Global Technical Analysis for Professionals: Equities + Bonds + Currencies + Commodities
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Our Market Methodology
Beginners in Economics are taught how Buyers drive up the price of an item the more they want to acquire, and Sellers affect prices the more they seek to dispose of. It is the interaction of these two groups which create basic Supply and Demand curves. Fundamental research notes, quantitative analysis, news flow - even technical analysis itself - are what create Supply or Demand for investments, but it is the extent to which investors react to these factors, and their actual buying and selling of those investments, which at the end of the day moves markets.
A bullish 60-page report on BP may be spot on in its analysis of the medium-term potential, but if there are more people who believe a different and bearish view, their selling will push down the price until their selling is exhausted. The impact of these combined actions by investors in a stock or a market is there for everyone to see. The degree of buying, or selling, shows up in the volume figures, the speed of a rise or fall, the number of stocks rising and falling. At tops, investors become too bullish, and, at bottoms, too bearish. All of this can be measured, and used to determine the health of an investment.
By monitoring what investors are actually doing with their money, and measuring the effect that their transactions are having on price, a technical analyst is able to add value in the investment process. For the past 30+ years, we have studied a wide variety of markets in real time, as well as historically. Market history contains valuable lessons for the very basic reason that the most important ingredient behind stock market movements has not changed - human emotion. The 1999/2000 technology bubble confirmed that we are just as greedy and fearful (in that case, of missing out on a good thing) as were our predecessors who bought into Tulip mania, the South Sea Bubble, Wall Street in the late 1920's etc. etc. For the unaware, the events of late 2008 through early 2009 were a further, painful reminder of how emotion still drives markets.
Our experience from analysing Japan weekly since 1989, and daily since 1994 proved invaluable in 2000-03. Not only did we recognise that a major top-building process was occurring in the 1999-2001 period, but we knew what downside pattern to expect, and that 2001 was not the low. Equally, in 2007 it became obvious that markets were at risk, although they proved weaker than even we were expecting. In October 2008, we were also able to say that markets had not bottomed, and that the low was 3-8 months away, and we subsequently recognised that a significant bottom was near in early March 2009. For more details, please see the sections Diary of a Bear Market, covering 2000-03 and the Our Performance section of our website covering the events of 2007-09.
At the market index level, our methodology combines the following:
Elliott Wave Theory Fibonacci Ratios and targeting Momentum Breadth, New Highs and New Lows Volume Sentiment Cycles Support and Resistance Trends and moving averages Pattern analysis and targeting Point & Figure targeting
Elliott Wave Theory defines the pattern of bull and bear markets. Over twenty-five years of experience of it allows us to state this categorically. It provides a “road map” of what to expect in terms of pattern development, and to provide a real-time example of its power, we have included below a chart of the S&P 500 taken from the 3rd July 2009 publication, followed by the same chart two months later, showing how closely the index had matched our July expectations.
However, at that point it was clear that the rally pattern was still not complete.
EWT can be summarised as follows:
True bull markets contain three advancing waves, separated by two corrective periods, producing a pattern of five swings.
The Rule of Alternation suggests that the shape of the two corrections will probably (but not always) be different. One will be a sharp decline, whilst the other will be a period of complex or sideways trading, although not necessarily in that order.
All waves sub-divide, and are comprised of smaller versions of themselves.
The third wave (i.e. second advancing wave) is usually the longest, strongest and most dynamic part of the bull market.
Waves are very often related in terms of both price movement and time taken by Fibonacci ratios, for example 0.618, the Golden Ratio.
The chart below is of the S&P 500 since 1927, illustrating the 5-wave advance off
the Great Bear Market low of 1932, as first shown in August 2003. We believe that 1929 marked the high of a very long 1st Wave from about 1784,
with 1932 forming the low of a sharply downwards 2nd Wave. The whole period of 1932-2000 was a 3rd Wave, and 2007-2009 produced the second downswing in a sideways trading range to form the 4th Wave of a multi-century pattern. So the Rule of Alternation has worked perfectly. See this 2003 Global Markets Review for our view of the rest of the decade at that time, which includes the forecast of a second major bear market due by 2010.
Elliott works in all markets. The next chart is of UK 2½% Consols - an Undated Gilt. In 1946, Consols topped at par (£100) at the end of the post-Depression low inflation period, and fell steadily to a bottom in 1974 at £14. The early stages of the bull market were marked by base-building as a series of 1st and 2nd waves formed. The rally of 1994-98 was absolutely classic as the bull market's mid-section in terms of its dynamism and carry. Third waves are most often 1.618 times their first wave, and fourth waves usually retrace 0.382 of their preceding third wave. (See the section on Fibonacci targeting). Consols has produced a 38% retracement twice since the 1999 high, helping confirm that the wave count is correct, and that its bull market pattern remains incomplete.
Because we know what shape the early second wave patterns were in the 1974-1990 period, we know from the Rule of Alternation what patterns to expect in the remaining stages of Consols' secular uptrend. It makes intuitive sense that the bull market in bonds during the 2000-2003 equity bear market should be followed by a sharp "down" move as interest rates rose, with profits being taken in bonds, and re-invested in the equity bull market of 2003-2007. The events of 2007-09 produced further gyrations, as required by this long-term model.
However, Elliott patterns can become very complex in real time, so we whilst employ Wave Theory to provide an expected profile, other techniques are needed to help confirm whether our map-reading is correct, and a discussion of these follows the chart.
Fibonacci Ratios and targeting is usually associated with Elliott Wave Theory, but actually stands alone as a technique. Our own research shows that its effectiveness and range of application is not fully understood by the vast majority of users. Here are examples of the two most common uses:-
Percentage retracement - the 2009 rally by Topix hit its 38.2% target at 967 in August. Below is the chart from GMR of 13.3.09 which set that target. It also shows the calculation of the target zone for the low. See also the chart below that for another ratio which signalled buying Japan in March 2009. Target projection - Euro1st 300 hit its “extended 5th wave” downside target at 672 in March 2009. It then rebounded into the % retracement target range signalled at the time. The third chart illustrates this.
What a lot of critics of Fibonacci targeting fail to realise is that the technique only “works” when the correct range of ratios is applied to the correct wave count in the correct place.
The Fibonacci sequence on which these ratios are based is: 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377 .... (each number is the sum of the previous too).
The most common ratios are:
.146 = 13 ÷ 89 or 21 ÷ 144 and so on
.236 = 21 ÷ 89
.2764 = 1 - .7236
.333 = 1 ÷ 3
.382 = 34 ÷ 89
.50 = 1 ÷ 2
.618 = 55 ÷ 89
.7236 = 1 ÷ 1.382
.764 = 1 - .236
.854 = 1 - .146
Equality, i.e. 1.0, is also important. Other major ratios are:
1.618 = 89 ÷ 55
2.618 = 89 ÷ 34 etc.
Momentum measures rate of change, and can be calculated in quite a number of different ways. We monitor several indicators over a number of different timeframes. As a generality, the more extreme the readings the stronger is the trend, and we expect to see different types of reading at different stages in the market cycle. Momentum's two main uses are to:
Confirm the direction of the trend
Warn of an increasing likelihood of a change in trend.
In an on-going uptrend, the indicators should be making higher highs in tandem with the market, or, conversely, lower lows in a downtrend. When the trend reaches a new extreme, but the indicator produces a less extreme reading than its previous one, the process of divergence has begun. This is rather akin to an early warning signal, because divergence can be forming for quite lengthy periods.
The terms "overbought" and "oversold" are used to describe a period where the trend has become over-extended, and may be due for a pause or consolidation. However, with rare exceptions, the more extreme the reading, the more likely the trend is to continue.
Think of a cricket ball thrown into the air. It achieves maximum momentum just after leaving your hand, but has to slow to zero before its trajectory turns downwards. By measuring its momentum, we could tell when it is about to start dropping. The application to markets or stocks is similar - if not quite that straightforward!
The next two charts show a simple percentage change indicator applied to the S&P 500 and FTSE100, measuring point-to-point over 13-week periods. Note how the indicator matches the broad trends in the market, and produces divergence at several of the important turns. These charts show why we were able to say on 14.11.08 that “...THE low is anything from 3 to 8 months away.” (it was actually 4 months). Further examples of other shorter-term momentum indicators and their signals can be seen in the section on Cycles, which illustrates the important Japanese top of June 2008.
Breadth measures how many stocks in a market index are rising or falling over a given period. Like momentum, it provides another angle on whether a trend is healthy, or vulnerable to a turn.
If a trend is to be sustainable, then the majority of stocks in an index must be moving in the same direction as that index. That may sound obvious, but because individual stocks have different weightings in their index, it is mathematically possible for a few index heavyweights to distort the apparent trend of the market. Whatever the trend of an index, a look at its breadth statistics will tell you whether that trend is broad (i.e. many stocks participating) or narrow (i.e. a few). The narrower an advance or decline, the less likely it is to last. The signals in Japan's 30-day indicator in 2001-03 are typical, and contributed to a BOTTOM-FISHING BUY stance in November 2002.
Below we have shown the US in 2007-09 to illustrate how the indicators performed in a different market. It contributed to these views:
October 2007: “Deep correction or extended period of consolidation expected to begin Q3.”
February 2009: “Momentum, breadth and volume are all set up for bullish divergence buy signals on a re-test of the November lows, and further weakness could erode sentiment to the point of producing bullish readings. Based on the speed of the decline so far, the low should occur in late March or early April. If this overall scenario is what happens over the next 4-6 weeks, we would expect it to be followed by the largest rally in 18 months.”
New 52-week Highs and Lows are considered part of breadth, but provide another angle on a market’s health, since a market making new index highs or lows should produce new extremes in these statistics if the trend is to remain intact. The next chart shows New Low figures for the UK since 1997, highlighting the bullish divergence signals in 2002-03, and the bearish similarity to 2001 during 2008. The second chart shows the bullish divergence in New Lows in Q1 2009, and the subsequent upside confirmation from bullishly expanding New Highs.
The New High/Low figures also form the core of the Hindenburg Omen. The third chart shows its signals at the 2006, July 2007 and October 2007 tops. See www.wikipedia.com for an outline.
From the GMR 19.10.07: "Since this week produced another Hindenburg warning, the risks remain on the downside, although the very short-term signals suggest that the US may consolidate until early November. Targets are S&P down to 1,370-1,460 until 1,550 is bettered ..."
Volume is what drives markets, and there would be no markets without it! An uptrend is only sustainable so long as buyers are prepared to raise their bids progressively to tempt sellers, and a downtrend can only last as long as sellers are prepared to exit their investments as prices drop. Measuring volume in relation to the price action allows a judgment to be made about the state of a market.
One simple indicator is the On-Balance Volume accumulator (OBV). It makes the very basic assumption that all volume was traded in the direction of the index change, and, although this is clearly not true, the effect does tend to average out. Near turning points it can provide useful signals as volume in the direction of the trend begins to dry up. The weekly chart below of France's CAC 40 is a good example.
We also use OBValue, which employs the value of trading normalised for the index level. Two other accumulators complete the pack: Williams’ Accumulation & Distribution, and the MTS Adjusted Volume Accumulator (MAVA), which is a refinement of WAD. The second chart shows the bullish divergence at the Topix low in March 2009, when our stance turned bullish, and the subsequent upside confirmation.
Finally in the volume section, we have illustrated below Up and Down Volume Lines. These monitor a unique relationship between the price and the value of trading in an index, and also provide signals on the basis of confirmation of a trend (both index and indicator making new extremes together), or divergence warnings. The chart of the US includes the 2007 top and 2009 bottom signals, as well as short-term warnings at rally peaks on the way down.
Sentiment measures how bullish or bearish market participants are, and is mainly used as a contrary indicator, by recognising that the crowd is usually too bullish at tops (e.g. NASDAQ in 1999/2000) and too bearish at lows (e.g. Gold in 2000, Equities in 2009). Sentiment measures are most widely available for the US market and come in quite a number of forms, such as opinion-type polls, or the percentage of monies which are invested in "short" or bearishly positioned mutual funds. Because it is such a complex and time-consuming area, we buy in two services which help complement our analysis.
Cycle analysis looks for turning points in markets at equally-spaced intervals, and there will be many operating in a market at any one time - daily, weekly, month, yearly and even decades-long cycles. As previously, the following two charts below are presented exactly as they appeared in our Global publication. The one below warned of an early January top in the US, which occurred right in the window given.
A longer cycle is shown below, together with a sell signal from the 200-day moving average and warning signals from several momentum indicators. That week’s headline read: “Japan has reached the first point in time and price where it is vulnerable to a deep correction ...”. It was actually the beginning of the 2008 Crash, although we were not expecting that degree of damage.
Support and Resistance is the way of describing areas where there has been a lot of buying and selling historically, as well as important individual turning points. These zones tend to provide a break, sometimes only temporarily, on subsequent trends which re-visit them.
Trendlines and moving averages are simple technical tools, but can be very effective in helping to prevent exiting a successful investment too soon. Trendlines provide support and resistance, and a moving average is a type of curved trendline which smooths out price fluctuations. Contact between the price and m.a. also produces buy and sell signals. There are a number of examples of both included in the chart illustrations throughout this document.
Pattern analysis and targeting has many decades of successful history, and involves looking for certain shapes developing in market action. It works equally well on price and price relative charts. Both patterns below are of the Head-and-Shoulders top type, but Rectangles, Pennants and Flags are other well-know shapes which can be used to derive targets. Target projection is simple - the minimum carry should equal the depth of the pattern, measured from the break-out point. Not all targets are met, so “stop-loss” levels should be used in conjunction with this technique.
Point & Figure targeting provides another way of arriving at price projections, and helps confirm upside or downside potential. A target is derived as twice the length of the column created after a turning extreme. An upside target requires an upward move to produce at least two columns of X’s, and a downside target needs a decline which creates two columns of O’s. The target is only confirmed once there is a break above or below the high or low of the initial column which creates the target.
Our website contains a page here which sets out all of the targets and stops given for markets monitored by Global Markets Review during 2007-09, so that you can see how much value this technique can add.
Hopefully, the above demonstrates that there are quite a number of ways to monitor what traders and investors are doing, partly by measuring the effect of those actions on market indices. We believe that it provides an important perspective from which to view market trends and investment alternatives. Having helped us to avoid a decent chunk of the massive damage done to portfolios during the 2000-2003 and 2007-09 bear markets, we hope that it is a perspective which will gain increasing acceptance.