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THE JOURNAL OF THE STA

THE JOURNAL OF THE STA MARKET TECHNICIAN JANUARY 2009 The last issue of the Market Technician

MARKET TECHNICIAN

JANUARY 2009

The last issue of the Market Technician went to press in the midst of unprecedented financial turmoil. Old and respected institutions were disappearing from the financial landscape at such an alarming rate that some questioned whether we might not be witnessing a systematic collapse of the international financial order as we know it. But governments around the world stepped in to underpin the banks. However, no sooner had they had shored up the financial sector when the real economy started to buckle. The authorities are now competing with each other to bring in the largest fiscal packages in order to try and ward off an economic depression.

It was encouraging to see a good delegation of STA members at

the IFTA conference in Paris in November. A criticism of previous IFTA gatherings has been that they have tended to invite the same speakers. But this year’s hosts, Afate, made a big effort to ring the changes. The theme was research and analysis of financial markets which brought together academics and market practitioners. And, perhaps not surprisingly, this gave rise to some spirited discussions. In fairness to the academics presenting papers at this conference, they all accepted that market behaviour is totally inconsistent with random-walk theory. But some traders found the academics’ statistical analysis of historical data completely divorced from the realities of the market and revealed a lack of understanding about the underlying rationale of technical analysis. For example, a central bank had apparently sent out a questionnaire asking technical analysts to come up with an end-

year forecast without realising that technical analysis is essentially

a dynamic process rather than a static modelling system. For their

part, academics were frustrated by the lack of standardisation of technical analysis. For example, patterns such as head and shoulders can be interpreted completely differently by different analysts. As scientists, academics are looking for ways to formalise the subject so that they can measure its results but the lack of standardisation makes it difficult for them to do this in conventional academic terms. Looking ahead, academics are trying to develop genetic algorithms that evolve patterns or rules that are not currently used by technical analysts.

Tony Plummer gave an excellent talk on ‘The logic of non-rational behaviour in financial markets’ in which he examined how the market works as a system. As well as looking at what drives group

IN THIS ISSUE

2

STA diploma results

3

Obituaries

4

Market forecasts for 2009

J. Nebenzahl

6

Charting the rise of technical analysis

K. Edgeley

8

2009 Market perspectives

T. Parker

10

Perpectives on technical analysis

J. Hanahodzid

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MARCH 2009

www.sta-uk.org

No. 63

behaviour, he put the recent turbulence within an historical perspective.The chart below shows how 1-day percentage changes tend to cluster around a centre of gravity of relatively small moves in the middle of the diagram. Over the past 62 years two main events have been outside this inner core – October 1987 and October 2008. In other words, if looked at from sufficiently wide perspective, seemingly random movements assume an order or pattern. As a corollary, it is clearly possible to identify unusual events.

DJ Industrial Average: Jan 1946 to Nov 2008 1-day percentage changes

Average: Jan 1946 to Nov 2008 1-day percentage changes Overall, the Paris conference provided a forum

Overall, the Paris conference provided a forum for some very interesting discussions and was a useful step in developing a better understanding of how academics and market practitioners can work together.

The education committee under John Cameron’s direction have just completed another foundation course. The course for the diploma will begin this month.The autumn Diploma exam resulted in one Distinction, 19 passes and 9 fails.

FOR YOUR DIARY

10th February

How to use the lesser known Tom De Mark Oscillators Speaker: Trevor Neil

10th March

Technical analysis – art or science Speaker: Tim Parker

15th April

Speaker: Julien Nebanzahl

N.B. Unless otherwise stated, the monthly meetings will take place at the British Bankers Association, Pinners Hall, 105 -108 Old Broad Street, London EC2N 1EX at 6.00 p.m.

PUBLICATION OF THE NEXT ISSUE APRIL 2009

2 Issue 63 – January 2009

Networking

WHO TO CONTACT ON YOUR COMMITTEE

CHAIRMAN

Deborah Owen: editorial@irc100.com

TREASURER

Simon Warren: warrens@bupa.com

PROGRAMME ORGANISATION

Mark Tennyson-d'Eyncourt: mdeyncourt@csv.org.uk

Axel Rudolph: axel.rudolph@dowjones.com

LIBRARY AND LIAISON

Michael Feeny: michaelfeeny@yahoo.co.uk

The Barbican library contains our collection. Michael buys new books for it where appropriate. Any suggestions for new books should be made to him.

EDUCATION

John Cameron: jrlcameronta@tiscali.co.uk

Adam Sorab: adam.sorab@cqsm.com

IFTA

Robin Griffiths: robin.griffiths@cazenovecapital.com

MARKETING

Clive Lambert: clive@futurestechs.co.uk Simon Warren: warrens@bupa.com Karen Jones: karen.jones@ commerzbank.com

MEMBERSHIP

Simon Warren: warrens@bupa.com

REGIONAL CHAPTERS

Alasdair McKinnon: AMcKinnon@sit.co.uk

SECRETARY

Mark Tennyson d’Eyncourt: mdeyncourt@csv.org.uk

STA JOURNAL

Editor, Deborah Owen: editorial@irc100.com

WEBSITE

David Watts: DWattsUK@aol.com Simon Warren: warrens@bupa.com Deborah Owen: editorial@irc100.com

Please keep the articles coming in – the success of the Journal depends on its authors, and we would like to thank all those who have supported us with their high standard of work. The aim is to make the Journal a valuable showcase for members’ research – as well as to inform and entertain readers.

The Society is not responsible for any material published in The Market Technician and publication of any material or expression of opinions does not necessarily imply that the Society agrees with them. The Society is not authorised to conduct investment business and does not provide investment advice or recommendations.

Articles are published without responsibility on the part of the Society, the editor or authors for loss occasioned by any person acting or refraining from action as a result of any view expressed therein.

MARKET TECHNICIAN

as a result of any view expressed therein. MARKET TECHNICIAN STA diploma results AUTUMN 2008 Distinction

STA diploma results

AUTUMN 2008

Distinction

C. Bain

Pass

A

Al Haddad

N

Al-Rantisi

T Babooa

D Binnington

C Chevalier

P Colas

D Grover

M

Harniman

J

Hawbrook

N Holt

S Kelly

C

Manian

C Matthews

A Myers

H Rashdan

J Remington-Hobbs

N Suiffet

C Viketos

D Williams

STA Diploma Course 2009

The STA is again holding its Diploma course in Technical Analysis at the London School of Economics in Aldwych.

All teaching is by STA members.

The course runs from: 14 January – 2 April 2009

It prepares students for the Diploma examination in April 2009. The Course consists of 11 Wednesday evenings and is followed by a full Exam Preparation Day (including Report writing), on Thursday 2 April 2009. The sessions are from 6.00pm to 9.00pm and the Exam Preparation Day, which includes lunch, runs from 9.30am to 5.00pm. The Exam itself lasts three hours and will be held Wednesday 22nd April 2009.

It is possible to attend individual lectures.

If you would like further information please contact Katie Abberton on

0845 003 9549

MARKET TECHNICIAN Obituaries Issue 63 – January 2009 3 Françoise Skelley 1963 – 2008 On

MARKET TECHNICIAN

Obituaries

Issue 63 – January 2009

3

Françoise Skelley 1963 – 2008

On rare occasions in our personal and professional lives, we meet certain people who are unique, who make a lasting impression. It may be because of their fierce intelligence, their strength of character, passion for life, loyalty, or their complete sense of fun. Françoise Skelley was such a person, and she had all of these qualities in abundance.

Fran started her career in technical analysis in the late 1980s, when she and her husband Steven were running a TA consultancy. However, it wasn’t until she joined Credit Suisse in 1992 that she really came to international prominence. Here she built a world renowned team and created many innovative technical products.

Full of energy and never afraid to state her views, Fran was passionate about technical analysis and always looking to learn new techniques. She was, though, equally focused on the correct and disciplined application of the core basics, and her approach to market analysis was rigorous and thorough, professionalism at its peak. But her real joy was in calling market tops and bottoms, which she did on a regular basis.

Fran had a close association with the STA, where she was a member of the forward planning and grandfathering committees, and was an active and enthusiastic supporter of the annual dinners and conferences, where she became a recognised speaker. She also felt strongly about IFTA, attending many of its conferences and was herself a speaker at the London IFTA conference in 2002. She was also a member of the American Association of Professional Technical Analysts. Fran was made a Fellow of the UK Society of Technical Analysts in 2005.

When speaking to friends and colleagues, words and phrases that repeatedly cropped up when describing Fran were: “wonderful”, “intelligent”, “fun”, “loyal”, “independent”, “strong”, “passionate”, “force of nature”,“didn’t suffer fools”, “unafraid of anyone or anything”. She had that rare ability to light up and enliven any event, whether a professional business meeting or a social gathering. For those that worked with her, she was an inspirational colleague and a loyal and trusted friend.

Fran was diagnosed with cancer in early 2007 and passed away in August 2008, after a brave fight, at the tragically young age of 45. Her strength of character, practicality and lack of self-pity during this period was incredible to behold, not just to family and friends, but also to the doctors and nurses. We extend our thoughts, sympathies and prayers to her family, with whom we share great sadness at this loss.

David Sneddon and Anne Whitby

Ian S. Notley 1936-2008

Ian passed away in May of 2008 after a bout with cancer. I first met Ian in the 1970s when he spoke in New York City. One could only be impressed with his knowledge of the subject under discussion and his erudite manner of presentation. I became a dedicated follower and learned much from Ian over the years.

He did a great service to the industry by presenting his cyclical material with style and confidence. His delivery did as much to convince audiences as did the integrity of his data and his thorough knowledge of past market cycles. Ian always stuck to his guns, and his resolve was based upon history, market and political history. I recall his presentation in Canada in 1989 during which he said that the economy and the markets were about to turn up. Many were very dubious, citing the fundamental problems of the day. Ian remained resolute and his forecast proved to be accurate. I am certain that we all have similar stories to tell.

He had moved from Australia to Canada in the early 1970s, working with several firms in Toronto. In 1987, he moved to Connecticut and formed Yelton Fiscal, his own advisory group. He supported our craft during his entire career, being one of the founders of the Canadian Society of Technical Analysts (CSTA) and of the International Federation of Technical Analysts (IFTA). We all remember the Walkabout, Ian’s introductory session at IFTA conferences. In 1993, he was awarded a Fellowship of the Society of Technical Analysts and was given an award for Cycle Wave Analysis by the MTA in New York in 1997. In 2002, he was presented with the A.J Frost award by the CSTA. In 2006, the MTA honoured him again with an annual award in recognition of innovative work.

Ian said that “A man lives on through his protégés” and Ian certainly developed a following of dedicated and knowledgeable professionals who remain students of the markets.” His work and his service is continuing under the guidance of Jonathan Arter who spent nearly twenty years working with Ian and who recently conducted the always well received Walkabout at the IFTA conference in Paris.

Ian personally altered my life when he introduced me to an Arab who subsequently hired me. This led to my marriage and 14 years in the Gulf. My wife and I always looked forward to his visits to our villa and our discussions of history and culture. Surya and I and Ian’s many Arab friends miss him, as well as all of those who knew him worldwide.

Bill Sarubbi

4 Issue 63 – January 2009

Market forecasts for 2009

MARKET TECHNICIAN

– January 2009 Market forecasts for 2009 MARKET TECHNICIAN The article is a summary of a

The article is a summary of a presentation given at the November 2008 IFTA conference.

By Julien Nebenzahl

This presentation will examine the 2009 outlook for the foreign exchange, bond and commodity markets together with the major stock indices.

FOREX 2009 Chart 1 shows the monthly Euro/dollar cross rate. The analysis displays a double top at $1.6, which is also the top of a long term channel. The logical correction is very violent and seems to be cyclical. The first “quote” of the Euro/dollar (January 1999) is $1.17; which is also the pivot of the 1999-2008 downside and upside swings. The most favoured scenario is, therefore, a fall of the Euro/dollar during 2009 with $1.17 the major target. Any brief rally below $1.4910 will confirm this forecast (selling area) but a break up above this threshold level would trigger a new wave of buying, probably take the rate to a high of around $1.64 (alternative scenario). Once the $1.17 level is reached, the Euro/dollar should resume its secular uptrend (2010-2012).

Chart 1

resume its secular uptrend (2010-2012). C h a r t 1 BONDS 2009 The Eurozone bond

BONDS 2009 The Eurozone bond contract, the Bund, has been moving broadly sideways since establishing a major top at 124.60.The market seems

Chart 2

establishing a major top at 124.60.The market seems Chart 2 to be tracing out a flat

to be tracing out a flat and somewhat complex correction which is likely to continue over the coming months until the 118.50 level is breached. This technical signal will trigger a huge rally toward new highs, above 124.60 and could occur within the next three to six months.

COMMODITIES 2009 Oil (shown on Chart 3) is about to reach the 38.2% fibonacci ratio of $52. This level could trigger an intermediate bounce but the fall from $150 has been so strong that 50% is a more likely retracement target. Oil should bounce from the $35/37.50 area, probably helped by momentum supports (such as the 52-wk displayed here). This reversal will nevertheless take some time as bottoms in commodity markets are commonly ‘rounded’ (whereas tops are ‘V- Top’ patterns as seen at the $150 peak). From this support area, oil should rally back up to $100 in the course of 2009 and probably higher in 2010, with the potential to make new all-time highs.

Chart 3

2010, with the potential to make new all-time highs. Chart 3 Gold (chart 4) has been

Gold (chart 4) has been the strongest commodity during the financial turmoil. A 38.2% ratio should complete the correction of the previous bullish Elliott cycle and, from here, some rebound should occur. But the current complex correction (ABC/X) allows for a longer base formation than that of oil. Under this central scenario, gold should move sideways during 2009, possibly bottoming at $635, the 50% ratio. The two boundaries ($725 and $635) are clearly long term entry prices for the on-going secular bullish movement.

EQUITY INDICES 2009 Chart 5 shows the S&P500 implied volatility. Markets have clearly entered a new highly-volatile territory.This should last another two to three years with the lows unlikely to fall below 30. In the short term, it is very difficult to evaluate the possible paths of a crash given the high volatility.

MARKET TECHNICIAN Chart 4 Chart 5 With a 50% fall in global equities in less

MARKET TECHNICIAN

Chart 4

MARKET TECHNICIAN Chart 4 Chart 5 With a 50% fall in global equities in less than

Chart 5

MARKET TECHNICIAN Chart 4 Chart 5 With a 50% fall in global equities in less than

With a 50% fall in global equities in less than 18 months, it is common sense to say that we are closer to the end of the correction process than the beginning.

In cyclical terms, the most important event is the failure of the US presidential cycle to trace out its usual pattern in 2006, as was the case in 1986 and the subsequent consequences of that episode are well known (see chart 6 of the STOXX600). Despite this major interruption in the four-year cyle, one can assume that the cycles will soon re-synchonize, as they have done in previous years -

Chart 6

re-synchonize, as they have done in previous years - Chart 6 Issue 63 – January 2009

Issue 63 – January 2009

5

especially if we understand the credit bubble as the main cause of this cycle disturbance. The four-year cycle points to a low in 2010; the 10-year (or business cycle) is expected to occur in 2012.

We can, therefore, have an intermediate rally before the 2010 and 2012 cyclical bottoms (given that both of them may or may not create new lows). The monthly chart of the STOXX600 (Chart 7) shows a bullish channel broken this autumn.This indicates that the trend is over but it leaves room for some recovery before a new correction gets underway. Once the current bottom is in place - and this could be either October 2008 or February 2009 (for the reasons discussed above, it is very difficult to evaluate the exact timing) - the favoured scenario is a fast rally toward 38.2% or even 50%, therefore a +33/50% rise from the lows.

Update on December 23rd:

Chart 7

+33/50% rise from the lows. Update on December 23rd: Chart 7 FOREX 2009 The sharp correction

FOREX 2009 The sharp correction in December has not challenged the Euro/dollar bearish scenario of $1.17 in 2009 because the $1.491/1.5 level has not been broken. However, volatility should decrease in the first quarter.

BONDS 2009 The outlook for bonds has changed dramatically: the upper threshold of the Bund has been realised much sooner than expected. Bond markets will remain strong in early 2009 and then peak before the end of the year.This correction could be an issue for financial markets.

COMMODITIES 2009 Oil is now on the support (50% ratio) and gold is still in the ABC/X complex correction.

EQUITY INDICES 2009 Markets are in the process of forming a base but no strong signal has appeared so far. It seems that the beginning of the year will still create anxiety before hope.

Julien Nebenzahl is the founder and President of DayByDay, the leading independent European technical analysis research house. He was chairman of the French society of Technical Analysis (AFATE) from 2004 to 2007 and is co-author of L'analyse technique, theories et methodes.

6 Issue 63 – January 2009

MARKET TECHNICIAN

6 Issue 63 – January 2009 MARKET TECHNICIAN Charting the rise of technical analysis Technical analysis

Charting the rise of technical analysis

Technical analysis along with behavioural finance (with which it shares many beliefs) is gaining more popular acceptance. Volatility in asset prices since the 2000 stock market peak commends a more active investment stance over a buy-and-hold strategy. Technical analysis is well placed to provide guidance in these troubled times.

The random-walk theorist and the technical analyst have been

prickly adversaries for more than 30 years. Burton Malkiel’s best

selling

1973 after a 20-year bull market; a “golden age” of growth, low inflation and minimal unemployment. The book suggests that markets fluctuate with no set pattern around an intrinsic fair value. If

the theory holds, prices will reflect all available information and any residual excess return will be random; the best strategy in the stock market in such an environment is one of buy-and-hold. The book suggests no excess return can be generated by the use of technical or fundamental analysis. Certainly, in the years preceding 1973, buy- and-hold seemed to be the best course of action for equities, but in the 10 years thereafter it was significantly less profitable.

book “A Random Walk Down Wall Street” was first published in

Figure 1: Inflation adjusted S&P (source: Haver Analytics)

1: Inflation adjusted S&P (source: Haver Analytics) The crowd drives the trend The rational investor, Homo

The crowd drives the trend The rational investor, Homo Economicus, beloved in the ivory towers of academia, bases his decisions on the maximisation of wealth and utility. However, he is an elusive creature once he steps on to Wall Street and his progress is far from random. The advances and recognition of behavioural finance, with its basis in cognitive and emotional biases, do not explicitly commend technical analysis, but the technical and behavioural approaches share many beliefs. Traditional economics proposes that the rational investor will learn from past mistakes, but a psychological approach would argue against this. Psychologists and technical analysts suggest that past behaviour is the best predictor of future behaviour; cognitive biases cause sentiment to fluctuate cyclically from extreme optimism to extreme pessimism.

Kondratieff, Schumpeter and Kitchin, among others, have identified repetitive cyclical rhythms in economic activity. It is the

By Kevin Edgeley, CFA, MFTA

interaction of cycles of different length that give the appearance of randomness but, in reality, this interaction is far more predictable. The cyclical rotation out of stocks and into commodities in the 1970s may be before the memory of many currently in the market place, but again, after a 20-year bull run in equities, we have seen a similar rotation since the 2000 stock market peak. Politicians may make claims to reduce boom and bust, but attempts to smooth out economic activity are often in vain, as we are now discovering.

The argument of what drives asset returns is one of the logical against the psychological. The “rational” investor may exist in isolation, but when he enters the market place he becomes one of the crowd and is governed by the group mentality. This herding behaviour is often driven by expectations based on prior price action; in this respect the individual can become influenced by the sentiment of the crowd. The market reaction to a news release is based on how the outcome differs from the pre-announcement consensus forecast. Crowds can sometimes reflect better the sum of the individual members’ knowledge but can also behave irrationally when trends extend; hence the old Wall Street adage – “right during trends, but wrong at both ends”. As Charles Dow said “the market reduces to a bloodless verdict all knowledge bearing on finance”. In this respect, technical analysis agrees with Fama’s Efficient Market Hypothesis in that prices discount everything, reflecting shifts in supply and demand; where it differs is in emphasizing the potential for crowd psychology to drive trend activity.

The trends are in the distribution tails Biases prevail in almost all market behaviour; these can range from overconfidence in a price forecast to the rejection of data or analysis that contradicts one’s current trading position. An expectations bias can develop when relying on a past correlation between two securities to continue indefinitely. Optimism and confidence dominate decision making and investors tend to overestimate their knowledge, underestimate risk and exaggerate their ability to control their emotions.

A key argument against the random walk theory is extreme price movement. Prices do find a long-run equilibrium, albeit a rising one in stocks linked to economic growth, but there are also periods of serial correlation. How often do moves of three, four or more standard deviations from the mean occur? Certainly more than a normal distribution would allow. Market returns do not follow a normal path, the distribution being more leptokurtic, with fatter tails at the distribution extremes reflecting the trend activity that a technical analyst looks for.

Technical tools The ability to identify clearly the prevailing phase of the market is critical to successful analysis. A range-bound market of price fluctuations around a stationary mean provides trading opportunities if one can identify when prices will revert to the mean. By using a bounded oscillator such as the Relative Strength Index, it is possible to time entry and exit points to trade the range.

MARKET TECHNICIAN A trending market provides quicker returns, but oscillators are often a poor tool

MARKET TECHNICIAN

A trending market provides quicker returns, but oscillators are often

a poor tool in such an environment; they will gravitate to the upper,

or overbought, area in a bull trend and the lower or oversold area in

a down trend. The more traditional tool for trading a trend is a

moving average system which will maintain directional positions as the trend develops, but the problem remains - which is the best moving average? The significance of a break above or below a moving average is often over-emphasized. Contrary to popular opinion, the optimal average length varies across time and across asset class. The identification and measurement of trend strength is the key determinant in investment selection; an indicator such as Wilder’s Average Directional Movement Index (ADX) can be used to measure the relative trend performance of different assets but note that this indicator measures the strength of a trend, not its direction. Many funds and managed programs use variations on these themes for price direction and market timing purposes.

Complementary analysis The technical and fundamental approaches are not necessarily contradictory. Fundamental analysis looks at the cause of economic change – supply and demand, productivity, industrial development – technical analysis looks at the effect. These fundamental drivers impact on the market consensus and thereby on price. Price can and does vary from a fundamental fair value. The difference can often be one of value against momentum. In fundamental terms, a stock may look cheap and worthy of a buy recommendation but technically, the momentum of a price trend may make the stock cheaper still as the move enters the fat tail of the distribution. The net result may be a buy at the same level as a fundamental strategy buys against the trend on the way down, while a technical strategy buys with the trend on the way back up.

Technical analysts have often been accused, probably rightly in many cases, of a lack of rigour in testing their beliefs. There have

Figure 2: FTSE 100 and Trend Strength (source: Updata)

Issue 63 – January 2009

7

been a number of empirical tests on the validity of chart patterns, with varying results as these subjective patterns are difficult to quantify. Others have found persistent serial correlation in prices - the so-called momentum effect. Many academics, however, remain sceptical of technical analysis due to its inconsistency with traditional financial theory. Blind adherence to a moving average breakout or a particular chart pattern as a signal for a price move does not endear technicians to the broader market. However, in the same way a fundamental analyst would not rely purely on a low P/E ratio for recommending a stock purchase, sound technical analysis relies on a mix of different indicators to generate a trade recommendation. Technicians make no claims to get the market right every time, but more and more empirical research on behavioural principles reinforces the case for technical analysis to play a more prominent part in the investment process.

Professional fundamental analysts vastly outnumber those using a technical approach, but the technical contingent is growing and is supported by regional societies in the same way as the CFA. Many regional chapters run an education syllabus; in the UK this leads to the STA Diploma, and on further study to the IFTA Master of Financial Technical Analysis. This education process aims to provide more rigorous support for technical methods.

The current market environment is supportive of further growth in the use of technical methods. In the 1970s, the US stock market changed phase from trend to range and, although there were periods of serial correlation within this range, these trends were short term and fluctuated around a fairly stationary long term mean. This period led to a number of innovations in the technical world and it is likely that the current market conditions will engender further expansion in the use of technical analysis.

This article first appeared in Professional Investor (Autumn 2008)

further expansion in the use of technical analysis. This article first appeared in Professional Investor (Autumn

8 Issue 63 – January 2009

2009 market perspectives

MARKET TECHNICIAN

– January 2009 2009 market perspectives MARKET TECHNICIAN The article is a summary of a presentation

The article is a summary of a presentation given at the November 2008 IFTA conference.

By Tim Parker

This article is a re-run of a short presentation I made to the International Federation of Technical Analysts in Paris in early November, when the world seemed to be falling apart.The analysis I used was based on mainstream Dow Theory, using many longer term charts for perspective while making some important inter- market observations.

By November 2008 returns in global equity markets had posted their worst year since the 1970s. The US equity markets fell 43% in 1931, and in 2008 to date were already down 40%, and appeared to be heading for their second worst year after 1931 in 140 years. In addition, volatility was exploding (7 days in October saw falls of 4% or more), hedge funds and others were deleveraging fast, and forced selling was beginning to emerge everywhere; downgrades to corporate profits had hardly even begun, credit spreads were rapidly widening, and so on

The charts, however, were more encouraging:

1. S&P 500 Index: On the monthly bar chart the coincidence of support from the 1982 uptrend and the 2002 low (a 100% retracement of the 2002-07 rally) were too significant to ignore. Also the long term RSI was becoming extravagantly oversold. A reaction at just below 750 was to be expected.

oversold. A reaction at just below 750 was to be expected. 2.The VIX: blew out to

2.The VIX: blew out to historic highs by end October.The key use of this measure is to look for a lower high on the indicator coincident

is to look for a lower high on the indicator coincident with a new low November.

with a new low November.

on the S&P

500. This

was

to be

seen in late

3. The TED Spread (the spread between 3-month interbank rates

and the 3-month US Treasury Bill yield).This market is at the core of the global financial crisis (rather than equities), so must be watched. By 3rd November it had fallen 38% from the highs.

watched. By 3rd November it had fallen 38% from the highs. 4. Spot Gold (in US$):

4. Spot Gold (in US$): On 6th November this chart was telling us

that a supposed key beneficiary of de-leveraging was not working that well, despite US$ strength.

was not working that well, despite US$ strength. 5. Japanese Yen Trade-Weighted Index:This de-leveraging

5. Japanese Yen Trade-Weighted Index:This de-leveraging beneficiary,

but was already 11% off its highs,

on the other hand, worked well

suggesting a cooling off in the panic to unwind the carry trade.

already 11% off its highs, on the other hand, worked well suggesting a cooling off in
MARKET TECHNICIAN 6. US 10-Year Treasury Note Yield: I pointed out that a one-year basing

MARKET TECHNICIAN

6. US 10-Year Treasury Note Yield: I pointed out that a one-year

basing process may have been underway

completed and, instead, yields collapsed to record lows. Again, this is not necessarily bearish for equities in comparative yield terms.

in fact this was never

equities in comparative yield terms. in fact this was never 7. US$ High Yield Corporate Bond

7. US$ High Yield Corporate Bond Index: at extended levels, and

may also have been topping out.

at extended levels, and may also have been topping out. 8. Asian Equities: steepened downtrends were

8. Asian Equities: steepened downtrends were just broken.Was this

the first sign of imminent basing?

9. Taiwan TAIEX index – monthly chart. The long term chart of this

equity market showed a reaction at significant 18-year uptrend support.

showed a reaction at significant 18-year uptrend support. the Shanghai Composite index had retraced 100% of

the Shanghai Composite index had

retraced 100% of the bubble and was now approaching lots of support at the prior 8-year range.

10. China: back to basics

11. DJ EuroStoxx 600 Pan European index: this was showing a long term oversold condition at the 20-year uptrend

12. Defensive sectors were testing the top of multi-year relative

ranges: such as the ratio of the Food & Bevs sector against the DJ EuroStoxx 50 index.

Issue 63 – January 2009

9

the DJ EuroStoxx 50 index. Issue 63 – January 2009 9 13. Another defensive sector at
the DJ EuroStoxx 50 index. Issue 63 – January 2009 9 13. Another defensive sector at
the DJ EuroStoxx 50 index. Issue 63 – January 2009 9 13. Another defensive sector at

13. Another defensive sector at 10-year relative highs was Health Care.

defensive sector at 10-year relative highs was Health Care. Conclusion All was looking bleak in early

Conclusion All was looking bleak in early November, and by Christmas it is still a very fraught environment. However, the longer term charts are not all that bad, and we wouldn’t be surprised to see a better 2009 in markets than generally anticipated.

Tim Parker is Managing Director of PH Partners Ltd www.phanalysis.com

10 Issue 63 – January 2009

MARKET TECHNICIAN

10 Issue 63 – January 2009 MARKET TECHNICIAN Perspectives on technical analysis Introduction Ever since the

Perspectives on technical analysis

Introduction

Ever since the emergence of modern finance theory, the followers of technical analysis have found themselves marginalized by the financial establishment and held at bay by fortress walls built on misunderstanding and contempt; misunderstanding, since the technical jargon of head-and-shoulders, wedges, and pennants does not resonate with minds steeped in physics and statistics; contempt, for the fervent adherents of modern finance reject the mere possibility of patterns in market prices. Such a segregative state of affairs hints at the striking dichotomy which permeates the financial world. On the one hand, academics tend to embrace the efficient markets hypothesis which, roughly speaking, stipulates that markets are unpredictable, in the sense that there is no way to forecast future prices based on previous ones and thereby make a profit. The efficient markets hypothesis was shaped in the writings of Eugene Fama and Paul Samuelson in the 1960s, and despite the recent proposals of alternative hypotheses, it remains deeply ingrained in the culture of academic finance.

This stands in sharp contrast with technical analysis, which attempts to divine market’s direction based on past prices. Often and quite controversially this is done by searching with the naked eye for certain patterns in price histories that are believed to embody the prime mover of all market action: crowd psychology. For example, a sequence of successively higher highs and lower lows which traces the so-called “triangle bottom” pattern in the price data is usually interpreted by technicians as a manifestation of strengthening confidence punctuated by subsiding terror, and hence as the presage of an uptrend. Perhaps surprisingly, technicians in some cases do appear to make consistent profits that cannot be attributed to chance alone.

In the light of this dichotomy, the rift between academics and technicians is not quick to heal, but may require the two communities to take a careful look at the other. In this article we present our insights from one exploration of technical analysis, spanning past, present, and future. First, to place technical analysis in context, we conduct a historical study of its evolution through time and across cultures. Second, we deal with the current lack of formalisation of technical analysis: there is no complete agreement on what technical analysis is, with many texts only partially overlapping on the methodologies to be employed. Consequently, our second main endeavour is to understand fully what present- day technical analysis consists of, and to this end we conduct interviews with its current leading practitioners. Finally, we consider the future of technical analysis, which in our view will move away from ambiguous heuristics towards formally defined indicators and dynamic strategies, capturing the ever-changing nature of financial markets. In the rest of this article we discuss these three perspectives in turn, each the subject of a forthcoming book co-authored with Andrew Lo.

The historical context of technical analysis

That human nature will never change and technical analysis

By Jasmina Hasanhodzic

therefore never become obsolete is often heard from seasoned technicians. But if fear and greed have always been the main drivers of supply and demand in the markets, then technical analysis that measures supply/demand imbalances should have spread its web of roots deep in the realms of history and widely across civilizations. Historical evidence suggests that this indeed is the case. Arguably as old as the markets themselves, technical analysis dates back to at least the ancient Babylon of the 7th century B.C. This evidence comes from a set of price diaries that survived until our time, 1 where the prices of the same six commodities such as barley, dates, sesame, and wool were carefully charted, continuously through centuries, with the purpose of predicting them. In fact, just like contemporary technical analysts do, the diary keepers would adjust the frequency at which they recorded the market quotations according to the level of market volatility.

More recently, technical analysis was used in the 17th century at the Amsterdam Exchange where business was conducted in a way that is remarkably similar to that of current exchanges. In Confusión de Confusiones (1688), one of the oldest books ever written on stock exchange business, Joseph de la Vega provides a vivid account of the dynamics of this Exchange and observes that “on this point we are all alike – when the prices rise, we think they will run away from us,” suggesting that people at that time were naturally inclined to make inferences about future prices based on past ones.

From the 18th century, the evidence that technical analysis was used in Japan comes from the writings of the legendary trader Munehisa Homma, who in his book The Fountain of Gold describes how market psychology can help predict prices; for example, “when all are bearish,” he suggests that “there is a cause for prices to rise.” 2 Homma also documents the “candlesticks” charting technique, which is used to this day, especially in Japan.

Skipping one century ahead, to late imperial China, the similarities between Chinese merchant manuals and present-day technical analysis texts manifest themselves in the emphasis of both on the cyclicality of markets and the role it plays in market timing. The statement from Essential Business, one such manual, that “when goods become extremely expensive, then they must become inexpensive again” 3 is as fully understandable now in the context of trend reversals as it was then.

The foundations of the present-day technical analysis were laid down in the early 1900s by Charles Dow. In the January 4th, 1902 edition of The Wall Street Journal, Dow proposed his famous definition of a trend as a sequence of successive highs and lows by saying that “it is a bull period as long as the average of one high point exceeds that of previous high points.” However, even this most recent form of technical analysis has never been formalised, but continues now as always to flourish on the fringes of the establishment and pass from one generation to the next through odd apprenticeships and confabulations, remaining to this day a most colorful part of the financial folklore.

MARKET TECHNICIAN Insights from the interviews with leading technicians Given the lack of standardisation of

MARKET TECHNICIAN

Insights from the interviews with leading technicians

Given the lack of standardisation of technical analysis, learning about it from books is a daunting task: the contradictory advice and loose and frequent use of qualifiers such as “often” and “probably” throws the uninitiated into ambivalence and confusion. Learning about technical analysis from its leading practitioners is more inviting; after all, that is how this intricate craft survived till our time – not through books, but through the word of mouth.

If a single word could summarise the interviews we conducted, it

would be “diverse,” as it captures both the intriguing beauty of this craft and the troubles that plague it. Spanning a striking variety of styles in their practice of technical analysis, our interviewees range from short-term traders (Raschke, Weinstein) to educators (Murphy, Acampora), long-term investors (Desmond, Deemer), artist technicians (McAvity), highly eclectic technicians (Dudack), historians (Shaw),long-term market theme writers (Farrell),and those who insist on being labelled market rather than technical analysts (Birinyi).

Diverse, too, are their interpretations of technical analysis, a telling illustration of which is provided by their responses to the question “does the lack of hard and fast rules in technical analysis ever bother you,” which varied from “that’s exactly what bothers me” to “but there are hard and fast rules in technical analysis.” The interviewees do agree however on one point, and that is the significance of the role intuition plays in their decision making. As Murphy puts it,“I’m not sure I could explain to you how I do what I do. I look at many things in a short interval of time and come to a conclusion.” That elusive skill may explain why these practitioners do not have a problem with sharing their knowledge, the tools they develop, or the strategies they pioneer.There is no single right way to put it all together. Everyone does it in slightly and sometimes widely different ways. Some technicians operate best in complete isolation from the outside world – Linda Raschke, who does not watch TV or read The Wall Street Journal, is a prime example – others prefer to complement their technical per- spectives with fundamental, economic, and political ones.

The palpable heterogeneity among leading technicians that emerges from our interviews yields a potential explanation for the lack of impact that technical analysis has had on the broader financial community. Without a unified, standardised, and broadly recognised body of knowledge in which every practicing technician must be conversant, it is difficult to see how technical analysis can spread. The advent of the Chartered Market Technician program by the Market Technicians Association is a step

in the right direction but, as our interviews underscore, there is still

a considerable amount of art and subjectivity in the practice of technical analysis.

Towards a science of technical analysis For too long languishing in the murky waters of part art-part science, technical analysis is finally starting to develop a more rigorous approach. Big strides, indeed, have been made towards the standardisation of technical analysis in recent years, such as by Aronson (2007) and Kirkpatrick and Dahlquist (2006). The impetus for statistically evaluating technical analysis naturally comes from academia, with studies yielding evidence of its validity in wide- ranging areas, such as moving averages (Brock, Lakonishok, and LeBaron, 1992), genetic algorithms to discover optimal trading rules (Neely,Weller, and Dittmar, 1997), and the Dow Theory (Brown, Goetzmann, and Kumar, 1998), to name a few.

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In their quest to quantify technical analysis, academics have turned, too, to the most controversial of its techniques: patterns. Finding patterns in price charts is a subjective endeavour that relies on the natural smoothing filter of the human eye; a main challenge therefore in quantifying the patterns lies in modelling the way in which eyes smooth the data they view. The pioneering works by Chang and Osler (1994, 1999) and Lo, Mamaysky, and Wang (2000), as well as the recent extension of the latter by the author (Hasanhodzic, 2007), take on this challenge by smoothing the data using statistical filtering techniques, such as kernel regression and neural networks. They then develop algorithms to identify automatically technical patterns in that data, and finally evaluate the information content of the patterns thus found. 4 These works, too, find proof of the validity of technical analysis.

The observation that human nature never changes, and that consequently technical indicators designed to measure the reflection of human nature in market prices never change either, is a notable argument in favour of technical analysis, but one that at the same time underscores its main shortcoming: technical analysis has not kept up with technological advances. Of course, charting and data collecting have become automated, but most popular patterns and heuristics of today were developed in the pre- computing age when calculating a simple moving average was a formidable task. For example, a 10-day moving average became popular because it was easy to compute – one could divide by ten simply by moving the decimal place to the left – not because it was statistically optimal, and it remains commonly used to this day.

Suboptimal parametrisation is only a symptom of a chronic disease afflicting technical analysis: its static nature cannot account for the ever-changing character of financial markets. In the past, when execution was manual and costly, and financial systems far less connected and complex, “static” used to be a prerequisite for implementability, now it is a condition for failure. As markets evolve and trading strategies become more sophisticated, the need for new, dynamic indicators becomes apparent. Never has this need been more urgent than now, when in the light of the events of last year’s August, one can no longer deny that hedge funds have become a paramount force: it is not the feeling of the crowd but the action of a single gigantic hedge fund that precipitated the crisis continuing to this day. This is echoed by many of our interviewees, including Walter Deemer who finds ingenious ways of tracing the hedge-fund activity indirectly, via certain mutual funds: “I am convinced that these 6 or 7 billion dollars of assets in Rydex funds reflect the general hedge-fund trading activity which is the driving force in the market,” he notes.

Directly tracking hedge-fund activity is of course what one would want, but this is problematic if not infeasible for, shrouded in secrecy, hedge funds are notorious for their inaccessibility and infrequent reporting. A possible way to circumvent this problem is jointly proposed by the author (Hasanhodzic and Lo, 2007), and consists of replicating hedge funds in a transparent and publically available format. Starting from the empirical observation that a large portion of hedge-fund returns can be obtained by passive exposure to certain common risk factors – such as those captured by stocks, bonds, currency, commodity, and credit markets – we show how hedge-fund returns can be expressed in terms of returns realized in those markets, via a linear regression model. Based on this idea, a number of prominent asset-management firms have recently launched mutual funds that aim to replicate

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hedge-fund factor exposures. Unlike hedge-fund returns, the returns of these funds are public and updated daily, and can be used as an indicator of the aggregate performance of the hedge- fund sector. Moreover, assets flowing in and out of these mutual funds are publically available, which raises the possibility of using them to gauge the investors’ sentiment shifts.

Conclusion

In this article we presented some of our perspectives on technical analysis spanning past, present, and future. Our historical exploration reveals that technical analysis was a force throughout centuries and across cultures. Our interviews with the present-day masters of technical analysis help us understand what technical analysis is, and armed with that understanding we can move towards the future, which in our view consists of standardisation and development of new indicators to measure fast-changing market environments. Although the fortress walls separating technicians from the adherents of modern finance still stand tall, they are not insurmountable, and we hope that the growing volume of in-depth examinations of technical analysis will awaken the sceptics and open the door for the dialogue between the two communities to begin.

1 As documented by Slotsky (1997).

2 As quoted by Nison (1994).

3 As quoted by Lufrano (1997). 4 It is important here to distinguish between evaluating “profitability” of technical trading rules and evaluating the “information content” of technical analysis; the former necessitates the modelling of the trading implementation and risk management, whereas the latter detects supply/demand imbalances regardless of whether or not one can profitably act on that information.

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Jasmina Hasanhodzic, Ph.D. is a research scientist at AlphaSimplex Group, LLC. The views and opinions expressed in this article are those of the author only, and do not necessarily represent the views and opinions of AlphaSimplex Group, MIT, or any of their affiliates and employees. The author makes no representations or warranty, either expressed or implied, as to the accuracy or completeness of the information contained in this article, nor does she recommend that this article serve as the basis for any investment decision – this article is for information purposes only. The research summarized in this article was supported by the MIT Presidential Fellowship and the MIT Lab for Financial Engineering.

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