfred Hubnerand Patrick Hussy. The index beganwith the S&P 500 and has sinceexpanded to include 9 additional stock,bond and currency markets. Sentix isavailable on Bloomberg, Reuters andshortly on Updata.

The Sentix is a survey of investoropinion taken every Friday and pub-lished on Monday morning. Sentix pollsa total of around 1200 private investorsand institutional professionals such asfund managers for both their one-month and six-month outlook for eachmarket. These two private and institu-tional polls are published separately andalso aggregated to produce the 'head-line' Sentix index (See Figure 4). ANeutrality Index is also listed which isthe poll of all investors who expect themarket to move sideways. The neutrallevel for the headline Sentix is zero. Theindex is calculated by subtracting thenumber of bears from bulls and divid-ing by the total. An overall positivenumber is bullish and a negative num-ber is bearish. If the index deviates farfrom zero then conditions may be con-sidered overbought or oversold. Theseparate institutional index may also beviewed as the 'smart' money with theprivate investor index being used as acontrary indicator. www.sentix.deFigure 3.

Figure 2.

Techniques


Put/call ratios The put/call ratio usually refers tothose published by the CBOE, theworld's largest option exchange. Theput/call ratio for any market is simplythe volume of put options traded onthe exchange divided by the volume ofcall options. As such, the ratio gives anindication of market sentiment. Whenthe market is bullish, the ratio fallsbelow average as call volume exceeds

put volume. When the market is bear-ish, the ratio is above average as putsexceed calls.

The put/call ratio works best as acontrary indicator when the ratio is farabove or below its long-term averagelevel indicating the market is oversoldor overbought (Figure 5). The volatilityof daily data means a clearer picture isusually given by applying an appropri-ate moving average. Daily put/call

ratios are available for CBOE tradedequities, equity indices, US Treasuries,the short-term interest rate index andoil. www.cboe.com/data

The Consensus BullishSentiment IndexThe Consensus Index of BullishMarket Opinion is a weekly poll of pro-fessional brokers and advisors. Theindex is a contrary indicator indicatingwhen market conditions may be over-bought or oversold (Figure 6). The pollis taken every Friday.

The index covers 31 markets includ-ing foreign exchange, bonds and com-modities plus a generic US stocksindex. An index of 75% or above sig-nifies an overbought level and a readingof 25% or less indicates oversold con-ditions. Richard White of ConsensusInc. recommends the index is best usedto compliment another indicator suchas Bollinger bands or moving averages.www.consensus-inc.om

Advisors SentimentThis indicator was established in 1963and is published every Tuesday. Thereport takes the opinions of 100 inde-pendent market advisors in the US andmeasures the balance of those with abullish, bearish and neutral outlook.The typical reading, which implies mar-ket equilibrium, is 45% bulls, 35% bearsand 20% neutral. This is a bull/beardifference of 10%. The report works asa contrary indicator so a bull/bear dif-ference of around 30 and above may bean indication to sell. If the report fallsbelow 0 this is considered bearish andso a signal to buy. Dominic Hawker,head of research at Investor'sIntelligence says the report is targetedprimarily at the professional marketand is especially popular with US fundmanagers. The report is available exclu-sively at:www.investorsintelligence.com.

Figure 5.

Figure 4.


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Figure 7.

Figure 6.

Barron's Confidence Index Developed in 1932, the Barron'sConfidence is the longest estab-lished market sentiment index. Theindex measures the ratio of theaverage yield on 10 top-grade bondsto the average yield on 10 interme-diate-grade bonds. The discrepancybetween the two establishes a meas-ure indicating investor confidence inthe economy. If investors are opti-mistic about the economy, they aremore likely to invest in speculativebonds, thereby driving speculativebond yields down, and theConfidence Index up. On the otherhand, if they are pessimistic aboutthe economy, they are more likely tomove their money from speculativegrade bonds to conservative high-grade bonds, thereby driving high-grade bond yields down and theConfidence Index down.

Vickers Insiders IndexInsiders (e.g. company directors) areassumed to have superior informa-tion about their firm's future per-formance so may buy their compa-ny's stocks if they expect the shareprice to rise and sell if they expect itto rise. This weekly index is pub-lished by Vickers Stock ResearchCorporation, part of the ArgusGroup, and reports insider transac-tions for the past six months forcompanies included in the Dow.

Odd Lot Balance Index The Odd Lot Balance Index showsthe ratio of odd lot sales to pur-chases (an odd lot is a stock transac-tion of less than 100 shares). Theassumption is that the odd lots areexecuted by the market's smallesttraders who are the least wellinformed market players. When theOdd Lot Balance Index is high, oddlotters are selling more than they arebuying and are therefore bearish onthe market. Therefore it is best tobuy when they are selling (as indi-cated by a high OLBI) and sellwhen they are buying (as indicatedby a low OLBI).

Other indicators:

The Coppock Indicator Edwin Coppock developed the Coppock Indicator with one sole purpose: toidentify the commencement of long-term bull stock markets and successfullydid so in 1988 and 1994. The indicator was originally designed for use on theDow Jones but is also suitable for other market indices. It is typically calculat-ed by taking a 10-month moving average of the sum of the 11- and 14-monthrates of change. The Coppock indicator is available on CQG and Bloomberg.

Techniques


FIVE FIBONACCI STUDIES

by Yuriy Zubarev

When Leonardo Fibonacci was solving arabbit population problem in the 13th cen-

tury he might not have known what kindof affect his discovery would have on ourmodern world of investment and trading.

The significance of his finding has beenconstantly demonstrated and built upon

ever since. But even today the majority ofmarket analysts tend to reduce Fibonacci

studies to only two practical applications -Fibonacci retracements and extensions - in

spite of there being a number of otherFibonacci studies that can be used

to good effect.

This article provides a summary overviewof five tools which, although visually dif-ferent, are all geometrical representations

of Fibonacci ratios. They are time projec-tions, channels, ellipses, fans, and spirals.

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Time projectionsFibonacci time projections indicatewhen a price event is supposed tooccur. The base for drawing this shapeis two critical points: two highs, twolows or a low and a high. Fibonacci lev-els are projected into the future basedon those points (see Figure 1). How farout the tool forecasts depends on thesize of the price swing considered.Longer-term projections tend to begiven when larger price swings are con-sidered, and vice versa. It's worth not-ing, however, that it is impossible to saywhether those levels will mark peaks orvalleys. If the price is declining or risingapproaching a given time projectionlevel, this level will likely mark an endor a pause to that particular trend. Timeprojections should always be combinedwith other Fibonacci tools for moredependable signals.

ChannelsMarket behaviour is not only reflectedin chart patterns as large swings, smallswings or trend formations, it is alsoexpressed in peak-valley formations.Fibonacci channels make use of peakand valley formations to forecast majorchanges in trend direction. The reliabil-ity of Fibonacci channels depends onwhich tops and bottoms are used tolocate the channel base line (see Figure2) - only major tops and bottomsshould be considered. The channelitself should contain one or moreprominent side swings. The trigger lineis located at the widest swing awayfrom the base line. Once the base lineand trigger line are located, support andresistance lines can be drawn weeks andmonths into the future.

EllipsesFibonacci ellipses identify the underly-ing structure of price moves. We canfind long and short ellipses, fat and thinellipses and those that are flat or have asteep angle. There are very few marketprice moves that do not follow the pat-tern of a Fibonacci ellipse. In general,the shape of an ellipse is defined by theratio of the major axis to the minoraxis. An ellipse is turned into aFibonacci ellipse where this ratio is amember of the Fibonacci series.

A Fibonacci ellipse starts at the begin-ning of a wave A in a 3-wave patternand its width is chosen so that thebeginning and the end of a wave B istied between the extreme points of theellipse's minor axis. As long as the pricestays inside the ellipse it is likely toreach the level indicated by the end ofthe major axis. When Fibonacci ellipsescan be plotted, they provide a solidoverall picture of the total price pat-tern, no matter how many waves orsub-waves occur. (See Figure 3).

Figure 1. The period between an original price swing of VZ stock is multiplied by Fibonacci ratios of 2.618 and 11.09 to givetiming forecasts for another two swings.

Techniques


Figure 2. Prominent peaks and valleys create an opportunity to see major support and resistance lines using Fibonacci chan-nels.

Figure 3. Fibonacci ellipses with ratios of 11.09 and 4.236 identify target price and timing. →→

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Figure 5. A Fibonacci spiral

Figure 4. A Fibonacci fan

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FansFibonacci fans are drawn using tops orbottoms. They are made up of threetrendlines which start from a commonpoint. The three trendlines project intothe future with slopes of 38.2%, 50%and 61.8% (although additional levelscan be used) and these lines can then beused to indicate levels of support andresistance. (See Figure 4).

SpiralsFibonacci spirals provide the optimallink between price and time analysis.Corrections and trend changes occur atall those prominent points where theFibonacci spiral is touched on itsgrowth path. If the correct centre ischosen, Fibonacci spirals identify sup-port and resistance levels that can pin-point turning points in the market withremarkable accuracy. (See Figure 5).

Fibonacci confluenceTo significantly enhance reliability,trend reversals or continuations can beconfirmed with two or more Fibonacci

shapes as in Figure 6. It's also goodpractice to confirm trading signals ontwo or more time frames.

More than one way …Fibonacci is not just a numbers game;it is the most important mathematicalrepresentation of natural phenomenaever discovered. The financial mar-kets seem to recognize this fact andFibonacci studies are now widely usedby analysts and traders. Yet this analy-sis has, by and large, been dominatedby the use of Fibonacci retracementsand extensions. The studies andshapes outlined in this article shouldprovide a more diverse toolbox withwhich to apply Fibonacci principlesto the markets.

Yuriy Zubarev is president ofSolution Realm Software Inc. Seewww.fibonaccisolution.com

Figure 6. Combining the studies (including retracements and extensions)

“FIBONACCI ISTHE MOST

IMPORTANTMATHEMATICALREPRESENTA-

TION OF NATURAL

PHENOMENAEVER

DISCOVERED.”

TTA: What does your current role with CQS involve?

AS: CQS manages about $4.7 billion in hedge fund strate-gies. My work involves the development of technical strate-gies to support our trading activities and the managementof portfolios.

TTA: Your first City job was with Bank of Credit &Commerce from 1984-86 as a money market dealer. Howhas the City's perception and use of technical analysischanged since then?

AS: Technical analysis has become increasingly acceptedwithin the City over recent years. In reality it had always hada strong following amongst FX, fixed income and commod-ity professionals. The bear market that developed in the lastfew years did a lot for promoting TA amongst equity mar-ket participants. When the STA started out, over 25 yearsago, technicians in the UK were not popular and tended tohuddle together in the corners of pubs sharing chartinsights. Today technical analysis forms an increasinglyimportant part of all research published and even gets goodcoverage from the financial markets television media. As aresult technicians find a greater and more receptive audi-ence for their research and are able to obtain betterresources from their employers to produce their work.

TTA: Do you think TA is now a major part of all hedgefunds' strategy? Do you detect a move away from funda-mental analysis to any extent?

AS: Hedge funds are very different to many classic invest-ment houses. Not least because the portfolio managers tendto invest their own money alongside their clients and earnthe bulk of their fees from their share of the absolutereturns. As a result they are very focused on positive returnsand are open to all and any approaches that bring themcloser to achieving these goals. Accordingly, technical analy-sis is employed in one form or another by pretty much allhedge funds; even those who have a firmly fundamental

investment process. The reality is that professional investorshave for a long time realised that the two approaches arenot mutually exclusive but instead can be highly compli-mentary. While it is true that many hedge funds today usetechnical analysis exclusively to generate investment strate-gies I don't think this reflects a move away from fundamen-tal analysis. The reality is that it's the fundamentals thatactually move markets. The advantage a technician has overan economist is that he or she may pick up on a change insentiment and trend before the change in the fundamentalshas been picked up.

TTA: What are your favourite TA techniques that you usein your trading strategies?

AS: I tend to favour the KISS approach to technical analy-sis and as a result tend to focus on prices and volumesrather than complex oscillators and second order deriva-tives. I tend to look for classic support/resistance levels andtrendlines to pick my spots to enter and exit markets. Forlong and medium-term analysis I like candlestick charts,Ichimoku Morning Clouds, point-and-figure. For short termanalysis, particularly in the futures market, I also like usingMarket Profile.

TTA: What are the major developments in TA at themoment?

AS: TA is always evolving and the advent of cheap comput-ing power has accelerated this progress in recent years. Idon't see very much that is really new these days in TA.However, there is a lot more cross fertilisation of ideasacross disciplines and markets. For example while manyJapanese techniques have existed for centuries, it's reallyonly been in the last 10 years that these have been properlytaken up by western analysts. I think IFTA deserves a lot ofcredit for encouraging this ongoing exchange of ideasbetween technicians all over the world. From my point ofview the real development in TA is the extent to which theordinary private investor now has access to TA software

THE TECHNICAL ANALYST TALKS TO…Adam Sorab

Adam Sorab is head of technical research and trading at CQS, a hedgefund management company. Prior to this he was a director ofAbsolute Return Strategies at Deutsche Asset Management from 2000to 2004. He has served as a director on the UK's Society of TechnicalAnalysts executive committee since 1993 and been chairman since1996. Mr Sorab is also a director of the International Federation ofTechnical Analysts.

Interview


Interview


and analytics. In the past TA was the City's secret weapon.Today, the investment bank prop desks have to competewith Joe Public when we get to big chart points. This hasgot to be a good thing in the long run; even if it does makethe markets a little choppier whenever we get to major chartpoints.

TTA: What do you think about backtesting TA techniquesand trading strategies?

AS: I have systems that allow me to set up a mechanicaltrading strategy and then backtest it to establish how well itwould have fared had it been trading in the past. The soft-ware even allows me to optimise the system to maximisethe historic returns. This all sounds great in theory howeverin practice it's a lot more complex than that for a numberof reasons. Firstly, it's not obvious that a static system is thebest way to trade markets. Instead more adaptive/reactiveapproaches may be more suitable. Secondly, it's not obviousthat one should always be just looking to maximise returnsespecially if the price of doing so is high volatilities or hugeadverse excursions. Thirdly, it's unlikely that the systemsthat work best in the past will always work as well in thefuture. As a result, systematic approaches have to be treatedvery carefully by investors even when the backtested resultslook fantastic. There are a number of excellent books onthis subject which are worth reading. One good one I readrecently was Thomas Stridsman's "Trading systems thatwork".

TTA: To what extent, if any, should people combinebehavioural finance and quants with TA?

AS: To my mind behavioural finance and technical analysisare one and the same thing albeit approached from com-pletely different angles. Behavioural finance attempts tounderstand how psychology affects financial decision mak-ing and financial markets. It has developed out of acade-mia's recognition of the fact that classical financial econom-ics is a blunt tool for supporting trading decisions in mod-ern developed markets. Technical analysis attempts to useprice action and volumes traded to interpret trends orchanges in market psychology. In this way the two fields arevery similar.

Quantitative finance is a very different field and I thinkhighly complementary alongside TA when used to assist inportfolio construction and risk management.

TTA: How important are fundamentals?

AS: As an economist by training I can assure you that fun-damentals are very important. The problem I have as a trad-

er is that they change so slowly as to be almost worthless asan aid in supporting day-to-day position taking and strategy.

TTA: As chairman of the STA what are your ambitions forthe organisation?

AS: I hope to see the STA continue to grow in size andresources. Over the past 25 years the STA has developedinto one of the oldest and most respected TA societies inthe world. I would like to see it build on this success byexpanding its membership and increasing the services it isable to offer its members. A major part of the STA workrelates to its accreditation program and the STA Diploma(which also forms the basis of IFTA's international DITA2exam). In the future, I would like to see more people usethis resource to get properly qualified as technical analysts.

TTA: How much time do you devote to your role with theSTA?

AS:: I am fortunate to have a large volunteer board at theSTA so the work gets spread around many people. Eachmonth we hold formal board meetings and hold lectures. Inaddition to that a lot of work gets done via email over theweekends. Several years ago the STA elected to employ aprofessional administration company to deal with the day today needs of running the society. Today STAAdministration, along with all the other active board mem-bers, does a tremendous amount of the real work. Thismakes my job a lot easier.

TTA: How has the membership of the STA changed inrecent years both in number and nature of members (pri-vate traders/professionals)?

AS: In the early years the STA membership was mainly pro-fessional and then in the 80s it began attracting a lot moreprivate investors. Today the membership is about 800 intotal. About 55% of these are professionals working in thefinancial markets.

TTA: What changes do you plan to make to the STA syl-labus?

AS: The STA syllabus is constantly under review and we areplanning to make a number of changes to it in the nearfuture to reflect the proposed changes to IFTA's interna-tional exam accreditation programme. Precise details ofthese changes are yet to be announced but in essence theyinvolve the incorporation of several Japanese techniquesand the addition of Ethics within the syllabus. We thinkthese changes will greatly enhance the syllabus and ensurethe exam retains its international high standing.

Subject Matters



Subject Matters

A50 to 60 year economic cyclewas first described in detail byN. D. Kondratiev. Kondratiev

cycles are most readily apparent inmonetary data such as prices and inter-est rates. Figure 1 shows a plot of theUS Producer Price Index (PPI) (in red)over the period 1790 to the present.Prior to WWII, the Kondratiev cyclecan be seen clearly as periodic waves inprices spaced about 50 years apart.

Kondratiev, working in the 1920's,predicted a deflationary depressionusing his cycle theory. He was right, butsubsequent attempts to apply his theo-ry have been unsuccessful due to theabsence of declining prices after theGreat Depression. Since then, inflationhas been an ever-present fact of life asthe steadily rising red line in Figure 1shows. Near-constant inflation over thepast 70 years is the result of stimulato-ry economic policy that began with theNew Deal in the US and continues tothis day. Stimulatory policy falls intotwo categories: fiscal and monetary.

Fiscal policy involves government

expenditures. By running a deficit thegovernment can put more money intothe hands of consumers than it takes intaxes, which increases the amount ofmoney available for spending.Monetary policy affects the money sup-ply and the Federal Reserve has a vari-ety of means by which it can increasethe amount of money in circulation.Both of these policies are stimulatoryin that they can increase the rate ofeconomic growth (at least in the short-term) and produce rising prices.

To account for these effects, I definestimulation (S) as the sum of govern-ment debt and money supply relative toreal GDP (See box).

From equation 4 it follows that veloc-ity is equal to Price divided by S. I callthe P/S ratio the "reduced price".According to standard quantity ofmoney theory, velocity is supposed tobe constant and so reduced priceshould be approximately constant aswell. It is not. As shown in Figure 1(black), reduced price shows the samewave-like pattern as regular prices.

Figure 1. PPI Commodities Index and Reduced Price since 1790

Michael Alexander uses 'reduced prices' to reveal Kondratiev waves inmodern price data. He goes on to use his findings as a tool for model-ing the price of gold.

GOLD AND THE KONDRATIEV CYCLE by Michael Alexander

→→


Subject Matters

More importantly, it continues to showa wavelike pattern after the GreatDepression, after which ordinary pricesstop doing so. Reduced price clearlyshows a Kondratiev trough in 1946 anda peak in 1981. These dates are close tothose estimated from a considerationof interest rates or stock market cycles,both of which correspond to theKondratiev cycle. It would seem thatreduced price captures the Kondratievcycle that underlies the actual price. Orput another way, the Kondratiev cyclefor actual prices has been distorted bystimulation. In the next section the

concept of stimulation is applied togold.

Modeling the price of gold Gold is a unique asset in that it is botha commodity and a monetary instru-ment. As a metal, it is subject to thesame sorts of supply and demand pres-sures that apply to other metallic com-modities. Unlike other commodities,however, gold has often served asmoney and thus has use as a store ofvalue (i.e. savings). The willingness ofgold owners to keep large stocks of themetal out of economic use means thatgold can trade (for years) way out ofline with the supply and demand stric-tures that apply to other commodities.

Figure 2 outlines the history of goldprices. The money role of gold meansthat we should be able to apply thestimulation concept used to producereduced prices to the price of gold(POG). Figure 2 shows a stimulation-based model (bold black line) for theprice of gold. This model simplyassumes that the gold price is linearlyrelated to stimulation. For the period1860-1915 the POG and the stimula-tion model closely agree. The only dis-crepancy is in the 1862-1879 periodduring which the US dollar was off thegold standard. In order to finance theCivil War, the US government had toprint money in the form of greenbacks.Doing so took the US financial systemoff gold in 1862. It was only in 1879that the dollar came back to parity with

gold and the US went back on the stan-dard. What this means is the price forgold given by the stimulation model(the true value of gold as "money")rose above the market price in 1862 anddidn't fall back until 1879.

From 1879 to just before World WarI, the US dollar was on the gold stan-dard. This is shown in Figure 2 by theclose correspondence between theprice of gold predicted by the stimula-tion model and the actual POG. Ofcourse, this is necessary since the wholepurpose of a gold standard is to regu-late stimulation in such a way that thiscorrespondence occurs. During WWIthe US (and the rest of the WWI bel-ligerents) went off the gold standardjust as the US had done for the CivilWar. After the war, the US (and eventu-ally the rest of the western world) wentback onto gold. But this return to goldwas not at parity. That is, the actualprice of gold was well below what thestimulation model calls for. For parityto be reached it would have requiredpolitically unacceptable levels of defla-tion after World War I and so the goldstandard was re-established under whatwas called the gold-exchange system.Throughout the 1920's the economicauthorities were able to maintain stablecurrencies well above the value consis-tent with gold. When the world econo-my fell into depression after the 1929stock crash, the gold exchange systemwas no longer tenable and one countryafter another went off gold. The USleft gold in 1933 and a new POG wasestablished at $35 an ounce by a deval-uation of the dollar.

World War II introduced anotherround of stimulation. As a result, theprice of gold given by the stimulationmodel once again rose above the POG.This time the world did not return tothe gold standard. Instead, the worldcurrencies were pegged to the US dol-lar, which was then pegged to gold at$35 per ounce. The strong trade posi-tion of the US coupled with the vastgold reserves of the US treasury meantthat the US could keep this new dollarsystem going for decades despite thelack of parity between the dollar andFigure 2. Annotated price history of gold

1. S = (Debt + Money) / GDP Government debt is calculated bysumming government deficits overtime. For money supply I use the M3measure. (For the period prior to1959 when M3 data is unavailable, Iuse M2). I now write a standardquantity of money equation forinflation:2. Money x Velocity = Price x OutputI can rearrange this and substituteGDP for output and obtain:3. Money / GDP = Price / VelocityIf I include government debt in mydefinition of money I obtain3. (Debt + Money) / GDP = Price /VelocitySubstituting equation 1 into equation3 above, gives:4. S = Price / Velocity

Subject Matters


gold. Eventually the system collapsedin 1971 just as the gold exchange sys-tem had before it and gold began totrade as a commodity. After more thantwo decades of under-valuation, thePOG exploded upward after 1971.Now freed of its monetary characteris-tics, gold began to behave as a com-modity. As the world economy pro-gressed through the inflationaryKondratiev summer period, gold rosein price along with oil and other com-modities reaching a peak around thetime of the K-peak in 1980-81. That is,gold rose partly as a response to its pre-vious under-valuation, and partly as acommodity following the K-cycle asdefined in reduced prices (the thinblack line in Figure 2).

By 1980, gold had become extremelyovervalued relative to its value asmoney. The very fact that gold has beenused historically as money suggests thatit has a higher value as money than anyother use. Thus, once the Kondratievdownwave got underway after 1981 weshould expect gold to fall in price alongwith other commodities, but at a fasterrate, because of its overvaluation. Notehow gold has fallen in price along withthe reduced price. A few years ago, goldreached parity with the dollar. That is,gold was no longer either over orundervalued compared to the dollar.Since then gold has climbed.

Right now, the model value for goldis about $320 and it has been rising atabout $13/year since the beginning of2001 due to stimulation from interestrate cuts and deficit spending. Thus, ata POG at or below $320, gold lookscheap. Indeed this was demonstratedrecently by the rally that followed whengold's valuation fell below parity in1999.

Michael Alexander is the author ofStock Cycles (2000, Writer's ClubPress), The Kondratiev Cycle (2002,Writer's Club Press) and Cycles inAmerican Politics (2004,iUniverse.com)

Economists recognize four major cycles, or regular fluctuations, in the economy:

Many researchers believe the cycles are inter-dependent. In particular, they notethat the average length of each of the four cycles is slightly longer than doublethe length of the immediately preceding shorter cycle. Kondratiev's cycle mayitself be followed by a centennial cycle, the secular trend, identified by Braudel,Simiand, and Larousse in the 1930's.

The long-wave cycle in the capitalist economy was discovered by the Sovieteconomist N. D. Kondratieff (1892-1930) in 1922. Kondratiev's methodologyinvolved the analysis of 21 economic indicators including the price index, therate of interest, wage rates, rents, volume of production, consumption, exports,imports, employment, as well as their standard deviations, for Britain, France,Germany and the US. In studying volumes, Kondratiev used per capita data. Hecalculated deviation from the trend through the method of least squares. Inorder to filter out noise caused by the shorter cycles he employed nine-year mov-ing averages.

Kondratiev confirmed the presence of a long wave-cycle in 15 of the 21 series.Significantly, in the case of the price level and the rate of interest the evidencewas strong. Kondratiev's ultimate conclusion was that he obtained sufficientempirical basis to support the hypothesis of the existence of a long-wave eco-nomic cycle in the capitalist economies he studied, with an average duration of54 years. He allowed a 25 percent deviation from this average. In particular,Kondratiev identified three historic waves:

Kondratieff was exiled to Siberia by Bolshevik officials who flatly rejected hisconclusions. To the faithful there could only be one falling phase of the capitalisteconomy, followed by the socialist revolution and the dictatorship of the prole-tariat. And, following that, there was to be only one rising phase.Kondratiev died in the Gulag in 1930 at the age of 38. His work was later updat-ed by other economists using his original methodology. They found that thefalling phase of the third wave ended 1947-48, and that there is a

Antal E. Fekete, Professor Emeritus, Memorial University ofNewfoundland

The Kondratiev Cycle

Kitchin's short-wave cycle of average duration 3-5 years, discoveredin 1930;Juglar's cycle of average duration 7-11 years, discovered in 1862;Kuznets' medium-wave cycle of average duration 15-25 years, discov-ered in 1923;Kondratiev's long-wave cycle of average duration 45-60 years, discov-ered in 1922.

1.

2.3.

4.

First wave: rising phase from 1780-90 to 1810-17; falling phase from1810-17 to 1844-51.Second wave: rising phase from 1844-51 to 1870-75; falling phasefrom 1870-75 to 1890-96.Third wave: rising phase from 1890-96 to 1914-20; falling phase started 1914-20.

(i)

(ii)

(iii)

Fourth wave: rising phase from 1947-48 to 1973-80; falling phase started 1973-80.

(iv)

Subject Matters


A COMPARISON OF MOVING AVERAGEENVELOPES AND BOLLINGER BANDSby Joseph Man-joe Leung and Terence Tai-leung Chong

Constructing channelsMoving average envelopes andBollinger Bands are channels that arebased on a moving average. In thisstudy we use the simple moving aver-age, where the N-day moving average atany given time is the mean of prices inthe previous N days. For moving aver-age envelopes, the channel boundariesare plotted at a fixed percentage aboveand below the moving average value.For our analysis, we use percentage val-ues (k) of +/-3% and +/-5%.

In contrast, the width of BollingerBands is determined by a certain stan-dard deviation value from the movingaverage - i.e. the band width dependson the fluctuation of prices around themean. When volatility increases in sucha way that the moving average remainsunchanged, Bollinger Bands expand tocapture the price fluctuations, whilemoving average envelopes will not.Bollinger Bands are normally plottedwith two standard deviations (usedhere), which should capture around95% of price movements.

The trading rules The region above the upper boundaryof moving average envelopes andBollinger Bands is considered an indi-cator of overbought conditions, whilethe region below the lower boundariesis considered an indicator of oversoldconditions. However, because it is oftenhard to predict how long a stock willstay in an overbought or an oversold

region, the trading rule does not signala buy or sell until the stock price hasmoved away from those extremeregions. Therefore, a buy signal is gen-erated when the price crosses the lowerboundary from below. Similarly, a sell

signal is generated when the price pen-etrates the upper boundary from above.

In this article, moving averageenvelopes of 3% and 5%, and BollingerBands of two standard deviations areapplied to 10-, 20-, 50- and 250-day

Trading rules based on simple moving averages are the most frequently tested of all the different trad-ing strategies. However, when the market lacks a clear trend or when prices fluctuate significantlyaround a trend, it is more appropriate to use channels for capturing short-run fluctuations. Two suchchannels that are popular with traders are moving average envelopes and Bollinger Bands. Yet fewempirical studies have explored their profitability. This article attempts to fill this gap by comparing theperformance of these two trading techniques on 11 stock market indices.

Table 1. MAE and BB averages across 11 stock market indices

N =

10

20 50 250

Average annualised returns

MAE-3% 2.4% 3.2% 3.8% 1.7%

MAE-5% 3.3% 3.3% 2.5% 1.0%

BB (2 SD) 1.9% 2.9% 1.4% 2.2%

Average number of transactions

MAE-3% 45 41 28 45 MAE-5% 15 20 18 7 BB (2 SD) 53 40 20 4

Location

USACanadaItalyUnited KingdomGermanyJapanFranceSouth KoreaSingaporeHong KongTaiwan

Index

Dow Jones IndustrialsToronto 300BCI GlobalFTSE 100DAXNikkei 225 Stock Avg.CAC40 InstantaneousKOSPIStraits Time IndexHang Seng IndexTWSE

From

1/1/19851/1/19851/1/19851/1/19855/9/19893/1/198516/7/19874/1/19854/1/19851/1/19854/1/1985

To

29/12/200029/12/200029/12/200029/12/200029/12/200029/12/200029/12/200029/12/200029/12/200029/12/200029/12/2000

The data


Subject Matters

moving averages. We assume that trans-action costs and stock dividends arenegligible. We also assume that shortselling is not allowed, and transactionscannot be accumulated, i.e., two con-secutive buying actions are not allowed.Since there are about 250 trading dayseach year, the performance is evaluatedin terms of annualized rates of return

ResultsTable 1 shows the average annual ratesof return generated by the two tradingrules across all 11 indices. It also showsthe average number of transactionsgenerated.

ObservationsOn average, both trading rules generate

positive rates of return. Rates of returnare especially good for the Dow Jones,DAX, CAC and Hang Seng Indices (e.g.the Dow Jones averages 5.6% acrossthe 12 trading rule permutations - notshown here). However, both rules gen-erate a negative rate of return in mostcases for the Nikkei 225 and theKOSPI.

Note that the number of transactionsgenerated by moving average envelopesfalls with a lower k. This is because thelarger the value of k, the more the pricefluctuations will be captured by theenvelopes and the fewer trading signalswill be observed. Note also that thenumber of transactions generated byboth channels falls with increasing N.In general, when N = 10 and 20, thenumber of transactions for BollingerBands and for MAE-3% are close.While for N = 50 and 250, the numberof transactions for Bollinger Bands iscloser to the number of transactionsfor MAE-5%.

Overall, when used to formulate amechanical trading rule, moving aver-age envelopes perform better thanBollinger Bands for 10-, 20- and 50-daymoving average periods, whileBollinger Bands perform better on a250-day moving average. We thereforesuggest using moving averageenvelopes for short-term investmentand using Bollinger Bands as a long-term investment tool. However, sincetechnical trading rules are usuallydesigned for short-term investmentpurposes, it would be reasonable toconclude that moving averageenvelopes are better than BollingerBands in practice. Therefore, despitethe fact that Bollinger Bands can cap-ture sudden price fluctuations thatmoving average envelopes cannot, theydo not out-perform moving averageenvelopes in terms of profitability.

Joseph Man-joe Leung and TerenceTai-leung Chong are professors ofeconomics at The ChineseUniversity of Hong Kong

Figure 1. Moving average envelope on Dow Jones Index (20 day moving average, 3 percentenvelope). Source: Telerate

Figure 2. Bollinger Bands on Dow Jones Index (20 day moving average, 2 standard deviations).Source: Telerate

The London Stock Exchange is leading the way in opening up the competitive landscape to ensure that investors get access to thelargest pools of liquidity in Dutch securities at the best price. The service will be up to 40%* cheaper than Euronext and this sustainablelevel is aimed at attracting a wide cross-section of the market.

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Client Services Laura Pandit Tel: +44 (0)20 7797 1328 [email protected]

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Flow of funds information is firmly established inthe market as important data that can give traders anoticeable edge. Often, the information is passed

around anecdotally and is used to explain short-term pricemoves. Captured and presented in a verifiable form, thisdata may also be used for identifying medium- and longer-term trends.

The Bank of New York's position as the world's largestcustodial bank has given it unique access to daily cross-border portfolio flows in the equity and fixed income mar-kets. This has led to the development of the InteractivePortfolio Flow Monitor (iPFM), the bank's portfolio flowsservice used primarily by fund managers and hedge funds.

The iPFM uses proprietary data from the Bank of NewYork's global custody activity. The bank currently has $8.5trillion worth of assets under administration which repre-sents over 20% of the total global custody market.According to Michael Woolfolk, head of research at TheBank of New York, "This is a sufficiently large sample tofairly reflect total custodial flows for both major andemerging markets." Speaking as an in-house user of the iPFM, he continues,"In the strategy department we are primarily interested inany flows likely to trigger FX transactions. Sustainedchanges in net flows are often a harbinger of changes inthe underlying real money flows that ultimate determinethe value of currencies."

The iPFM on-line The iPFM was launched in 1998 and became available onthe Bank of New York website in 2001. At present, theservice only includes portfolio inflows into each countryalthough the service is expected to be expanded to incor-porate bilateral flows in the near future. The iPFM allowsthe user to plot portfolio flows into 26 countries includingthe US, UK, Japan, the Eurozone, Australia, New Zealand,Canada and Scandinavia. Also included are 14 emergingmarkets. The flows are divided into three 'investmentclasses'- fixed income, equity or the total of both. Againsteach of these classes can be plotted up to three 'indica-tors': 25 FX rates (against the domestic currency), 20benchmark government bond yields and 34 equity indices(see Figures 1-3). All data is updated daily and can be plot-ted for periods ranging from one month to two years.

All iPFM charts represent flows in yellow on a scale of

+100 to -100. This scale is a normalized index of cumu-lative net daily flows in local currency terms. A bar chart(not shown) below each chart displays the net capital flowfor each day that contributes to the aggregate chart aboveit. The charts, however, are somewhat crude and there isno source data available to support them.

The iPFM Flow MatrixThe flow matrix is an add-on to the iPFM which ranksthose investment classes and indicators that exhibit thegreatest correlations. The iPFM Flow Matrix sorts and

THE BANK OF NEW YORK'S INTERACTIVE PORTFOLIO FLOW MONITOR

Figure 1. Total portfolio flows and spot USD/CHF

Figure 2. Equity flows and Dow

Software


Figure 3. Fixed income flows and 10-year gilt


Software

presents the iPFM data identifying the major trends andcorrelations in currency, equity and fixed income marketsranking them on an index of +/- 100. This index is ameasure of relative correlation and says nothing about theactual correlation that may exist between an investmentclass and indicator. For example, even if an actual correla-tion is low, it may have an index of +100 if it is the high-est correlation that the iPFM identifies. To aid in the iden-tification of trends, the ranked output is colour coded inshades that vary from dark blue (positive) to dark red (neg-ative). The matrix (Figure 4.) shows that the strongest cor-relation over the past 3 months was between Brazilianequity inflows and the domestic stock market. Clicking onthis square displays the chart (see Figure 5).

Not a predictive tool The Bank of New York's claim that their custodial hold-ings are representative of total capital flows is open toquestion. The iPFM only looks at private sector cross-bor-der flows into each country which means the system can-not, as yet, measure and display net capital flows, surely amore important determinant of market prices. Moreover,

as the bank readily admits, it does not have a significantshare in two important areas - official flows such as cen-tral bank reinvestment of intervention proceeds and theJapanese market. Japanese investors still prefer usingdomestic custodial banks.

Basic flow-of-funds interpretation implies that positiveor increasing capital inflows into a country will supportthe domestic currency. This appears obvious as invest-ment in US fixed income or equity instruments require thebuying of dollars. However, as a guide to currency move-ments, the iPFM seldom provides explanations for marketbehaviour. For example, over the past 3 months, capitalinflows into the US have been positive although the dollarcontinued to weaken against the euro and other curren-cies. The Bank of New York accepts that the service mayhave limited forecasting ability. "The iPFM," saysWoolfolk, "is designed to be a value-added explanatorytool for financial market professionals and not a predictivetool."

Nevertheless, The Bank of New York's position as acustodial bank affords it a unique advantage in havingaccess to portfolio data when no daily cross-border capitalflow data is publicly available elsewhere. As Woolfolkexplains, "We choose to focus on providing the most up todate and accurate cross-border capital flow data availablein the market."

More information is available from www.globalmarkets.bankofny.com

"REAL MONEY FLOWS ULTIMATELY DETER-MINE THE VALUE OF CURRENCIES."

MICHAEL WOOLFOLK, THE BANK OF NEW YORK

Figure 4.

Figure 5. Brazilian equity inflows and stock market (IBOV)

Book Review


THE (MIS)BEHAVIOUR OF MARKETS

The (mis)Behaviour of MarketsA Fractal View of Risk, Ruin and Reward

By Benoit B. Mandelbrot and Richard L.HudsonPublished by Profile Books Ltd328 pages, £18.99ISBN 1 86197 765 4

The (mis)Behaviour of Markets is availablefrom The Technical Analyst bookshop at thereduced price of £13.29 plus P+P. To orderplease call 01730 233870 and quote "TheTechnical Analyst magazine". Books areusually posted within one working day ofyour order.

In the late 1980s and early 1990s, Chaos Theory was a fashionableway of looking at the world, complete with essential vocabulary(turbulence, determinism, fractals) and posters of Mandelbrot

sets. Yet today, far from being a theory with which to illuminate, it istoo often used to blag - especially in the financial markets where 'blackbox' solutions abound.

Benoit Mandelbrot's book will do much to set the record straight.This is the first book he has written on finance for lay readers andthere are few others who could write about the application of fractals- a branch of mathematics that perceives hidden order in the irregular-ity of nature - to the financial markets with such authority and, thanksto his co-author Richard Hudson, clarity.

Mandelbrot's CV is impressive: professor of mathematics at Yale,inventor of fractal geometry, and winner of numerous scientificmedals and prizes. Richard Hudson also ranks high amongst his jour-nalistic peers, having been managing editor of the Wall Street JournalEurope for six years.

The book is organised into three parts. Part one provides a convinc-ing argument against the Modern Theory of Finance. It argues thatmarkets, like most natural phenomena, operate according to a powerlaw. This means that instead of the "mild mannered bell curve",extreme values occur much more often than would be expected.

Why is it, Mandelbrot asks, that "the seemingly improbable happensall the time in financial markets." The 6.8% decline in the Dow JonesIndustrial Average on the 31 August 1998 had, according toMandelbrot's measure of standard theory, a one in 20 million chanceof happening.

Such incidents, often viewed as anomalous by the markets, can leadto financial ruin. Yet much of financial theory continues to be basedon assumptions of normal distribution. This is "… the guiding princi-ple for many of the standard tools of modern finance… taught inbusiness schools and shrink-wrapped into financial software pack-ages... [It] is a house built on sand."

According to these principles, you are "more likely to get vaporizedby a meteorite landing on your house than you are to go bankrupt in afinancial market."

The second part of the book is humbly entitled "The New Way", inwhich Mandelbrot talks us through his findings with regular referenceto fractal cartoons. His fractal cartoons explain how seemingly irregu-lar chart patterns can be built up by regularly repeating patterns atmany different scales. This fractal view of the financial markets canexplain why all charts look similar, regardless of timeframe.

In essence, his models highlight two important characteristics of themarket: Price discontinuity and long-term dependence. With price dis-continuity, prices move with "wild randomness" where the "fluctua-

Book Review


tion from one value to the next is limitless and frighten-ing." Under these assumptions, the odds of ruin are farmore realistic - more like one in ten or one in thirty.

Another property of wild randomness is that volatilityis concentrated into clusters and these clusters occur atall scales. This also matches the data. For example, nearlyhalf of the decline in USDJPY from 1986 to 2003occurred in just ten days (out of the 4,695). If you thenfocus in on those ten days, then most of the decline wasfurther concentrated into a few minutes. And so on.Prices do not move smoothly and continuously from onevalue to the next, but "jump, skip and leap - up anddown."

The second important characteris-tic, long-term dependency, recognisessomething that technical analysts havedone for a while - that prices do notmove in a random walk as predictedby the Efficient Market Hypothesis.Events of the past are still playingthemselves out in today's prices. Oneof the authors' illustrations is how theGreat Depression made thoseinvestors who lived through it morerisk averse. "Their memories provideda practical form of long-term dependence in the finan-cial markets. Is it any wonder than in 1987, when most ofthose men were gone and their wisdom forgotten, themarket encountered its first crash in nearly sixty years?"

But, he warns, "The long-range dependencies in pricescreate a kind of tendency in the data - not towards anyparticular price level, but towards price changes of a par-ticular size or direction." He continues, "The changes canbe persistent, meaning that they reinforce each other…or they can be anti-persistent, meaning they contradicteach other. Because of this, he thinks that "spurious pat-terns" make the markets deceptive and that technicalanalysts are the ones being deceived.

Yet Mandelbrot's attitude towards technical analysisisn't as emphatic as his other views. At times he seemsdismissive, describing technical analysis as "financialastrology" and part of the "fun-house mirror logic ofmarkets", but elsewhere he seems less certain of howtechnical analysis fits into his model, agreeing that:

"… a by-now substantial body of economics researchsuggests that there is, indeed, money to be made in sucha "trend-following" strategy; how much, and whether it is

worth the risk and expense, is a matter of debate. Butclearly, the market pros have already voted: More than

half of currency speculators play some form of trend-following game…"

This hesitancy seems to stem from a respect for themarkets and a belief that the markets' understanding,conscious or not, may be far ahead of any economic the-ory: "The market has known for years that the Black-Scholes formula for option pricing is "simply wrong…Improving or replacing Black-Scholes is one of the liveli-est sub-disciplines in mathematical finance."

Referring to the equity premium puzzle, an academicdebate which struggles to understand why equity premi-

ums should be as high as they are,Mandelbrot says:

"Real investors know better than theeconomists. They instinctively realize

that the market is very, very risky,riskier than the standard models say.So, to compensate them for takingthat risk, they naturally demand and

often get a higher return."

In the third section, Mandelbrotand Hudson list what they call the

"Ten Heresies of Finance". Mandelbrot's challengingconclusion to technical analysis is that you cannot fore-cast the financial markets. But he does not mean it in thesame sense that proponents of the Efficient MarketHypothesis or Random Walk do. To him, such thinking isequally flawed because it does not recognise the long-term dependency of prices.

So can any of Mandelbrot's conclusions be used fortrading and investment decisions? Well, according to him,yes. You may not be able to forecast direction, but withthe understanding that periods of high-volatility clustertogether, then you can step out of the market at thoseperiods and reduce the chance of loss and ruin. Thequestion he leaves unanswered is how to do this in prac-tice.

Regardless of whether you will like his conclusions ornot, The (mis)Behaviour of Markets is highly recom-mended to anyone working in the financial markets. It isboth entertaining (no doubt because of RichardHudson's involvement but also because Mandelbrot talksopenly about his route to scientific discovery) andinformative. Above all, however, the book is recom-mended because it is a serious presentation, albeit writtenfor the layman, of Mandelbrot's formidable views.

"REAL INVESTORSKNOW BETTER THANTHE ECONOMISTS.

THEY INSTINCTIVELYREALIZE THAT THEMARKET IS VERY,

VERY RISKY.”

Letters


LETTERS TO THE EDITOR

SIR: I would like to draw your readers' attention to a subjectthat appears to receive little coverage in your publication -artificial intelligence (AI). This relatively new discipline,which has emerged from the progress of mathematics andcomputer sciences, has immediate relevance and applicationfor technical analysts. More specifically, there are two pow-erful AI tools which are already being used for forecastingin the financial markets: neural networks and genetic algo-rithms.

The link between AI tools and technical analysis is aston-ishingly natural, making the application of new computa-tion methods to the financial markets inevitable. Any kindof algorithms can be used as the initial seeds for an evolu-tionary process. We use neural networks as seeds and theresult is a genetic net, something that germinates, grows,reproduces itself and eventually dies - something very nearto being alive.

At the core of AI systems are algorithms. They are whatneural networks and genetic programs optimize to solve agiven problem. One by one, year by year, we programmedthe most diverse range of algorithms into our neuronal sys-tems, based on: Quantum mechanics, decision theory, statis-tical methods and probability. Many of them proved to beuseful in forecasting prices and were quickly accepted by the

neuronal systems. Then we came to technical analysis meth-ods - attacked by many who argue they have no real scien-tific basis. After many years of investigation, we found thefollowing:

Our neuronal systems fell in love with classic technicalanalysis. The weights assigned to some of its methods rangeupon the higher ones. The genes that codify them frequent-ly become dominant ones. One discipline shines over alland deserves a special mention: Elliott wave analysis. It wasthe most difficult method to program. It took us more thana year to show our systems how to count waves and inter-pret them. To program something into a computer, youmust understand its mathematical nature completely. So wewent into Elliott theory and started translating its simplerules into mathematical equations. We ended up with a setof mathematical theory, having defined an Elliott geometry,an Elliott topology and an Elliott probability algebra.Connections to chaos theory, fractals and the phase spacebecame increasingly evident. Once programmed, our neu-ronal systems adopted Elliott wave quickly as a key forecast-ing method.

Mario Martin, chief programmer, Neuronal Systems

SIR: I saw with interest your article in The TechnicalAnalyst magazine on the January Barometer. In the past Ihave done similar research into the indicator but have onlydiscussed the results internal to the firms where I haveworked.

First, I think it is only sensible to look at what happens inthe following 11 months for the simple reason that the indi-cator should indicate the likely future and not include whathas already passed. After all, investing can not be donewith hindsight.

As you show in your article, 31 out of 44 years is still agood strike rate for an indicator (or 29 out of 44 if the 1%threshold is applied). However, when you link the indicatorto the returns the picture changes completely. Test straight-forward strategies such as (1) going long for the remaining11 months when January was up and staying out whenJanuary was down, and (2) going long for the remaining 11months when January was up and going short when Januarywas down. Neither strategy comes anywhere close to beat-ing a simple buy-and-hold strategy of being 100% longthroughout (i.e. 100% long every February-December), overany time period, with or without a threshold.

For example, from 1960 to 2003, a buy-and-hold strategyreturned 1439%. Following strategy (1) (i.e. long/flat)

returned 572% with no threshold and 694% with a 1%threshold. Strategy (2) (i.e. long/short) returned 314%.Other time periods such as a rolling 5 year or 10 year peri-od gave results in roughly the same order.

What does this tell us? That the risk/reward of the strate-gy is very poor. In high return years, often a lot of the gaincomes in January. However, when the indicator is wrong, itis often very costly to be on the wrong side or sidelines.For example, in 2003, the opportunity loss was nearly 30%.The high success ratio for the indicator predicting directionis more a function of the upward drift of equities overall.It is noticeable that the barometer was at its least effectivein periods when the market trended sideways or downwards(1966-1979, only 7 out of 14 successes, and 1930-1948,only 10 out of 19 successes).

Conclusion. Don't use the January barometer. It is worsethan a simple buy-and-hold strategy most of the time.Appreciate that when the indicator is likely to be wrong, itcan be very wrong since this likely indicates a change intrend and consensus about the market. Maybe there isworthwhile work to be done exploring this idea.

Simon Donne, Japanese equity long/short fund,Invicta Investment Management LLP


Commitments of Traders Report

COMMITMENTS OF TRADERS REPORT6 January 2004 - 4 January 2005 Futures only (open interest) non-commercial net long positions and spot rates

10-year US Treasury Source: CBOT

Dow Jones Industrial Average Source: CBOT

5-year US Treasury Source: CBOT

Swiss franc Source: CME

Pound sterling Source: CME Yen Source: CME

-250000

-200000

-150000

-100000

-50000

0

50000

100000

150000

200000

06/01/2004 30/03/2004 22/06/2004 14/09/2004 07/12/2004

3.00

3.20

3.40

3.60

3.80

4.00

4.20

4.40

4.60

4.80

5.00Non-commercial net long

Spot

0

50000

100000

150000

200000

250000

300000

06/01/2004 30/03/2004 22/06/2004 14/09/2004 07/12/2004

2.00

2.50

3.00

3.50

4.00

4.50

Non-commercial net long

Spot

-8000

-6000

-4000

-2000

0

2000

4000

6000

8000

10000

12000

06/01/2004 30/03/2004 22/06/2004 14/09/2004 07/12/2004

9400

9600

9800

10000

10200

10400

10600

10800

11000


Spot

-20000

-10000

0

10000

20000

30000

40000

50000

06/01/2004 30/03/2004 22/06/2004 28/09/2004 21/12/2004

1.10

1.15

1.20

1.25

1.30

1.35

Non commercial net-long

Spot

-10000

-5000

0

5000

10000

15000

20000

25000

30000

35000

40000

45000

06/01/2004 30/03/2004 22/06/2004 14/09/2004 07/12/2004

1.70

1.75

1.80

1.85

1.90

1.95

2.00


Spot

-40000

-20000

0

20000

40000

60000

80000

06/01/2004 30/03/2004 22/06/2004 14/09/2004 07/12/2004

100

102

104

106

108

110

112

114

116Non-commercial net long

Spot


Commitments of Traders Report

Euro Source: CME

Nasdaq Source: CME

3-month eurodollar Source: CME

Nikkei Source: CME

Gold Source: CEI US dollar index Source: NYCE

-800000

-600000

-400000

-200000

0

200000

400000

600000

06/01/2004 30/03/2004 22/06/2004 14/09/2004 07/12/2004

0.00

0.50

1.00

1.50

2.00

2.50

3.00


Spot

-25000

-20000

-15000

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0

5000

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15000

06/01/2004 30/03/2004 22/06/2004 14/09/2004 07/12/2004

1000

1200

1400

1600

1800

2000

2200

2400


Spot

-6000

-4000

-2000

0

2000

4000

6000

8000

10000

06/01/2004 30/03/2004 22/06/2004 14/09/2004 07/12/2004

9500

10000

10500

11000

11500

12000

12500


Spot

-15000

-10000

-5000

0

5000

10000

06/01/2004 30/03/2004 22/06/2004 14/09/2004 07/12/2004

102

104

106

108

110

112

114

116

118

120Non-commercial net long

Spot

-20000

-15000

-10000

-5000

0

5000

10000

06/01/2004 30/03/2004 22/06/2004 14/09/2004 07/12/2004

104

106

108

110

112

114

116

118

120


Spot

0

20000

40000

60000

80000

100000

120000

140000

160000

06/01/2004 30/03/2004 22/06/2004 14/09/2004 07/12/2004

300

320

340

360

380

400

420

440

460

480


Spot

Long-Term Technicals


LONG-TERM TECHNICALS

Provided by Thomas Anthonj, ABN Amro, Amsterdam

Stalling right under the projected target zone for a potential 5th wavetop (1.9566-88) and breaking below the last major top at 1.8771, wecould indeed be due for a much bigger setback. But unless the mar-ket breaks below trend line support at 1.8378 and 1.8236 on weeklyclose we have no confirmation for a reversal yet and would stillexpect a resumption of the up-trend shortly. Having said that, thenext targets to focus on would be at 1.9753 with massive resistancebetween 2.0115 and 2.0165 (old top/Fib. projections) which shoulddefinitely cap the market for a while.

GBP-USD

Coming close to the old low at 101.25 the market started to hesitate,but this looks like nothing but profit taking so far. As long as the mar-ket doesn't exceed 106.78/107.03, though we expect renewed weak-ness and a conclusive break below 101.25. Thereafter the downsidewould be pretty open towards the head-and-shoulders target at95.75. A break above 107.03 would on the other hand open furtherupside potential towards 108.75/109.39. A break above the latterwould more or less break the bears neck and give room to re-testneckline resistance at 114.83.

USD-JPY

Stalling around a projected Fibonacci-target for a 5th wave top(1.3650) the market could have started a setback with a minimumdown-potential of 1.1760 (bottom of wave 4). But showing severalsubcounts within the latest advance coming from the 1.1950 handle,we would only be confident of having completed a bigger 5-wavecycle up once the market breaks decisively below a strong supportcluster between 1.3017 and 1.2928 (38.2 %/old top). Such a breakwould give room to test 1.2470/61 (trend line/old top) which lookslike the last resort for the bulls. Above 1.2928 we expect furthergains towards 1.3804/1.3921 (Fib. projections) and 1.4160 (historictop) thereafter.

EUR-USD

The key-reversal week down at the end of October triggered astronger setback than expected. But as long as the market remainsabove key-support between 35.50 and 33.94 we don't see anystrong evidence that the whole up-trend has reversed. Above, weexpect a minimum rise to 48.42 (76.4 % of the last decline). This hasto be cleared in order to call for a straight resumption of the up-trendto trend channel resistance at 53.87 and the calculated target zonefor this 3rd wave impulse at 56.52-58.64. A failure to clear 48.42would call for another corrective leg down to the 37/36 handle.

Brent Crude


Long-Term Technicals

The market managed to break the row of lower tops at 11143 recent-ly so we could see a test of key-resistance between 11648 (61.8 %)and 11789/11969 (76.4 %/old top). Only a break above the latterwould eliminate the threat of missing the left shoulder of a biggerinverted head-and-shoulders pattern down to around 9383. A breakbelow triangle support at 10637 would point in that direction.

Nikkei

Stalling right at the head-and-shoulders target (10860) the market isin danger of having completed a first 5-wave cycle up. Nevertheless,we are currently running a significant risk of performing a 2nd wavesetback that usually retraces 61.8 % or 76.4 % of the whole advancefrom 7197 to 10868. However, it would take a weekly close belowtrend line support at 9984 to give room for a decline to 8598 andpotentially even 8063/62. A straight break above 10868 would on theother hand give room to extend the upside to 11350 and 11750 (oldtops) from where we again expect a bigger setback.

Dow Jones

Breaking the row of higher lows in the daily chart and showing a 5-wave structure up from the 1108 low that already came pretty closeto the last major top at 2328, we clearly have to expect a bigger 2ndwave setback that could easily erase 61.8 % or 76.4 % of the gainssince October 02. Having said that, it would still take a weekly closebelow trendline support at 1870 to trigger a bigger decline towards1522 (61.8 %) or 1387/64 (old low/76.4 %) to potentially form theright shoulder of a bigger inverted head-and-shoulders reversal pat-tern. Only a break above 2328 would re-open the upside for sub-stantial gains again.

Nasdaq

Stalling right inbetween a Fibonacci-target cluster for a potential 5thwave up at 1211/26, the market is definitely in danger of having com-pleted its accumulation phase. But unless it closes the week belowtrendline support at 1125, we have no evidence at hand to argue fora bigger setback yet. To at least delay the permanent risk of a biggersetback (wave 2) the market would have to clear strong resistancebetween 1246 and 1308. A close below trendline support would bereally worrisome and could trigger a setback to 954/40 (old top/61.8%) or to 878/75 (trendline/76.4 %) at the worst.

S&P 500


11-22JAN - MAR

Course:STA diploma course

Organiser: Society of Technical Analysts

Contact: [email protected]

9FEBRUARY

Event:STA Meeting

Organiser: Society of Technical Analysts


22-23FEBRUARY

Course:Bond Investors Congress

Organiser: Euromoney Conferences

Info: www.bondcongress.com

28FEBRUARY

Course:Introduction to technical analysis

Organiser: Quorum Training


17/18MARCH

Course:Technical analysis and charting

Organiser: Chartwatch


SUBMISSIONS FOR

EVENTS & COURSES

IN 2005

Please email us at:

[email protected]

23MARCH

Course:Advanced Technical Analysis

Organiser: 7City


TRAINING AND EVENTS DIARY

Training and Events Diary

Documents

Contrary Opinionvisionaries will give keynote speeches. Conference speakers will include Avinash Persaud, Dr Adam Posen and Stephen Roach. ... COMMITMENTS OF TRADERS REPORT LONG-TERM