56 - 2001 Winter

SM
MTA JOURNAL
2001
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THE MTA JOURNAL TABLE OF CONTENTS

FALL-WINTER 2001
ISSUE 56
THE MTA JOURNAL E DITORS AND REVIEWERS
MTA MEMBER AND AFFILIATE INFORMATION
MTA 2001-2002 BOARD OF DIRECTORS AND MANAGEMENT COMMITTEE
EDITORS COMMENTARY
Henry O. Pruden
EDITORS FAREWELL
Henry (Hank) O. Pruden, Ph.D., Editor & David L. Upshaw, CFA, CMT, Associate Editor
THE ART OF TECHNICAL ANALYSIS
Harry W. Laubscher
TECHNICAL VERSUS FUNDAMENTAL ANALYSIS: A VIEW FROM ACADEME
Hamid B. Shomali, Ph.D.
A DOW THEORY UPDATE
11
Ralph J. Acampora and Rosemarie I. Pavlick
IT PAYS TO BE CONTRARY
15
James L. Fraser
TEN WAYS TO PROFIT FROM A RUNAWAY BULL MARKET
21
James Dines
ANATOMY OF A TRADING RANGE
23
Jim Forte
MTA JOURNAL
Fall-Winter 2001
ANSWERING THE BELL OF SENTIMENT INDICATORS
31
Brent L. Leonard
COMBINING TECHNICAL ANALYSIS WITH FUNDAMENTAL VALUATION TO CREATE A

RISK INDICATOR FOR THE STOCK MARKET
Jurrien H. Timmer, CMT
THE STORY OF THE THREE STOCK MARKET BOTTOMS:

THE PAPA BOTTOM, THE MAMA BOTTOM AND THE BABY BOTTOM
47
Kenneth Safian
EXPLOITING VOLATILITY TO ACHIEVE A TRADING EDGE USING AN AVERAGE-T RUE RANGE (ATR)
SECOND FILTER: MARKET-NEUTRAL/DELTA-NEUTRAL TRADING USING THE PRISM TRADING SYSTEMS
10
39
Jeff Morton, M.D., CMT and Randi Schea, M.D.
MTA JOURNAL
Fall-Winter 2001
55
THE MTA JOURNAL

FALL-WINTER 2001
ISSUE 56
EDITOR
Henry O. Pruden, Ph.D.
Golden Gate University
San Francisco, California
ASSOCIATE EDITORS
David L. Upshaw, CFA, CMT
Lake Quivira, Kansas
Jeffrey Morton, M.D. CMT

PRISM Trading Advisors
Missouri City, Texas
MANUSCRIPT REVIEWERS
Connie Brown, CMT
Aerodynamic Investments Inc.
Pawley's Island, South Carolina
John A. Carder, CMT
Topline Investment Graphics
Boulder, Colorado
Ann F. Cody, CFA
Hilliard Lyons
Louisville, Kentucky
Cynthia Kase
Kase and Company
Albuquerque, NM
Charles D. Kirkpatrick, II, CMT

Kirkpatrick and Company, Inc.
Chatham, Massachusetts
Cornelius Luca
Bridge Information Systems
New York, New York
Theodore E. Loud, CMT
Tel Advisor Inc. of Virginia
Charlottesville, Virginia
John McGinley, CMT
Technical Trends
Wilton, Connecticut
Michael J. Moody, CMT
Dorsey, Wright & Associates
Pasadena, California
Richard C. Orr, Ph.D.

ROME Partners
Marblehead, Massachusetts
Robert B. Peirce
Cookson, Peirce & Co., Inc.
Pittsburgh, Pennsylvania
Kenneth G. Tower, CMT
UST Securities
Princeton, New Jersey
J. Adrian Trezise, M. App. Sc. (II)
Consultant to J.P. Morgan
London, England
PRODUCTION COORDINATOR
PUBLISHER
Barbara I. Gomperts
Financial & Investment Graphic Design
Marblehead, Massachusetts
Market Technicians Association, Inc.

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MTA JOURNAL
Fall-Winter 2001

STYLE OF THE JOURNAL'S AUTHORS
MEMBER AND AFFILIATE INFORMATION
You want your article to be published. The staff of the

MTA Journal wants to help you. Our common goal can be
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Fall-Winter 2001

2001-2002 BOARD OF DIRECTORS & MANAGEMENT COMMITTEE
Board of Directors
Management Committee
(4 Officers, 4 Directors & Past President)
(4 Officers, Past President and Committee Chairs)
Director: President
Accreditation
Library
Ralph J. Acampora, CMT

Prudential Securities Inc.
212/778-2273, Fax: 212/778-1208
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J. Les Williams, CMT

Williams Capital Management, Inc.
817/548-8332, Fax: 817/548-9289
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John C. Brooks, CMT

Yelton Fiscal Inc.
770/645-0095, Fax: 770/645-0098
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Van Der Moolen LLC
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Samex Capital Partners
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Phil Erlanger Research Co., Inc.
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Directors:
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NDB Capital Markets Corporation
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Body of Knowledge
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Richard A. Dickson
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Education
Philip J. Roth, CMT

Morgan Stanley
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Ethics & Standards
Neal Genda
National City Bank
310/888-6416, Fax: 310/888-6388
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Foundation
Bruce Kamich, CMT

Reuters America Inc.
646/223-6043, Fax: 646/223-6049
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Bruce Kamich, CMT

Reuters America Inc.
646/223-6043, Fax: 646/223-6049
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Philip J. Roth, CMT

Morgan Stanley
212/761-6603, Fax: 212/761-0471
E-mail: philip.roth@morganstanley.com
Henry (Hank) O. Pruden

Golden Gate University
415/442-6583, Fax: 415/442-6579
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Kenneth G. Tower, CMT

US T Securities Corp.
609/734-7747, Fax: 609/520-1635
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IFTA Liaison
Internship
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Arbor Research & Trading
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Journal
Charles D. Kirkpatrick II, CMT

Kirkpatrick & Company, Inc.
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MTA JOURNAL
Fall-Winter 2001
Marketing
Membership
Larry Katz
Market Summary & Forecast
805/370-1919, Fax: 509/693-7473
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Newsletter
Anthony F. Dwyer
Kirlin Holdings
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Placement
Rick Bensignor
Morgan Stanley
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Regions
M. Frederick Meissner
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Rules
Charles S. Comer, CMT

ideaglobal.com
212/271-0769, Fax: 212/571-4334
Email: ccomer@ideaus.com
Seminar
Herbert G. Labbie, CMT

Technical Portfolio Strategies
412/391-3560, Fax: 412/391-2242
E-mail: labbieh@aol.com
Technology
Philip B. Erlanger, CMT

Phil Erlanger Research Co., Inc.
978/263-2536, Fax: 978/266-1104
E-mail: phil@erlanger.com
EDITORS COMMENTARY
Henry O. Pruden
A DYNAMIC BODY OF KNOWLEDGE
The six articles, reprinted in this issue, span the life of the existence of the MTA Journal. These articles give
testimony to the growing, dynamic quality of the body of knowledge we know as Technical Analysis. The
first two articles reflect the dynamic balance between the artful practitioner (Laubscher) and the scientific
academic (Shomali); Ralph Acampora's classic on Dow Theory appeared in the very first issue of the
Journal. This broad treatise on the market (joined by Dines) is followed by more specialized studies such as
Fraser and Leonard on sentiment, Forte on pattern recognition and Timmer on combining technical
indicators and fundamental information. And these articles are just a sample of the publications from the
MTA Journal. Some articles were selected from a list assembled by the MTA Educational Foundation;
others were chosen by the Editor. The two research notes by Safian and Morton are fresh contributions.
EDITORS FAREWELL
Henry (Hank) O. Pruden, Ph.D., Editor & David L. Upshaw, CFA, CMT, Associate Editor
Our deep and sincere thanks to the referees and staff of the MTA Journal, most notably Barbara Gomperts.
We are pleased to entrust the Editorship of the MTA Journal to the capable hands of Charles D. Kirkpatrick
II, CMT. And with the following, slightly modified verse from Rudyard Kipling, we bid our adieu.
The Long Trail
There's a whisper down the field where the year has shot her yield,
And the ricks stand grey to the sun,
Singing: "Over then, come over, for the bee has quit the clover,
"And your eleven years are done."
You have heard the beat of the offshore wind,
And the thresh of the deep-sea rain;
You have heard the song - how long? how long?
Pull out on the trail again!
Ha' done with the Tents of Shem, dear lass,
We've seen the seasons through,
And it's time to turn on the old trail, our own trail that is always new!
It's North you may run to the rime-ringed sun
Or South to the blind Horn's hate;
Or East all the way into Mississippi Bay,
Or West to the Golden Gate Were the blindest bluffs hold good, dear lass,
And the wildest tales are true,
And the men bulk big on the old trail, our own trail, the out trail,
And life runs large on the Long Trail - the trail that is always new.
MTA JOURNAL
Fall-Winter 2001
THIS ARTICLE APPEARED IN THE MTA JOURNAL, FEBRUARY 1986
THE ART OF TECHNICAL ANALYSIS

Harry W. Laubscher
Having spent almost twenty-nine of the last thirty years working in
the stock markets highways and byways, I hope that I have learned
something. We all manage to learn a great deal, regardless of what
field we work in, but all too often many of us tend to forget many of
the things that were learned and which should not have been forgotten. It has been often said that the stock market, along with drink
and women, is one of the great levelers of our time. Many of the
important pieces of market lore that we learned along the way, and
then in later years tended to forget, no doubt could have saved many
of us from experiencing many of the mistakes that all of us make. I
am reminded of this lately as I see a great rush on the part of inexperienced brokers and traders to be in the crowd regardless of where
that crowd is headed. For some strange reason, the more the stock
market rises, the more bullish many of us tend to become, finally
resulting in a great rush to own shares right at the top of the market.
On the other hand, it usually works out that the lower the market
goes in bear markets, the more bearish more people tend to become.
It has always been so, and as long as people are the driving force
behind all market movements, up or down, it will always be so.
We have all heard some of the sayings for which Wall Street is so
well known, such as sell on the good news and buy on the bad news.
Ive found that this does, indeed, work out to ones benefit more
often than not. During the Union Carbide fiasco in India when the
shares of the company dropped sharply to near 33, the wise people
were there buying all they could get, knowing full well that the lemming instinct had once again taken things too far. The recovery in
price of those shares since then is in the record for all to read and
great profits have been made in what everyone knew was going to
be a disaster for the company. More recently, we have the situation
of Texaco and Pennzoil. Many savvy traders recognized the rather
silly awarding to Pennzoil of several billions of dollars as an opportunity to acquire an historically good company at what appeared to
be bargain priced levels. As of this writing, the shares of Texaco are
still floundering near the 30-31 level, and although my point and
figure work suggests a potential downside count to approximately
the 29 level, I am advising investors with some patience to start acquiring Texaco shares in the 30-31 area. In time, this should work
out to be a good buy. I use it as another example of the unsophisticated atmosphere that appears to be so prevalent today.
And yet, I stop to wonder if I ever really did meet anyone at all
who could accurately be described as sophisticated in the stock market. Being sophisticated in the stock market probably is as out of
place as being logical. And we all know that in order to be successful
in the world of investing, logic has to be left outside the door. This
brings me around to the inevitable question: Is understanding the
stock market now becoming more of a science and less of an art?
No doubt, it is a question that has troubled the minds of many
marketeers for many years. I know, as a result of my recent trip to
Japan, that the Japanese believe that scientific applications can be
applied to the stock market, and they have gone to great lengths in
employing those applications. More than any group I know, the Japanese are attempting to make it more of a science than it has been.
And yet, I know that whenever you have to deal with something that
involves people to any great extent, science can only be carried so far
before art has to take over. Thanks to many of the new inventions
MTA JOURNAL
that have come along over the years, such as the price quoting machines, information is much more readily available, making the formerly onerous job of keeping up to date much less so. Today, a great
deal of information is quickly available perhaps too much so and
thus the odds in decision-making have increased on the side of error.
Now I know that that last sentence doesnt seem right somehow, but
then you are still thinking logically, aren't you? And that doesnt
work in regard to the market. Too much information, too easily obtained leads one into too many possible byways, and therefore, increases the chances for error. Too many people believe that the more
you know about something, the better off you are apt to be. I thoroughly agree, except in the stock market. In this arena, one often
can lose sight of the forest for all the trees that are available and it
often helps to use less data and a bit more gut feel. And, very often,
who you know is just as important, if not more so, than what you
know. How else do you explain the success levels of those who tend to
make it in the market?
And this brings me to one of my favorite sayings about the market. It is one in which I thoroughly believe and have seen the workings of it spread far and wide, among all types of marketeers. The
stock market is one of the easiest places in the world to get rich. All
you have to do to make it so is to avoid what most of the others are
doing. For example, I long ago gave up buying The Wall Street Journal.
It has too much information of too little worth and not enough of
the really valuable stuff. Barron's is somewhat better in that respect,
but the new newspaper Investors Daily has it all over both of the Dow
Jones papers. Once you start getting really good news on what is
going on in the market, the path to wealth is soon beneath your feet.
It helps also to look around you, ask the man in the street what he
thinks about the economy, or whatever, and when you have determined what the general drift of conventional wisdom is, go the opposite way. One of the biggest obstacles to obtaining wealth in the stock
and bond markets is to fall prey to the enticements of quick profits.
Of course, they are grand to have but more often than not it pays to
let your profits run, while making all endeavors to cut losses short.
Too often, technically oriented traders and investors see more in the
chart than really is there to be seen. False breakouts, up or down,
make us nervous and we jump, only to find out later on that there
was no alarm except in our own minds.
I also believe that it is a bit wise to be skeptical of almost everything. At times you will have to depend on what appears to be the
wisdom of those around you, those in whom you have faith to do the
jobs with which they are involved. But one also should take the time
to hear what others have to say, and then go and do a bit of checking
it out. It can't hurt. I also believe that too many investors fall prey to
the belief that information on revenues, management, contracts, industry items, sales and earnings are what makes stocks move up and
down. They seldom stop to think that all that kind of information
only has to do with the company itself, NOT the shares of the company in question. The only thing that makes shares move up or down
in price is buying or selling pressure outweighing one another. If
nobody sells, then all the good information on dividends and earnings isnt going to move shares upward. If all the bad news makes
buyers disappear, then shares can't move downward. So trying to
gauge what the buying pressure is probably is the most important
Fall-Winter 2001
thing that anyone can do in the search for profitability. At

PaineWebber, every week we publish a relative strength analysis of
over 4000 issues that when taken in conjunction with some other information, affords a very good indication of whether or not buying,
or selling, pressure is rising or declining. Once you have that tool in
your hands, the game becomes a lot easier. Over the last ten-eleven
years, every single issue recommended in my Trends & Opportunities Market has been based on my reading of the buying or selling
pressures. That has helped us achieve a 95% success ratio in those
recommendations, 250 profits, nine losses and three unchanged since
1974, regardless of whether a bull market or a bear market was in the
drivers seat. Get to know what direction the pressure is moving in
and you are halfway to your objectives. And that goes just as importantly for short-selling.
While we are on the subject of short selling, technical analysis can
be of great help in helping clients make money on the short side.
Once you find a chart pattern that is descriptive of distribution, move
on to find out if the selling pressure has been increasing, or if the
buying pressures are ebbing. If both suggest you should be shorting
the stock, go a step further and check out the short interest. If it is
high, so much the better, since most of the shorting is still done by
professionals. And dont fall for that old saw about stocks with high
short interest holding up well, because there is a buyers floor under
the price. It is quite true that those who sell short must sooner or
later buy back in again in order to take their profit, or their loss. But
a check of past bear markets will show that stocks that had the highest levels of short-interest usually sold off quite nicely, enabling those
who sold short to repurchase shares at lower levels. A floor under
stocks with high short interest is about as fleeting as support levels in
a bear market. I always try and remind brokers who ask me about
support levels in a bear market that support is only a seven-letter
word and usually doesnt afford the support sought. Support, on the
other hand, is much more important, technically, in a rising market.
The same goes for resistance levels. In bull markets, those resistance
levels usually provide only fleeting roadblocks to advances. In bear
markets, upside resistance takes on much more power, on average.
There always are exceptions, of course.
I guess if I had only one tool to select from all those that are available among the various charts and chart ser vices, I would come down
on the side of a good weekly bar line service. Something like Mansfield
that provides the relative strength indicator graphically presented,
MTA JOURNAL
various moving averages, and then throws in upside volume and downside volume to make it a bit easier. If you like having the fundamentals, those are provided as well. They once used to give earnings
estimates, but not anymore. Too bad! It helped to gauge things
better if you knew what the street was expecting. Then, when the
winds of winter were blowing and I was all snug by my fireside, Id
take out my barline book of charts and go through it every week,
looking for those seven cardinal patterns that indicate either accumulation or distribution. You all know what they are. You dont
need me taking up valuable space to repeat them again. Once I was
able to correctly identify some of those patterns, I would put some of
my funds to work. I guess that when push comes to shove, those
important patterns of accumulation or distribution are the most important things in our world of Technical Analysis. Without the knowledge of them, were always back at square one.
Now I certainly dont mean to knock point and figure analysis. I
have found it to be too helpful over the years to give it a position
below the salt. It is an invaluable tool in trying to gauge just how far
a move is going to carry once that move has started. But, if pressed,
I still would have to say that a bar line chart will tell you when the
move is going to start. Then you would move on to a P&F chart. If
anyone out there wants to make a lot of money in this business, I
would suggest that they start a point and figure weekly chart service
of the 500 most actively traded listed bonds. As far as I know, there is
no such service available. Since we are in the still early stages of a
super cycle bull market in bonds, their price performance will become increasingly important as the next five to seven years roll by.
And their volatility also will increase, making a point and figure analysis
far more valuable. Ive thought of doing it myself, but am just too
tired to take on another chore.
The twenty-nine years will soon be rolling into a nice round thirty.
I came to Wall Street intending to stay only twenty years, but the work
was so interesting and the people with whom I worked were so pleasant and helpful, that I stayed on and on and on. This has been the
most fascinating of my three careers and I am wondering if the fourth
and next career will be as rewarding.
BIOGRAPHY
Harry W. Laubscher is a member of the MTA and a Technical Analyst at Tucker Anthony, New York, NY.
Fall-Winter 2001
THIS ARTICLE APPEARED IN THE MTA JOURNAL, WINTER 1994/SPRING 1995
TECHNICAL VERSUS FUNDAMENTAL ANALYSIS:

A View from Academe
Hamid B. Shomali, Ph.D.
In the last several decades, there have been two competing schools
of thought regarding the analysis and valuation of financial securities. The traditional finance experts have espoused fundamental financial analysis, dealing with identification of variables that will determine the underlying value of securities. These traditional security
analysts have downplayed the significance and the relevance of the
other school, namely technical analysis. The strict fundamentalists
have viewed technical analysts as mere chartists who pass over past
data in order to find certain patterns in the behavior of security prices
over time. These traditional finance theorists at times have likened
the technical analysts to astrologers in the field of finance. The
technical analysts, on the other hand, would like to gain recognition
for their successes in forecasting security prices and be considered
more like astronomers than astrologers. But the debate continues.
In recent years technical analysis has been gaining wider acceptance in academia. Technical analysis received prominent and favorable review in a seminal article surveying the frontiers of finance which
appeared in the October 21,1993 issue of The Economist. The offering of courses in technical analysis at some universities such as
Dartmouth College, Golden Gate University and the McIntire School
at the University of Virginia, as well as the New York Institute of Finance, demonstrates the increasing recognition of the field of technical analysis by academia. As technical analysts align their field with
behavioral finance, they will gain even wider acceptance.
It is interesting to observe that both schools can be viable by explaining different behavior patterns at different time frames, and as
such do not have to be necessarily competing schools. The fundamental analysis rests on the assumption of a rational person who incorporates all of the relevant data concerning a certain asset before
making a decision about its acquisition. In that regard, the past history of the asset is totally irrelevant. In other words, with all the past
glory of IBM, if the fundamentals are pointing towards a dismal outlook, the investor will disregard the past history. In a sense, the rational school of thought, or the fundamental analysts, regard the valuation of financial assets determined by a random walk. In random
walk, the prices of securities are likened to steps of a drunken sailor,
where each step is independent of the previous one. Fundamental
analysts basically assume an efficient market when the stock prices
reflect all information available to the public. The efficient market
theory, that the fundamentalists adhere to, assumes rationality at all
times on the part of investors and does not allow behavior based on
emotion and all other impulses. Yet as a practical matter, human
irrationality is important. Even in the legal code, the plea of insanity
allows for impetuous behavior that is not based on rationality and
simply stems from a sudden urge or instant decision. Perhaps some
of the most persuasive evidence against the efficient market theory
comes from the anomaly literature, which has discovered unusual
patterns in the price behavior of securities. Some of the most puzzling price anomalies are related to seasonal patterns in the movement of stock prices. Other anomalies relate to returns that are dependent upon the size of a firm and the impact of new stock issues.
It is the contention of this author that in the short run (anything
MTA JOURNAL
from a day to a few months), emotions and other biases may lead us
to make a decision that may not be based on rationality. Impulsive
behavior, herd mentality or any other decision-making process which
relies on mechanisms other than rational analysis of all relevant factors are not allowed in the fundamental analysis or the theory of efficient markets. But how else can one explain the events such as markets behaving differently on Monday mornings than Friday afternoons, or that every year there is a sense of nervousness in the markets around October?
One of the major problems that behavioral analysts have to face is
that in their analysis of the market they often ignore the concept of
probability. In other words, they often sound as if they are stating
their forecasts with certainty. As a consumer I may react to a 50%
discount offer based on sudden impulse, but such impulse may not
dictate my actions every time I encounter such a discount. The behavioral analysts have to specify that their technique is only for shortrun decisions and as such may be more useful to traders than institutional investors, such as pension plans, who are concerned with the
long term returns on assets. The technical analysts also have to find
a way to incorporate probability analysis into their analysis. Otherwise, there is no basic problem with their use of past data to arrive at
certain conclusions about the future. In traditional forecasting models, such as time series analysis such as Box-Jenkins the past data
is also used to make inferences about the future. In fact in econometric forecasting, the least square estimation or maximum likelihood method, the forecast of a dependent variable is based on a
weighted average of the past observations of the same variable. The
above statistical methods simply determine the weights through statistical manipulation, and the forecasts are based on probabilistic assumptions about the behavior of variables, and as such are not deterministic numbers. In fact, auto regressive estimation methods are
an important part of econometrics where the past values of a variable
are used to determine its future forecast.
The fundamental analysts can point to the strength of an underlying security based on the fundamental variables that will impact its
value in the future. But this analysis, by its nature, is a long-term phenomenon that is incapable of pinpointing the time that such movement will begin. In other words, the fundamental analysts can never
provide us with the turning point.
Should we dismiss one theory in favor of another? The study of
these two methods of security analysis reveals that they are concerned
with different time horizons and different decision-making processes.
Fundamental variables can certainly affect the value of a security over
the long run. However, in the last few years, the economists have
accepted that there are a lot of human emotions entering the process of decision making, not just calculating rational behavior, at least
in the short-run. Granting of the Nobel Prize in economics in 1993
to Professor Douglas North is testimony of admission by mainstay
economists that other modes of behavior such as culture, habit, bias
and prejudice as well as impulsive or random behavior could be used
to explain consumer behavior. Increased attention paid to behavioral finance by some well-known finance scholars should open the
Fall-Winter 2001
door for a less-biased approach toward technical analysis by the

traditional finance professors. The fact that industry, such as Japans,
has decided to invest $30 million in researching such topics indicates
the security industrys serious interest in the topic of technical analysis.
BIOGRAPHY
Hamid Shomali, Ph.D., is professor of Finance and Economics, and Dean of the School of Business at Golden Gate University. Dean Shomali joined Golden Gate University in 1986 after
a distinguished career in banking and finance. At the Bank of
America, he completed several policy studies that impacted the
international lending of the bank. Also as a member of the energy-lending group, he made a substantial contribution to the
banks energy loan portfolio. As Deputy Managing Director of
Bank Farhangian, Iran, he managed the banks construction and
mortgage lending as welt as its international operations. Prior
to that he was an economist for the Central Bank of Iran where
he completed analytical projects on a broad range of macroeconomic and monetary issues. Dean Shomali has served on the
faculty of several universities including the University of California at Berkeley, University of Houston and the National University of Iran. His teaching and research has been in international
trade and finance as welt as oil economics. Dean Shomali consults with international companies on banking, finance and international management. Dean Shomali received a Ph.D. in
Economics from the University of California in Los Angeles
(UCLA) in 1973. His undergraduate education was completed
at the University of Salford, England where he received a B.S.
degree in Mathematics and Economics (Joint Honors) in 1968.
10
MTA JOURNAL
Fall-Winter 2001
THIS ARTICLE APPEARED IN THE FIRST ISSUE OF THE MTA JOURNAL, JANUARY 1978
A DOW THEORY UPDATE

Ralph J. Acampora and Rosemarie I. Pavlick
certainties of taxation and the interested aberrations of Congress.

All these factors are known and, if possible, over discussed.
After many years of observations, Charles Dow concluded that the

stock market, like the ocean, had three movements: primary, secondary and daily fluctuations. The major advances and declines of the
market were equated with the tides a dominant force that lasted for
a period of time. These long-term movements were subject to secondary reactions (waves) that lasted for a shorter period of time and
might temporarily appear to contradict the primary trend. And finally, the waves themselves were broken down into ripple (daily) reactions. But Dow strongly felt that no means of manipulator could
divert the eventual course of a major primary move. It is for this
reason that he dedicated his theory to the long-term outlook for the
stock market.
The discovery of the rhythmic movements of price led to the advent of the Dow Jones averages. Beginning in 1897 The Wall Street
Journal published two sets of averages: the industrials and the railroads.
The logic behind the specific makeup of these separate indices is
rooted in Dows premise that both of these sectors of the market were
interdependent. For example, if the large industrial firms of the day
were faring well, they depended upon the use of railroads to transport their products. Whenever the price trends showed disparate
movement between these two indices, it meant that one sector was
stronger or weaker than the other, and if allowed to continue, it would
eventually result in a major reversal for the general stock market.
At this time in history, as our nation was still growing pushing its
way across the entire expanse of the North American continent the
iron horse was the only means of transporting people and produce.
Thus industry and railroads prospered and suffered together. As our
country matured and the transportation revolution took hold, the
use of railroads diminished considerably. It was for this reason that
the Dow Theory came under recent attack. What about the airlines
or the truckers why are they not incorporated in this theory? This
argument was valid. So on December 22, 1969 Dow Jones & Company revised the rail average to include other means of transportation. Today, the new Dow Jones Transportation Average satisfies the
original requirements of a balance between industrial firms and the
transportation network.
The following is an excerpt from The Dow Theory Explained by
Charles B. Stansbury:
Charles Stansbury also wrote that

Over the years during which the averages have been observed
and recorded this confirmation by both averages has established itself as an
essential part of the theory.
The confirmation which carries authority need not develop in
our chart on the same day or even in the same week. It is deemed
sufficient if one average follows the other into new low ground, or
new high ground, before the first average retracts its half of the signal.
The first average retracts if it makes a new extreme in the opposite
direction before confirmation by the second average.
Confirmation of Primary Bull and Primary Bear Markets

In Chart I we depict the price trends of both the Industrial and
Transportation Averages. Note that drop B to C does not register a
new low (below A). This is the first sign of a potential positive shift in
the making. At C, one or both
averages holds above the low
(A). A bear market bottom is
confirmed at point D the first
time that the averages penetrate a previous rally of substance.
A bull market reversal occurs when there is tremendous
euphoria; the things couldnt
be better syndrome. Some
time during this period, the
average(s) is unable to register
a new high (G) above the previous and, in hindsight, ultimate peak
(E). It is at point H that the primary downtrend is established a
decisive break below a previous important (real) secondary low (F).
Secondary Reactions
In every primar y move, whether ascending or descending, there
is a time when prudent investors commence profit taking (Chart II,
point A). This normal process invariably causes the average(s) to
weaken perhaps both industrials and transportations show signs of
divergent trends at this point.
Significant redeployment of
funds becomes evident at point
D a time when the buyers activity supports sagging prices
and prevents a new low from
occurring below point B. Point
E suggests more optimism as
the minor high (C) is
breached. It is not until a new
high (F) is attained that the
primary trend can still be considered in force. This entire
pullback phase (A thru F) is known as a secondary reaction (waves
within the tides).
How does one distinguish between a secondary and a major reversal? It is at this extremely critical juncture that one pay close at-
We now come to a fundamental tenet of the Dow Theory and

that is that any signal to be authentic must be affirmed by both the
industrial and railroad averages. While this concept may seem a little
confusing at first, we have only to return to our simile of the movement of the tide to clear it up. Instead of watching a single beach (or
chart) we now must imagine ourselves standing at the mainland end
of a narrow peninsula from which we can watch two beaches: Both
are parts of the same ocean (market) which is divided into two parts
(industrial average and railroad average) by the peninsula. While
both beaches are subject to the same tidal action they may show varying wave action. The wave action on one beach may often prove highly
deceptive as to the course of the tide unless we find the movement
confirmed by similar action on the other beach.
The February 11, 1922, The Wall Street Journal stated:

... the stock market is acting not upon the known news of today
but upon what conditions will be as far ahead as the combined intelligence and knowledge of Wall Street can foresee. There are plenty
of bear arguments in the complicated conditions in Europe, the un-
MTA JOURNAL
Fall-Winter 2001
11
...The market barometer does not pretend to do the impossible.

It forecasts, defines and confirms the major swings... It does not pretend to forecast the secondary reactions any more than it clearly foretells the corresponding rallies in a major bear market.
This is because the secondary reaction, as distinguished from
the major movement, is governed by the unexpected.
tention to all the characteristics present during secondary reactions.

To begin with, secondary declines have a multiple effect (several downward swings in price). In Chart III, the most recent primary upswing
began at point A. At point E the
Dow theoretician must come to
gripes with the problem of identifying B through E as a secondary reaction or a major reversal.
If the verdict is Bear Market, he
will sell all of his or her stock and
perhaps go short. However, if
the interpretation reveals the existence of a secondary reaction
phase he or she will deem this
decline a normal happening and
slowly commit funds in order to
take advantage of an eventual major up move. Listed below are
those characteristics common during secondary phases:
The movement is more rapid in a reversal than in a primary trend;
they may last from three weeks to three months and typically retrace perhaps 40 percent of the movement since the end of the
last major reversal. But there have been occasions when a secondary reversal retraced as little as 30 percent of the primary move and as much as 70 percent.
The length of time needed to complete this reversal is usually a
much shorter time than the previous advance. From top to bottom (B thru E) more than three months time usually indicates a
bear market.
If volume during the reaction (B thru E) equals or exceeds the
level that prevailed at the time of the top (B) it would be bearish.
However, if volume continues to drop lower as prices decline there
is a good chance that this decline is nothing more than a reaction.
The atmosphere surrounding this entire period is also very important. If excessive speculation is present then this type of reaction could be interpreted as the beginnings of a bear market.
The Wall Street Journal, September 19, 1922

It is now imperative to define the distinctive phases present in
Dows bull and bear markets:
The Bull Market
Phase One is known as the accumulation phase very depressed
prices basic industry, utilities and high yielding stocks dominate.
Phase Two is characterized by increased activity, rising prices and
an improving business scene. Secondary stocks are in vogue.
Phase Three, the final explosive move, a by-product of excessive
public speculation. The cat and dog syndrome.
The Bear Market
Phase One is called the distribution phase. As the public
scrambles for stocks, the farsighted begin their deliberate selling.
Stocks go from strong to weaker hands.
Phase Two is referred to as the panic phase. Selling begets selling
as the urgency to liquidate mounts. Margin calls escalate.
Phase Three is marked by continued erosion in prices, the crunching of lesser quality issues object pessimism prevails. It's always
darker before the dawn.
THE THEORY TODAY

Charles Dow specifically emphasizes the use of the closing prices
for both averages, because he felt that these figures would give a true
picture of the floor traders and specialists positions. Despite their
long and short dealings, during the day, these professionals would
invariably even up before the close.
On Chart IV are depicted graphs of both averages: we have inserted the closing figures of the key reversal points and non-confirmation levels since September 21, 1976.
Chart IV
Dow Jones Industrial Average
Dow Jones Transportation Average
12
MTA JOURNAL
Fall-Winter 2001
where worthless stocks are bought for no other reason than because
they look cheap and because gamblers hope they will double in price.
This condition always has prevailed in the third phase of bull markets. . . .
This entire period is in question. Are we in a secondary reaction

phase or has a Dow Theory bear market signal been given?
In determining a trend, previous high and low points are used. A
succession of new highs is positive while a series of new lows is negative. The Dow Jones Industrial Average on Chart IV has been tracing
out a progression of lower highs since September 1976 (note points
A, D, E, G, H, J and K). Points B, C, F, I and L vividly portray a
succession of lower lows this combination is negative.
When viewing the Dow Transportation Average from October 1976
to May 1977, a distinct divergence is seen. Points. P, S and T represent a classic series of new highs while N, Q and R are important
higher reaction points - this combination is positive. The DJIA reached
its high on September 21, 1976 at 1014.79 (A) while the DJTA registered its high on May 18, 1977 at 246.64 (T).
Remember Dows fundamental tenet: for any signal to be authentic, both averages must confirm. It is deemed sufficient it one average follows the other into new low ground, or new high ground, before the first average retracts: its half of the signal.
Now the question is raised since the Transportation Average has
recently come under sharp selling pressure (points W and X), does
this move constitute a confirmation of the Industrial Averages negative behavior?
To begin with, the Dow Jones Transportation Average was confined to a tight trading range during the months of June and July
1977 (U and V). This is called a line formation. It usually lasts several weeks with price fluctuations in the magnitude of 5%. Such
movements indicate accumulation or distribution. Any break below
this formation is distribution and implies lower prices. Needless to
say the Transportation Average has decisively penetrated the lower
end of this pattern (W); in so doing, it also weakened below its Februar y 25 close of 221.81 (Q). It is here that the Dow theoreticians
differ. Is 221.81 the critical secondary low? If so, then the DJTA has
confirmed the breakdowns in the Industrial Average and has initiated a primary bear signal. A secondary low must be considered the
beginning of the recent primary upswing. We interpret the Oct. 3
low (N) of 203.85 the focal point for the primary upswing. Thus,
until the Transportation Average closes below 203.85, the move down
from T is still considered a secondary reaction.
The following excerpt from Richard Russells The Dow Theory Today is noteworthy:
Let us now investigate Rheas co-related factors:

Duration: The Dow Industrials has easily exceeded the three-week
to three-month time limitation used in measuring a secondary
reaction. The Transportations reaction began on May 18 (T),
also overstaying this requirement.
Extent of the Decline: A secondary reaction typically retraces perhaps 40% of the movement since the end of the last major reversal. On occasion, retracement of 30% or as much as 70% of the
primary move have been noted. The DJIA has retraced 34% of its
primary advance that began in December 1974. The DJTA has
only retraced 26% from its primary low, registered in October
1974.
Phases: To date we have witnessed impressive moves in the basic
industries, utilities, and high yielding stocks the fulfillment of
Phase One in a bull market. Secondary stocks have moved to the
fore and dominated the scene in the past twelve months, thus satisfying Phase Two. However, the overheated, speculative fever stage
has not been witnessed; thus the paramount requirement has not
been met. The reactions to date (A to L and T to X) have not
taken place during the third and final phase of a bull market.
In conclusion, it is only in the third and last phase of an extended
bull market that a bear signal is valid.
203.85 This number represents the important secondary low registered in the Dow Jones Transportation Average on October 12, 1976.
Since September 1976, divergence has existed between the DJIA and
the DJTA causing many Dow theoreticians to question the viability of
the bull market that began in January of 1975. Last Monday, the
Dow Jones Transportation Average closed below 203.85, giving a bear
market signal. However, everyone was fully apprised of this development leading Wall Street publications contained articles describing
this phenomenon and its ominous consequences. The nonbelievers
quickly responded with either a shrug of the shoulders or the statement that this signal was too much and too late. Some selling
came to the fore because of the breakdown but quickly reversed into
the first 5% rally in 1977. That rally nevertheless does not negate the
importance of the signal. In fact, the rally comes as no surprise the
market had already suffered slow deterioration for several months,
and at the time was in an extremely oversold condition. The reaction was anticlimactic, but dont be fooled by the resultant rally. Much
more is needed to reverse this negative signal. Charles Dow compared the markets primary trend with the oceans major tides. He
suggested that within the tides, waves would occur (secondary reactions) that move counter to the major flow. These counter moves
could extend from three weeks to three months and have no lasting
effect on the major trend. Thus, if this bear market signal is accepted,
temporary rallies could be viewed as a selling opportunity within a
major downward phase.
Bear market signals, however, must not be oversimplified. The

great Dow Theorist Robert Rhea wrote in 1938: Beginners frequently
make the mistake of basing conclusions wholly on the matter of penetration. Familiarity with the correlated factors such as duration,
extent, activity, divergence, and secondary implications of primary
bull markets is needed to make a correct diagnosis. Anyone who has
studied the works of Hamilton and Rhea knows that it is only in the
third and last phase of an extended bull market that a bear signal is
valid. Ignorance of this fact has led to one of the most disastrous
misreading of the Averages in modern stock market history.
Over and over again the great Dow theorists have warned us not
to take a shallow, mechanical reading of the Averages while disregarding phases, duration and extent of the market movements. By
calling a bear market on a false second phase signal, the majority of
the financial fraternity has committed one of the most costly errors
in market annals.
Once the fact is accepted that bear market signals are valid only
when they occur within the third phase of a bull market, the utmost
importance must be attached to identifying the third phase. This is
the time, wrote Rhea, when brokers and soothsayers prosper, and
when an excited public, lured by the bait of advancing prices, buys
stocks without regard to values; basing their action on nothing more
than hopes and expectations. He observes that this is the phase
MTA JOURNAL
Written 8/19/1977
Fall-Winter 2001
3:30 pm
DJIA 862.27
13
14
MTA JOURNAL
Fall-Winter 2001
THIS ARTICLE APPEARED IN THE MTA JOURNAL, NOVEMBER 1986
IT PAYS TO BE CONTRARY
James L. Fraser
There has been a steadily growing interest in Contrary Opinion
theory over the past few years. Beginning in the 1940s, Humphrey B.
Neill, who died in the mid 1970s at his homestead in Saxtons River,
Vermont, wrote about Contrary Opinion in his now retired Neill Letter of Contrary Opinion. I joined him in furthering the essence of
the theory in 1962 with The Contrary Investor, a newsletter on investment implications of Contrary Opinion that I continue to write
today. Moreover, I began to reprint old books that deal with human
behavior and the stock market while slowly moving into money management utilizing a Contrarian strategy.
Today, Contrary Opinion is accepted as an investment tool and,
in fact, has become part of conventional wisdom. Whereas for years
the uses of Contrary Opinion were always in the back room, now the
mainstream has recognized that to make money you buy the downtrodden, the misunderstood and the overlooked. Also, there are
numerous investment letters, books, and practicing managers who
seek lesser recognized or secondary growth stocks which do have
growth characteristics but not growth multiples. New investment
books have contrary or contrarian in their titles and institutions, now
responsible for perhaps 85% of stock market trading, nod sagely at
committee meetings when a manager says he uses Contrary Opinion.
However, reality is not that pure. Many people use the words but
not the strategy. Long-term Contrarian investors, which means value
players, include Warren Buffet, John Templeton, John Neff, Dean
LeBaron, Phil Carret, Ir ving Kahn, and David Dreman. They all
manage significant sums of money and have done so for a number of
years. Of course there are others, but at least this gives you an idea of
what I mean.
Phil Carret said years ago in his book, The Art of Speculation,
published in 1930 (he is still alive today managing money in New
York at the age of 89) that the road to success in speculation is the
study of values. The successful speculator must purchase or hold
securities which are selling for less than their real value, avoid or sell
securities which are selling for more than their real value. The successful investor must pursue exactly the same policy. Of course, the
time requisite for prices to move up is more important to a speculator than an investor. A security may be undervalued, but if it is also
out of style it is of little interest to the speculator. So, one has to
study the psychology of the stock market as well as the elements of
real value. When real value is out of favor, a Contrarian moves in. A
Contrarian investor waits patiently. A Contrarian speculator, on the
MTA JOURNAL
other hand, tries to judge the psychological climate with other tools,
as charts and technical indicators that will allow him not to wait too
long. Let me give you an example. The chart below from M. C.
Horsey & Company shows Sears, Roebuck, a major American corporation. Just before the August 1982 rise began, Sears was our
companys largest holding. How did we get that way? Sears was a
nifty-fifty stock back in 1972 and early 1973 and then declined with
the bear market of 1973-74. It recovered in 1975 and early 1976 and
then sank into its own tedious bear market.
During this time, the news was largely negative in that merchandising was not doing well, other firms were taking market share away
from Sears and as each year went by the financial press reported more
and more negative news. The price kept coming down until finally
negative news no longer pushed it down. The stock began the bottoming process in 1980 and, as long-term investors, we began buying
in late 1980 right up to late May in 1982. We felt we had value which
was then not being recognized.
As long-term investors, we bought too soon but that was not very
material once the stock moved up strongly in 1982 and 1983. However, a speculator would have timed the movement better and perhaps bought after a breakout above 21 in 1982. The main Contrarian
point is that once negative news no longer pushed the price down to
new lows, the price fairly represented all possible disappointments.
Of course the chart looked terrible at that time as past history for ten
years was downhill, but the unexpected income of positive change,
which takes a long time in a corporation as large as Sears, was about
to be the next major factor which coincided with a market move that
began in August 1982.
Take another example of a recent out of favor company with the
chart of Halliburton below. Everybody is aware of the great move
that took place in energy related securities during the 1970s that, in
most cases, peaked out in late 1980. We then had a sharp fall back, a
rise that participated with a 1982-83 bull market, then a continuing
down turn based on negative fundamentals for major industries within
the energy area. Oil field services represent a volatile sector.
Finally a Contrarian is attracted to the stock price after seeing it
decline significantly from a high level, keeping in mind that the high
price represents an extremely optimistic scenario and one that would
not last. The question becomes where is value and in relation to
what level of oil prices. An investor might begin buying in the low
20s and certainly participates below 20. A speculator or trader would
Fall-Winter 2001
15
TREND IS NOT DESTINY CHARACTER IS DESTINY
wait for more price confirmation, that is of the price stabilizing where
bad news is no longer a factor and where perhaps the next level of
news is likely to be favorable.
We tend to modify our judgment in response to the pressure of

majority and expert opinion. Most financial media reinforces majority beliefs and convictions. Investment practices are adopted on the
basis of reasons that appear valid. But each investor comes under
the sway of an already existing system of practices and values so he
cannot judge independently, and he is affected the most when he is
least able to exercise his own judgment. In other words, character
and temperament are more important than charts and systems. We
want to endow investing with specific guides that can be counted on.
This is good. But we should realize that our emotions and unconscious behavior patterns, as the tides of the Bay of Fundy, often overrun these guides and just as often leave them stranded.
Independence and basic confidence in your ability to control
doubts is a primary requisite for successful investing. Take the case
of Xerox as represented in the chart below. Obviously, when Xerox
was above 150 in 1972 and 1973, there was little independent thinking regarding the idea that the stock deserved such a high price.
This was group behavior in all its splendor. Then came the market
drop of 1973-74 with a bit of a recovery thereafter, but not much
when you consider the market bottom in recent times was year 1974
at 570 on the Dow, and the market has moved higher since then.
What happened is that the majority belief and conviction that Xerox
was a special company, deserving of high multiples and all good things,
was dashed through the rest of the 1970s and into the 1980s. To be
sure, the higher you were in 1973, the easier it was to fall down and
hurt yourself.
Anyway, right through 1982 and into 1984 the majority belief become one of Japanese competition winning the day with copiers, first
at the cheap end of the line and then finally across the board. Xerox
management was perceived to be incompetent and not paying attention to what was going on. We bought the stock in 1982 and again in
1984 an the basis that management, though a bit thick, was slowly
responding to the global changes influencing its business. These
changes take time. Finally, by 1984, negative articles no longer influenced the price of the stock. That was the safe time to buy in what
technicians might call a saucer bottom. The stock then became our
largest holding.
Interestingly, as you might suspect, as the stock rose up, we finally
began to see a few nice words about Xerox. News follows the price.
As the price moves higher the financial media speaks sweetly.
PREDICTIONS AND FORECASTING

Fred C. Kelly, a writer for the Saturday Evening Post back in the
1930s first published Why You Win or Lose in 1930 with a for ward,
interestingly enough, by John B. Watson, the founder of behavioral
psychology at Harvard. This book is a favorite reprint of ours and in
my preface I say we have difficulty struggling against crowd behavior
patterns. We dont compel thinking and observation. We dont work
at contesting the popular view. We are mislead by financial propaganda that makes us untimely in our opinions and often wrong in
our actions.
Kelly understands that human gullibility's are a constant contributory force to speculation. The only change between Kellys days and
our own time is that crowd reactions occur faster, thus opinions shift
quicker, and jumping to conclusions becomes an unprofitable pastime.
Every natural human impulse seems to be a foe to success in the
market. We all want to conform, to congregate as a herd. And yet we
win by understanding human psychology and by thinking ahead in
creating possible courses of action to todays conformity. You dont
have to be a highly competitive mental person to succeed, you only
have to watch and study the crowd in order to pick up useful clues as
to what the intelligent minority is not doing.
To succeed in the market one must not do what most others are
doing. He who does the opposite has a good chance to be right. We
may not know what insiders are doing until after they have done it,
but by watching and studying the investing crowd we pick up clues as
to what they are not doing. I do not mean that you want to avoid a
major current when it is strongly flowing because the uses of Contrary Opinion are most valuable at turning points. To get aboard a
major move at the right time, it is only necessary to disagree with the
opinion of most investors you know who follow logical reasoning processes fostered upon us by print and TV financial media.
It is not the stock market which beats us. It is our own unreasoning instincts and inborn tendencies which we do not master and which,
when we give in to them, lead to disaster. Natural instincts govern
action which means that fear and greed are at the opposite end of
the investment spectrum. I know, we all think, times have changed,
which they have, but human nature has not changed and that is the
point of wisdom regarding Contrarian investing strategies.
Another way to look at this is to say that money may be managed
profitably or conventionally but not both. Of course, stock prices represent consensus expectations. But to profit, the expectations have
to be both correct and different from what is current conventional
wisdom. A significant human problem is to withstand group forces
that seek to modify and distort individual judgments.
The business of investing is an actual study of social influence.
Personal investing is so widespread that a social group has been
formed, and we, as individual investors, are no longer indifferent to
this group. When we visit brokers offices we are alert to the group.
If we hang around long enough, we tend to reach an agreement with
the prevailing opinion since this is the dynamic requirement of a
group situation. Otherwise, our personalities would suffer. Even
watching business news on television puts us in the position to accept
prevailing opinion. The antisocial solution is to turn off the set.
16
MTA JOURNAL
PRIDE OF OPINION PRECEDES A FALL

I have been saying that a practicing Contrarian observes the psychological status of the crowd in question and then takes an opposite
approach. Of course, there are more than one opposite approaches.
Normally, if the crowd has decided upon a conventional future, then
the successful opposite approach is either more positive or more nega-
Fall-Winter 2001
tive, at the extremes, until one of the extremes becomes the conventional view and then the Contrarian again must take a different road
from the conventional view. The theory is based upon estimating the
prevailing crowd emotion and not on forecasting the future. We make
no attempt to predict the future, and we keep an open mind. Any
definite forecast of the future leaves one at the mercy of that forecast
because pride of opinion will tend to tie us down to that forecast.
Take a look at a medium-sized stock chart, which is Ransburg below. This company is not followed by Wall Street very closely, is located in Indianapolis, Indiana which people may come from but rarely
go to, and reflects future forecasting in price moves. Not of the company itself but of fields of activity that the company represents. Basically, Ransburg is a leader in industrial equipment and is associated
with robots. Not surprisingly, the all time high price of above 37 was
made in April 1981 when Time magazine had on its cover robots and
the tremendous future they represented. This cover journalism forecast of the future left investors at the mercy of brokers who were pushing robotic stocks. Anybody who read Time wanted such items and
Ransburg, normally a quiet stock, topped out at the peak of enthusiasm for robots. Obviously, this enthusiasm was not limited to the
month of April but had been building up since the second half of
1980.
Again, the high technology boom in 1983, which maximized in
June of that year, also saw Ransburg peak out on the basis of high
technology and robots.
The price came down
again only to rise a bit in
1986 on the basis of industrial expansion and
the improving of American productivity. Now
the stock is back down
once more to below the
15 area and is a Contrary
Opinion buy since we can
choose it with an open
mind that is not influenced by delightful future forecasts. These
forecasts will come to life
but not when anticipated
and so far we have had
three false moves which undoubtedly will keep investors away until
they miss the real move that takes place one of these days.
Oh, I realize that it is easy to make points from charts that back
me up. And yet, investing is not a science, and one must enjoy it to
do it well. However, we should stick to what we understand, have
some guts, and never become too overconfident. Again, Phil Carret
once said something to the effect that an investor who so lacks confidence in his own judgment that he wont buy any security until it is
favored by the consensus of the investment community, will buy few
bargains and is unlikely to achieve superior results. Of course, a security favored among professional investors is good but that is not
the same as being undervalued in price. If unpopular, or generally
unrecognized, some investigation is required to estimate basic value.
That is where security analysis comes in. Once assured the basic value
is there, then unpopularity will not deter the investor who is 1ooking
for long-term results.
A good trader, speculator or market technician is trying to do the
same thing though using somewhat different tools that offer insights
into value. We are all trying to buy things where the future is not
already discounted. We want stocks with merit and we should buy
MTA JOURNAL
them when they are weak. But usually we buy stocks with merit when
they are strong and thereby do not build good performance over
time.
PATIENCE IS SUSTAINED COURAGE

Another way to look at this is at perspective and patience of the
essential requirements. We all want to own shares of successful companies in areas of activity that have particularly promising future prospects. However, the Contrary lesson is that we all tend to be influenced by whatever feelings are sweeping over the investment community at the moment and that true investing, to be successful, requires fighting these feelings. Nevertheless, it is not that simple for
the inexperienced investor to be contrary since inexperience breeds
a certain contempt for long-term solutions.
Subscribers to advisory services aim at quick results, feeling that
the game is not worth the candle unless a system or technique works
immediately. An individual, fortunate enough to have an intuitive
sense of values, should be able to achieve reasonable profits with some
degree of consistency. The key words here are reasonable and consistency words not in the vocabulary of those who do not yet have
market experience.
R.W. McNeel, Financial Editor of the Boston Herald from 1912-1922
wrote Beating the Stock Market, published in 1921 on the human
side of speculation which means attitudes, beliefs, hopes, and fears
the emotions and characteristics that any of us associate with human beings. Now studying people may not seem rewarding. But if
you subscribe to the thesis that confidence makes business you study
people. Writers tend to emphasize their statistical figures, but people
give these figures meaning.
My point is that character is as essential as knowledge, even more
so today when basic statistical knowledge is readily available. In
McNeels day balance sheet figures were less reliable and yet they
were relied upon. In our day statistical analysis is clearly stated and
asset values are known yet the same stock swings take place. The
constant element is the human side of finance that has not changed.
Natural instincts will unquestionably govern action.
To illustrate, fear is probably the oldest human instinct. It is universal and deep rooted. It is the outgrowth of self-preservation
whereby we have been able to survive over time. To quote McNeel:
Because of its ancient origin and its great strength, man is at times
exposed to the absolute breaking down of his courage under certain
conditions and frequently without cause.
The other side of fear is greed or from the instinct point of view
that of companionship or gregariousness. Investors tend to flock
together. We have an inborn tendency to do what we see someone
else doing. Investors become excited and tend to act like lemmings
as they enter into the active or emotional states of others.
Consider how basic instincts cause us to act in the stock market.
We are told to buy low and sell high. Yet stocks are never low unless
the headlines are such as to cause the great majority of active investors to sell. Selling is usually a creation of financial necessity, needing money, or more largely through fear of pending developments in
the world that make you feel that prospect of financial 1055 is certain. Stock market bottoms are created when we sell stocks at ridiculously low prices without conscious reason. Whatever that price level
is at, it will look low in retrospect. Recent examples are Dow 570 in
1974, 770 in 1982, and 1079 in 1984. This may be a pattern of rising
bottoms, but each one offered exceptional opportunities for the purchase of stocks. The opportunity is only there because most of us are
unable to turn our instincts or emotions upside down and buy while
others sell.
Fall-Winter 2001
17
McNeel said: In order to avoid selling, and on the other hand to

buy, he must put his natural inclinations to the test of reason and
determine whether they are sound or unsound. Every investor tries
to do this, and I find from my own personal experience that it is
easier to do this if you are physically divorced from the financial black
holes of enthusiasm or despair which means the major metropolitan
centers. I am in Burlington, Vermont because it is just enough off
the beaten path to make it a Contrarians delight. Hopefully, this
keeps us a bit away from the inborn tendency to act in common with
others.
A few axioms to the uncertain art of economic prophesy follow; I will
create a bakers dozen guidelines:
1. The system is there is none. I know this sounds strange but successful techniques are counterproductive when widely followed.
Systems that work usually come to your dinner table as food for
the future when actually they are the result of previous activity
that is now so popular the system is not worth buying. What one
needs are systems at the breakfast table, for sustenance over the
coming day. Usually, one receives a system too late.
2. Consensus hopes or fears are embodied in current valuation levels. The corollaries to this are that realization of expectations
results in no price change while realization of unexpected outcomes moves prices. The chart of Aetna illustrates this point of
view which is represented by The Trader column by Floyd Norris
in the 18 June 1984 issue of Barrons [see Exhibit No. 1]. Norris
had attended the seminar on Value Investing sponsored by the
New York Society of Security Analysts where I was a speaker. His
attention was drawn to my mention that property/casualty insurance companies appear cheap in the marketplace.
The letter to the Editor is from the 25 June issue of Barrons and
concerns our mentioning of bottom fishing for property/casualty
insurance companies [Exhibit No. 1]. The point of Mr. Swifts comments is that the entire industry is so bad off that our timing is
nowhere near correct and investors should continue to avoid the
entire area.
Of course, Mr. Swifts letter represents good thinking and its inclusion in Barrons reflects a certain style of consensus wisdom.
The question comes down to that once your worst investment fears
are realized, there is only upside potential left. But what are the
worst fears? Is there a real crisis in the property/casualty insurance group or is it a case of the negative atmosphere being so
strong that this is not the time for selling but rather the time for
buying? Needless to say, the stock prices of both Aetna and Continental were both within 30 days of lows that have not been seen
since.
3. The ability to sense what is going on in the economy is more important than organizing facts. The result is that indicators are no
substitute for judgment. Besides, a simple yardstick of value can
beat exhaustive consideration of all relevant facts. When you have
too many facts there is the question of selection. To illustrate, low
price-earnings ratio investing is an extremely simple strategy which
works over time, probably because of its simplicity.
4. There is a failure to perceive new reality. In other words, it is
difficult to see the significance of outside events which produce
new watersheds. A recent example is the climb of energy prices
into 1980 and their subsequent decline into 1986. Most of us act
like generals who are fighting the last battle in a new arena where
we carry our experiences forward without taking into consideration the changing environment. The future is not always a continuation of the past. Be skeptical of past trends being stretched
18
MTA JOURNAL
far beyond the present. The elastic may break or snap back when
least expected.
5. There is a cultural-psychological lag in experience over expectations. We all have a tremendous capacity to believe anything until
it is no longer worth believing. The human factor tells us that we
see things according to our preconceptions, which then paralyze
perceptions. Indeed, when the market operates correctly, each
investor reports a slightly different version of what is going on in
the market and what signals he feels the market is sending us.
6. Trend is not destiny. The future is never clear, and one pays a
high price for a cheery consensus. The result is that uncertainty
is a friend of the long-term buyer, and we need to take a position
when most lonely. Easy to say, but not easy to do. Be suspicious of
widely held views. Educate yourself for ambiguity instead of certainty, and you have a chance for success.
7. Character is destiny. Do not put your trust in those who are trying to hustle you but rather believe in your own common sense.
Remember that our behavior patterns are restless and dynamic,
with emotions often making for strange statistical measurements.
For a Contrarian it is better to be right by oneself than be wrong
in good company.
8. The bedrock of reality is a world of disequilibrium. Instability is a
fundamental characteristic of transition. As Le Bon, the French
writer of The Crowd says, a crowd yields to instincts that individuals suppress. Rational outside perspective tends to remove you
from current investment climates.
9. The art of forecasting is in the choosing. One has to decide what
is important and what is not. We need time to reach conclusions.
We react to each new piece of information as concrete evidence
of a new trend that supports some exciting premise. The rise of
gold and silver in 1980 was a wonderful popular delusion. The
Hunt family of Texas was then worth over $5 billion and now, after some years of adversity, the family fortune seems to be well
under $1 billion. Still, a nice piece of change but not exactly what
they were used to in 1980.
10. The future is both promising and threatening. This is always the
case whether or not perceived to be. So, how you look at the
future is largely dependent upon your own psychological makeup.
Every human is anxious. We want to hear answers we agree with.
11. It is better to know some of the questions than all of the answers.
That is because the answers dont work out. To be sure, things are
more like they are today than they ever were, but most of us worry
over answers to an extent that worry consumes the spirit of action.
12. Complacency breeds surprises while fear breeds opportunity. We
have a few dozen buttons with sayings on them, some of which are
part of this article in various sentences. In this regard, patience is
sustained courage, and without curiosity, conviction is stubbornness.
13. Take not thyself too seriously. Take your work seriously but dont
confuse brains with a bull market.
This is a good place to say that it is of major importance in using
the Theory of Contrary Opinion to be contrar y to words and opinions, not to facts. It is words that mislead, distort, and delude. To
paraphrase Gustave LeBon, one of the great writers on the crowd
mind, we see how words are used as a mechanism of persuasion. The
four requisites are:
Affirmation affirm the word as truth
Repetition repeat over and over
Fall-Winter 2001
Contagion finally it catches

Prestige and imitation results
Contrary thinking cannot advise you it can only suggest Contrary trends. We are creatures of habit and prone to recession or
prosperity mentality. The irony is that widely followed forecasts bring
about their own demise.
Furthermore, one does not get by in being contrary alone, one
must also be curious. Nobody can afford to jump to conclusions since
we have to look at the whole picture. The Contrarian can clarify
thought so that recommendations fall into place. But dont force
them. Think first. Dont expect the market to conform to your own
preconceived opinions. It won't. Flexibility plus thought plus work
equals a chance for success. Rigidity of mind does rot.
as a beginning:
1. Past records give a point of departure for analysis. Average earnings, dividends, asset values and their trends should be examined.
Tangible value is the secret, either in a turnaround situation or a
special asset stock.
2. New and relevant facts that expect to have an influence may be
present. These facts should not yet be fully realized and appreciated by a majority of the financial community. (Clearly, technical
analysis offers portraits of sentiment which aid the decision making process.)
3. A lower speculative component is essential. The measurement
and delimitation of securities into investment and speculative areas is desirable. The method is largely to ignore popular trends
and to buy ex-public participation.
4. After basic principles, the distinction is still one of personal imagination and ingenuity. Confidence in market level factors influence price-earnings multiples. But a strict ladder analysis, where
you try to escalate your stock over comparative choices, is not good
practice.
5. Try to purchase under favorable conditions. A clear-cut demonstration of superior attractiveness is still subjective judgment. Facts
and ideas favorable to purchase are remembered, while negative
factors are forgotten.
Do not adhere to any formula or system. Keep no idols, but rather
stoke your noggin with antidotes for the temptation of conformity.
Rely not on a consensus indicator approach as a substitute for common sense. Then you will not be short-circuited. In fact, you may
even win.
OBJECT, PURPOSE, METHOD, PREMISE

Let us review a bit and put more pieces together. The object of
contrary thinking is to challenge generally accepted viewpoints on
the prevailing trends in politics, socio-economics, business, and the
stock market. Opinions react sharply as peoples emotions their
hopes, fears, and passions sway back and forth.
The contrarians purpose is to contest the Popular View because
the view is usually untimely, misled by propaganda, or plain wrong.
The method is to compel thinking and observation in place of
conclusion hopping and snap-guessing. Think prodding or the necessary concentrated reflection takes practice.
The premise is that alternative ideas make for a clearer, betterdefined judgment. Taking a contrary position frequently will suggest what is NOT coming next. When thinking through opposites,
one is led to sound thoughts as to what might come next.
Is the public always wrong? Is the Crowd never correct? After all,
we live in the most enlightened democracy of contemporary times,
and individuals acting in mass pull the voting levers.
For a correct answer we must rephrase the question. Is the public
wrong all the time? No. The public is probably right more of the
time than not. But the public is right only during the trends and
wrong at both ends usually wrong when it pays to be contrary. (I
feel we may include institutions as acting public-like in their investment activities. The market sheep are not all individuals. The fatter
flocks just trample more ground.)
Professor H. F. Harding of Ohio State once wrote me that the
odds are always good that the exceptional man is well ahead of the
crowd. When they catch up he is off in another direction. The
modern problem is that the speed of change influences the process
and tends to compress all movements. Remember Voltaire who said:
It is only charlatans who are certain. Doubt is not a very agreeable
state, but certainty is a ridiculous one.
Contrary Opinion theory is being discussed more and more in
the financial media as both professional managers and amateur individuals tend to use the expression when it fits them. Accordingly,
everybody is becoming aware that to do the opposite of what most
people are doing is the way to win. Simply, you win by being contrary.
Most of us should act as true investors. Forgetting about market
liquidity and the speedier ticker tape, while relying on our judgments
of what an investment will bring us over longer periods of time than
a trading cycle.
There are different approaches to the problem. The specific investment need of many Contrary Opinion readers is to tailor a program around undervaluation. This means you establish that securities purchased are worth more than they are selling. Characteristics
and criteria are set up. The following fundamental guidelines serve
MTA JOURNAL
BIOGRAPHY
James L. Fraser, president and founder of Fraser Management
(309 S. Williard St., Burlington, Vermont 05401), is responsible
for overall investment guidance as well as fundamental economic
research and portfolio management. He is a Chartered Financial Analyst and has been an investment counselor and financial
publisher since 1962. He is also a member of the Market Technicians Association.
Fall-Winter 2001
19
Exhibit 1
Norris, 18 June 1984 in Barron's
20
MTA JOURNAL
Swift, 25 June 1984 in Barron's
Fall-Winter 2001
THIS ARTICLE APPEARED IN THE MTA JOURNAL, WINTER 1989/1990
TEN WAYS TO PROFIT FROM A RUNAWAY BULL MARKET

James Dines
Any investor who thinks, a bull market is a bull market, is a bull
market, is a bull market does not understand bull markets. There
exists a very special type of bull market, a Runaway Bull Market, or
RBM. Because I know of no literature on RBMs, I would like to pull
together some of the conclusions about their characteristics.
The most difficult challenge of all, of course, is the very act of
identifying this special type of bull market. (That brings to mind the
vignette about how to grow a great English lawn: the gardener describes using the greatest seed stock, the finest loam and fertilizer in
the soil, the need to tend it carefully every day, to have good location, and so on. And finally the punch line: one needs to do all these
things for 300 years.) Comparably, I spotted the RBM based on many
years of experience. In fact it is more in the fulfillment of a set of
characteristics that we know a RBM is in force, rather than in some
specific signal. The young man knows the rules, but the old man
knows the exceptions.
Here are the identifying features that I feel delineate a Runaway
Bull Market:
1. A wholesale disregard of classic Technical Indicators; not just a
few, or many, but where nearly all negative Indicators are wrong.
Indeed, the RBM of the late eighties has shrugged off such hoary
negative Technical Indicators as Stovalls Four-Month General Motors Rule, Goulds Three-Step-and-Stumble Rule, the Inverted Yield
Curve, overbought markets, and more.
2. Setbacks are either aborted or are too small and brief to trade. In
other words, after a sharp rise, instead of the typical 1/3 to 2/3
Technical Correction such as that first identified by Charles H.
Dow at the beginning of this century, a RBM will have virtually no
setback. Instead, they have rolling adjustments within flat trading
ranges that simply amount to preparation for the next surge of
buying.
3. One would logically expect bad economic news to send the market lower, but RBMs seem to be stimulated by bad news to better
performance! For example, automobile sales dropped during
1989, yet General Motors continued to make new highs. In fact,
negative economic numbers can actually trigger buying frenzies.
A RBM either has no perceivable reaction to bad news (1) say, an
oncoming recession (2) or, perhaps, it dips slightly but is then
followed by explosive buying surges.
4. There is no stock market more profitable or dangerous to overstay than a RBM. Since RBMs tend to run their course like the
young blood of youth, this is a great time for call options: stocks
just seem to go up, up, up. Research suggests that RBMs frequently
occur after great economic prosperity, especially during the speculative finale in low-priced stocks that usually occurs near the end
of long bull markets. During a long prosperity, profits have time
to filter down to the lowest common-denominator companies,
where a small profit has a huge impact on the bottom line. Thus,
during a RBM, especially in its later phases, one would expect
more bullish action on the ASE and OTC markets than on the
New York Stock Exchange. If, it is mostly blue-chips on the New
York Stock Exchange that are in the limelight, we know that there
is more time ahead of us before we need to sell.
MTA JOURNAL
5. When a RBM ends, it tends to provide a spectacular opportunity

to make money on declining markets. In other words, a RBM is
apt to end in a spike rather than a leveling off to form a gradual
Top, so selling must be executed with great precision. RBMs are
incredibly profitable and well worth playing, but very close attention must be given to stop points. You should instruct your broker to act accordingly as soon as a trigger point is reached.
How to detect the Top, or sell point, therefore assumes paramount
importance, especially considering that we cannot rely on the usual
Technical Indicators.
Are we merely reduced to selling whenever an Uptrend line is
broken, or when a stop-loss point gets triggered? No, but the main
technique will be in the psychological realm. Therefore you might
want to review the first third of my first book Technical Analysis,
which covers mass psychology, especially the Greed/Fear Oscillation.
6. By far the most prominent characteristic of a RBM is that the investing public and professionals regard it with profound skepticism and disbelief. This is a crucial element, and there can be no
RBM without it. Thus, we are led to consideration of how we can
judge when public fear is replaced by greed, for that will be the
first sign of the RBMs end. Focusing on that crucial aspect of
RBMs, we first must distinguish between stock market and economic factors.
The Conference Board reported that consumer confidence
reached a 20-year high in July 1989. Psychologically, that was because consumers are looking at low unemployment levels around
5%. Also, with around 200,000 new jobs being created each month
in the US, dropping interest rates, and low inflation levels, such
confidence was understandable. But note very carefully that consumer confidence has little to do with stock-market investor confidence; the latters motivation is fear and a clear, sharp memory
of the Oct 1987 bear market (or crash, as tyros might describe
it).
For what then should we look when measuring the type of public
pessimism that would keep us in this stock market-hopefully making big profits? Most important is what is NOT happening! For
example, when the Dow Jones Industrial Average (DJI) made a
new all-time high in August 1989, there were no magazine covers
featuring this event; in fact the new high was greeted by yawning
indifference! Also, there was no news of hot new issues going to
immediate premiums. There were no large secondary offerings,
and in fact the news emanating from Wall Street was remarkably
subdued considering the DJIs huge rise since 1987. Because the
public buys its stocks through Wall Street, Wall Street is a wonderful mirror of what is truly happening in the minds and wallets of
investors. Note carefully it doesnt matter whether investors talk
optimistically, only whether they actually buy stocks. During 1989
the cash position in mutual funds was increasing steadily. In other
words, fund managers sold into the strength because they disbelieved it!
Yet more evidence of professional pessimism at that time could
figure in the price of a seat on the New York Stock Exchange. In
Fall-Winter 2001
21
late 1989, the price was below where it had been in Oct 1987!
Since such seats are bought by professionals, this was another gauge
of negative professional sentiment,
7. Another characteristic of REMs is gloom and-doom in the financial publishing industry, which the following quotation exemplifies.
no longer far away.

8. Self-observation is a crucial aspect of self control. As a RBM rises
in its final phases, excitement and greed will become palpable.
Remember the theory that all gamblers secretly want to lose; its
the source of mass masochism that leads the public to sell out at
Bottoms and to buy at Tops.
The same thinking can be applied to the decline in the price of a
seat on the New York Stock Exchange, mentioned above. Normally,
one would expect such seat prices to rise with the market, because
more public participation means higher commissions, but in a
RBM this Indicator is reversed.
9. As an example of how self-observation becomes crucial during a
REM, if you are afraid to buy, if you tremble at the thought that as
soon as you buy something the stock market is going to collapse,
that is bullish. It is when you take a second mortgage on your
home to buy stocks, or when you are extremely confident when
buying, that you should recognize the personal sign to get out.
10.The above nine points are a highly intangible evaluation. RBMs
tend to move with great rapidity so we have to institute trigger
points, just in case. Remember, deep Corrections are not a feature of RBMs, so at the first sign of a deep Correction it becomes
necessary to take precautions. How deep is deep? Well, there is
no easy answer to that one, and we will all have to use our own
judgments and limits.
No Boom on Wall Street for Printers

While the stock market reaches new highs, the Crash of
1987 is still taking its toll on the financial printing business.
Sorg Inc., one of the nations oldest and largest financial printers, filed for protection under Chapter 11 of the Federal Bankruptcy Code, joining Charles P. Young, founded in 1902, which
filed for bankruptcy earlier this month, and Packard Press and
its parent company, the Basix Corporation, which filed in January 1988. It will not be long, analysts and industry experts say,
before these companies are joined by others as the industry
continues to reel.
The New York Times, 12 Aug 89
Normally, one would think the bull market of that time would
have meant prosperity for the financial publishing industry.
At this same time, Charles Githlers Investment Seminars International held a seminar in San Francisco. I noted how much smaller
the crowds were than in August 1987, just before the market broke
dawn. Since tickets run $700 apiece, attendance is obviously not
casual, and as such it is an important gauge of investor sentiment.
Charles Githler told me that he had had a record 750 attendees in
Aug 87, and a record low of around 350 the following year.
In 1989 according to a number of newsletter editors, the industry
was in its worst depression ever. It has been my experience over
the last 35 years that new subscriptions remain very low all the way
up in a bull market, until a Top is approached. By the time the
public turns bullish enough to subscribe to a newsletter, a Top is
22
MTA JOURNAL
Excerpted from The Dines Letter, September 1, 1989
BIOGRAPHY
James Dines, Editor of The Dines Letter (PO Box 22, Belvedere, CA 94920) and a well-known gold bug, has written several
books on technical analysis including The Invisible Crash and
How the Average Investor Can Use Technical Analysis for Stock
Profits.
Fall-Winter 2001
THIS ARTICLE APPEARED IN THE MTA JOURNAL, SUMMER-FALL 1994
ANATOMY OF A TRADING RANGE

Jim Forte
In the following article I will discuss the analysis of a Trading Range,
employing terms and principles developed by Richard Wyckoff in
the 1920s and 30s and more recently by the Stock Market Institute.
In technical analysis, there are a variety of methods used to analyze
trading range formations and forecast the expected direction and
extent of the move out of a trading range. Most practitioners of technical analysis, whether familiar with the Wyckoff method or not, will
be able to relate many of the points and principles being discussed to
those they are already familiar with.
Much of Wyckoff's analysis and working principles were based on
what he identified as three fundamental laws:
1. The Law of Supply and Demand which simply states that when
demand is greater than supply, prices will rise, and when supply is
greater than demand, prices will fall.
2. The Law of Cause and Effect postulates that in order to have an
effect you must first have a cause, and that effect will be in proportion to the cause. This laws operation can be seen working, as
the force of accumulation or distribution within a trading range
works itself out in the subsequent move out of that trading range.
Point and figure chart counts can be used to measure this cause
and project the extent of its effect.
3. The Law of Effort vs. Result helps us evaluate the relative dominance of supply vs. demand, through the divergence or disharmony between volume and price, when considering relative
strength, comparative price progress and trading volume.
An objective of Wyckoff analysis is to aid in establishing a speculative position in correct anticipation of a coming move where a favor-
MTA JOURNAL
able reward/risk ratio exits (at least 3 to 1) to justify taking that position. Trading Ranges (TRs) are places where the previous move has
been halted and there is relative equilibrium between supply and
demand. It is here within the TR that dominant and better-informed
interests conduct campaigns of accumulation or distribution in preparation for the coming move. It is this force of accumulation or distribution that can be said to build a cause which unfolds in the subsequent move.
Because of this building of force or cause, and because the price
action is well defined, trading ranges represent special situations that
offer trading opportunities with potentially very favorable reward/
risk parameters. To be successful however, we must be able to correctly anticipate the direction and magnitude of the coming move
out of the trading range. Fortunately, Wyckoff offers us some guidelines and models by which we can examine a trading range.
A preview of the guidelines and model schematics presented here, along with
the accompanying explanation of the terms and principles represented in the
schematics, will go a long way to further the readers understanding of the text.
It is through the identification and analysis of the price and volume action and certain principles in action within the various phases
of the trading range (TR) that the trader can become aware and conclude that supply or demand is becoming dominant and correctly
anticipate the coming move. It is through the analysis of the phases
of the TR that we can distinguish accumulation/re-accumulation from
distribution/redistribution.
The Wyckoff method employs bar charts along with certain terms
and principles in action to determine the expected direction and
timing of a coming move. It also employs point and figure chart
Fall-Winter 2001
23
bottoms or it may go through a downside spring or shakeout, breaking

previous supports. This latter test is preferred, given that it does a
better job of cleaning out remaining supply from weak holders and
creates a false impression as to the direction of the ultimate move.
Our Schematic 1 shows us an example of this latter alternative.
Until this testing process, we cannot be sure the TR is accumulation and must wait to take a position until there is sufficient evidence
that mark-up is about to begin. If we have waited and followed the
unfolding TR closely, we have arrived at the point where we can be
quite confident of the probable upward move. With supply apparently exhausted and our danger point pinpointed, our likelihood of
success is good and our reward/risk ratio favorable.
The shakeout at point 8 on our Schematic 1 represents our first
prescribed place to initiate a long position. The secondary test at
point 10 is better, since a low volume pullback and a specific low risk
stop or danger point at point 8 gives us greater evidence and more
confidence to act. A sign of strength (SOS) here will bring us into
Phase D.
counts to aid in projecting the extent of the move.

For those interested in exploring the use of point and figure charts,
references are available from the Wyckoff Stock Market Institute
(SMI) and from other sources on technical analysis. Our emphasis
here will be primarily on the analysis of bar chart formations.
The following illustrations represent an idealized Wyckoff model
of market cycles involving supply and demand, accumulation and
distribution, and a conception of the primary market phases.
ACCUMULATION
Schematic 1 is a basic Wyckoff model for accumulation. While this
basic model does not offer us schematic for all the possible variations
in the anatomy of the TR, it does provide us a representation of the
important Wyckoff principles, often evident in an area of accumulation, and the identifiable phases used to guide our analysis through
the TR toward our taking of a speculative position.
Phase A
In Phase A, supply has been dominant and it appears that finally
the exhaustion of supply is becoming evident. This is illustrated in
Preliminary Support (PS) and the Selling Climax (SC) where widening spread often climaxes and where heavy volume or panicky selling
by the public is being absorbed by larger professional interests. Once
exhausted an Automatic Rally (AR) ensues and then a Secondary
Test (ST) of the selling climax. This Secondary Test usually involves
less selling than on the SC and with a narrowing of spread and decreased volume. The lows of the Selling Climax (SC) and the Secondary Test, and the high of the Automatic Rally (AR) initially set
the boundaries of the trading range. Horizontal lines may be drawn
here to help us focus our attention on market behavior in and around
these areas.
It is also possible that Phase A can end without dramatic spread
and volume, however it is usually better if it does, in that more dramatic selling will generally clear out all the sellers and clear the way
for a more pronounced and sustained markup.
Where a TR represents re-accumulation (a trading range within a
continuing up move), we will not have evidence of PS, a SC, and ST
as illustrated in phase A of Schematic 1. Phase A will instead look
more like Phase A of the basic Wyckoff distribution schematic (Schematic 2 or 3); but none the less, Phase A still represents the area of
the stopping of the previous move. The analysis of Phase B through
E would proceed the same as is generally advised within an initial
base area of accumulation.
Phase D
If we are correct in our analysis and our timing, what should follow here is a consistent dominance of demand over supply as evidenced by a pattern of advances (SOSs) on widening spreads and
increasing volume, and reactions (LPSs) on smaller spreads and diminished volumes. If this pattern does not occur, then we are advised not to add to our position and look to close our original position until we have more conclusive evidence that markup is beginning. If our stock progresses as stated above, then we have additional
opportunities to add to our position.
Our aim here is to initiate a position or add to our position as the
stock or commodity is about to leave the trading range. At this point,
the force of accumulation has built a good potential and could be
projected by using the Wyckoff point and figure method (or perhaps
another method of the readers own choosing).
We have waited to this point to initiate or add to our positions in
an effort to increase our likelihood of success and maximize the use
of our trading capital. On our Schematic 1, this opportunity comes
at point 12 on the pullback to support after jumping resistance
(in Wyckoff terms this is known as Backing Up to the Edge of the
Creek after Jumping Across the Creek). Another similar opportunity comes at point 14, a more important point of support and resistance.
In Phase D, the mark-up phase blossoms as professionals begin to
move up the stock. It is here that our best opportunities to add to
our position exist, before the stock leaves the TR.
Phase B
In Phase B, Supply and Demand on a major basis are in equilibrium and there is no decisive trend. The clues to the future course of
the market are usually more mixed and elusive, however here are
some useful generalizations.
In the early stages of Phase B the price swings tend to be rather
wide, and volume is usually greater and more erratic. As the TR unfolds, supply becomes weaker and demand stronger as professionals
are absorbing supply. The closer you get to the end or to leaving the
TR, volume tends to diminish. Support and resistance lines, (shown
as horizontal lines A, B, C, and Don the Accumulation Schematic 1)
usually contain the price action in Phase Band will help define the
testing process that is to come in Phase C. The penetrations or lack
of penetrations of the TR enable us to judge the quantity and quality
of supply and demand.
Phase E
In Phase E, the stock leaves the TR and demand is in control.
Setbacks are unpronounced and short lived. Having taken our positions, our job here is to monitor the stocks progress as it works out
its force of accumulation. At each of points 8, 10, 12, and 14 we may
take positions and use point and figure counts from these points to
calculate price projections and help us to determine our reward/risk
prior to establishing our speculative position. These projections will
also be useful later in helping us target areas for closing or adjusting
our position.
Remember our Schematic 1 shows us just one idealized model or
anatomy of a trading range encompassing the accumulation process.
There are many variations of this accumulation anatomy and we addressed some of these considerations earlier. The presence of a Wyckoff principle like a selling climax (SC) doesnt confirm that accumulation is occurring in the TR, but it does strengthen the case for
it. However, it may be accumulation, redistribution or nothing. The
Phase C
In Phase C, the stock goes through a testing process. The stock
may begin to come out of the TR on the upside with higher tops and
24
MTA JOURNAL
Fall-Winter 2001
Accumulation Schematic
Phases A through E: Phases through which the Trading Range
passes as conceptualized by the Wyckoff method and explained
in the text.
Lines A and B... define support of the Trading Range.
Lines C and D... define resistance of the Trading Range.
(PS) Preliminary Support is where substantial buying begins
to provide pronounced support after a prolonged downmove.
Volume and spread widen and provide a signa1 that the
downmove may be approaching its end.
(SC) Selling Climax... the point at which widening spread and
selling pressure usua1ly climaxes and heavy or panicky selling
by the public is being absorbed by larger professional interests
at prices near a bottom.
(AR) Automatic Rally... selling pressure has been pretty much
exhausted. A wave of buying can now easily push up prices
which is further fueled by short covering. The high of this
rally will help define the top of the trading range.
(STs) Secondary Test(s)... revisit the area of the Selling Climax to test the supply demand balance at these price levels. If
a bottom is to be confirmed, significant supply should not resurface, and volume and price spread should be significantly
diminished as the market approaches support in the area of
the SC.
The CREEK is an ana1ogy to a wavy line of resistance drawn
loosely across rally peaks within the trading range. There are
MTA JOURNAL
of course minor lines of resistance and more significant ones

that will have to be crossed before the markets journey can
continue onward and upward.
Springs or Shakeouts usually occur late within the trading
range and a1low the market and its dominant players to make
a definitive test of available supply before a markup campaign
will unfold. If the amount of supply that surfaces on a break of
support is very light (low volume), it will be an indication that
the way is clear for a sustained advance. Heavy supply here will
usually mean a renewed decline. Moderate volume here may
mean more testing of support and to proceed with caution.
The spring or shakeout also serves the purpose of providing
dominant interests with additiona1 supply from weak holders
at low prices.
Jump Across the Creek (JAC) is a continuation of the creek
ana1ogy of jumping resistance and is a good sign if done on
good spread and volume a sign of strength (SOS).
Sign of Strength (SOS)... an advance on good (increasing)
spread and volume.
Back Up (BU) to a Last Point of Support (LPS) a pull back to
support (that was resistance) on diminished spread and volume after a SOS. This is good place to initiate long positions
or to add to profitable ones.
Note: A series of SOSs and LPSs is good evidence that a
bottom is in place and Price Markup has begun.
Fall-Winter 2001
25
use of Wyckoff principles and phases identifies and defines some of

the key considerations for evaluating most any trading range and helps
us determine whether supply or demand is becoming dominant and
when the stock appears ready to leave the trading range.
This is shown at point 11 as an Upthrust After Distribution (UTAD).

Like the terminal shake out discussed in accumulation, this gives a
false impression of the direction of the market and allows further
distribution at high prices to new buyers. It also results in weak holders of short positions surrendering their positions to stronger players
just before the downmove begins. Should the move to new high
ground be on increasing volume and relative narrowing spread and
then return to the average level of closes of the TR, this would indicate lack of solid demand and confirm that the breakout to the upside did not indicate a TR of accumulation, but rather a formation of
distribution.
A third variation not shown here in schematic form would be an
up thrust above the highs of the trading range with a quick fall back
into the middle of the TR, but where the TR did not fully represent
distribution. In this case, the TR would likely be too wide to fully
represent distribution and there would be a lack of concentrated selling except in the latter portions of the TR.
DISTRIBUTION
Accompanying our discussion of distribution are Schematics 2 and
3, two variations of the Wyckoff model for distribution. While these
models only represent two variations of the many possible variations
in the patterns of a distribution TR, they do provide us with the important Wyckoff principles often evident in the area of distribution
and the phases SMI uses to guide our analysis through the TR toward
taking a speculative position.
Much of this discussion and analysis of the principles and phases
of a TR preceding distribution are the inverse of a TR of accumulation, in that the roles of supply and demand are reversed.
Here, the force of jumping the creek (resistance) is replaced by
the force of falling through the ice (support). Given this, I will not
repeat all the points made earlier, but rather emphasize those areas
where the differences merit discussion and where additional points
need to be made or reemphasized. It is useful to remember that
distribution is generally accomplished in a shorter time period as
compared to accumulation.
Phase D
Phase D, arrives and reveals itself after the tests in Phase C show
us the last gasps or the last hurrah of demand. In Phase D, the evidence of supply becoming dominate increases either with a break
through the ICE or with a further SOW into the TR after an up
thrust.
In Phase D, we are also given more evidence of the probable direction of the market and the opportunity to take our first or additional short positions. Our best opportunities are at points 13, 15,
and 17 as represented on our Schematics 2 and 3. These rallies represent Last points of Supply (LPSY) before a markdown cycle begins. Our averaging in of the set of positions taken within Phases C
and D as described above represent a calculated approach to protect
capital and maximize profit. It is important that additional short
positions be added or pyramided only if our initial positions are in
profit.
Phase A
In Phase A, demand has been dominant and the first significant
evidence of demand becoming exhausted comes at point 1 at Preliminary Supply (PSY) and at point 2 at the Buying Climax (BC).
(See Schematic 2 and 3.) It often occurs on widespread and climatic
volume. This is usually followed by an Automatic Reaction (AR) and
then a Secondary Test (ST) of the BC, usually on diminished volume. This is essentially the inverse of Phase A in accumulation.
As with accumulation, Phase A in distribution may also end without climactic action and simply evidence exhaustion of demand with
diminishing spread and volume.
Where Redistribution is concerned (a TR within a larger continuing downmove), we will see the stopping of a downmove with or without climactic action in Phase A. However, in the remainder of the
TR the guiding principles and analysis within Phases B through E
will be the same as within a TR of a Distribution market top.
Phase E
In Phase E, the stock or commodity leaves the TR and supply is in
control. Rallies are usually feeble. Having taken our positions, our
job here is to monitor the stocks progress as it works out its force of
distribution.
Successful understanding and analysis of a trading range enables
traders to identify special trading opportunities with potentially very
favorable reward/risk parameters. When analyzing a TR, we are first
seeking to uncover what the law of supply and demand is revealing to
us. However, when individual movements, rallies or reactions are
not revealing with respect to supply and demand, it is important to
remember the law of effort versus result. By comparing rallies and
reactions within the trading range to each other in terms of spread,
volume, velocity and price, additional clues may be given as to the
stocks strength, position and probable course.
It will also be useful to employ the law of cause and """ Within
the dynamics of a TR, the force of accumulation or distribution gives
us the cause and the potential opportunity for substantial trading
profits. It will also give us the ability, with the use of point and figure
charts, to project the extent of the eventual move out of the TR and
help us to determine if those trading opportunities favorably meet
or exceed our reward/risk parameters.
Phase B
The points to be made here about Phase Bare the same as those
made for Phase B within Accumulation, except clues may begin to
surface here of the supply I demand balance moving toward supply
instead of demand.
Phase C
One of the ways Phase C reveals itself after the standoff in Phase B
is by the sign of weakness (SOW) shown at point 10 on Schematic
2. This SOW is usually accompanied by significantly increased spread
and volume to the downside that seems to break the standoff in Phase
B. The SOW mayor may not fall through the Ice, but the subsequent rally back to point 11, a last point of supply (LPSY) is usually
unconvincing and is likely on less spread and/or volume.
Point 11 on both Distribution Schematics 2 and 3 give us our last
opportunity to cover any remaining longs and our first inviting opportunity to take a short position. Even a better place would be on
the rally testing point 11, because it may give us more evidence (diminished spread and volume) and/or a more tightly defined danger
point.
Looking now at Schematic 3, Phase C may also reveal itself by a
pronounced move upward, breaking through the highs of the TR.
26
MTA JOURNAL
REAL WORLD EXAMPLES

In addition to the model schematics provided here, some empirical examples of real world trading ranges are also presented (see
pages 30-31), where Accumulation/Re-accumulation preceded a
Fall-Winter 2001
Distribution Schematics
Schematics 2 and 3 show us two model variations of a distribution Trading Range.
Phases A through E... phases through which the Trading
Range (TR) passes as conceptualized by the Wyckoff method
and explained in the text.
(PSY) Preliminary Supply... is where substantial selling begins
to provide pronounced resistance after an up move. Volume
and spread widen and provide a signal that the up move may
be approaching its end.
(BC) Buying Climax... is the point at which widening spread
and the force of buying climaxes, and heavy or urgent buying
by the public is being filled by larger professional interests at
prices near a top.
(AR) Automatic Reaction... with buying pretty much exhausted
and heavy supply continuing. an AR follows the BC. The low of
this sell-off will help define the bottom of the Trading Range
(TR).
(ST) Secondary Test(s)... revisit the area of the Buying Climax
to test the demand/ supply balance at these price levels. If a
top is to be confirmed, supply will outweigh demand and volume and spread should be diminished as the market approaches the resistance area of the BC.
(SOW) Sign of Weakness... at point 10 will usually occur on
increased spread and volume as compared to the rally to point
9. Supply is showing dominance. Our first fall on the ICE
holds and we get up try to forge ahead.
The ICE... is an analogy to a wavy line of support drawn
loosely under reaction lows of the Trading Range. A break
MTA JOURNAL
through the ICE will likely be followed by attempts to get back

above it. A failure to get back above firm support may mean a
drowning for the market.
(LPSY) Last Point of Supply... (Schematic 2/Point 11): after
we test the ICE (support) on a SOW, a feeble rally attempt on
narrow spread shows us the difficulty the market is having in
making a further rise. Volume may be light or heavy, showing
weak demand or substantial supply. It is at these LPSYs that
the last waves of distribution are being unloaded before markdown is to begin.
Schematic 2/Point 13: after a break through the ICE, a rally
attempt is thwarted at the ICEs surface (now resistance). The
rally meets a last wave of supply before markdown ensues.
LPSY's are good places to initiate a short position or to add
to already profitable ones.
(UTAD) UPthrust After Distribution... (See Schematic 3/ Point
11). Similar to the Spring and Terminal Shakeout in the trading
range of Accumulation, a UTAD may occur in a TR of distribution. It is a more definitive test of new demand after a breakout
above the resistance line of the TR, and usually occurs in the
latter stages of the TR.
If this breakout occurs on light volume with no follow
through or on heavy volume with a breakdown back into the
center of the trading range, then this is more evidence that
the TR was Distribution not Accumulation.
This UTAD usually results in weak holders of short positions giving them up to more dominant interests, and also in
more distribution to new, less informed buyers before a significant decline ensues.
Fall-Winter 2001
27
Markup, and Distribution preceded a Markdown. While these empirical examples may not fit the idealized schematics exactly, I have
identified and annotated on each of the chart examples, the Wyckoff
principles in action and the five Wyckoff phases of a trading range.
Long Term Accumulation
BIBLIOGRAPHY
1. Hutson, J., Weis, D., and Schroeder, C., Charting the Market, The
Wyckoff Method, Technical Analysis of Stocks and Commodities, Seattle, 1990.
2. Pruden, H.O. and Fraser. B., The Wyckoff Seminars, Golden Gate
University, San Francisco, Fall 1992 and Spring 1993.
3. Wyckoff/Stock Market Institute, literature, illustrations, and audio tapes. 13601 N. 19th Avenue, Suite 1, Phoenix, Arizona 85029,
Tel: 602/942.5581, Fax: 602/942.5165.
4. Charts supplied by Telescan 3.0, Houston. Texas.
BIOGRAPHY
Jim Forte has been using technical analysis professionally and
personally in both stocks and commodities since 1986. He is
currently employed in the research services department of a
major brokerage firm where he maintains a market update service. He studies and teaches Technical Analysis at Golden Gate
University in San Francisco and also offers seminars. He is a
professional member of IFTA and the TSAA of San Francisco.
28
MTA JOURNAL
Phase A: Shows us the PS & SC with the exhaustion of supply as the steep downtrend in
ending. The AR & ST set the approximated boundaries of the TR to follow.
Phase B: In the early stage, we see a wide swing & higher vol, and the first signs of demand
asserting its dominance, as professionals are absorbing supply. Late in Phase B, low
vol shows supply has dwindled at the TR lows.
Phase C: Gives us a final unconvincing test and break of the TR lows on extremely light
volume. This is followed by a SOS on dramatically increased volume.
Phase D: We see a consistent & pronounced dominance of demand over supply on widening spreads and increased volume to the upside. Reactions are comparatively weak
and on light volume.
Phase E: The stock is marking up on rising volume. Demands remains in control.
Fall-Winter 2001
Intermediate Reaccumulation
Intermediate Reaccumulation
Phase A: Stops previous move.

Phase B & C: Shows comparatively weak volume on consolidation as stock moves down.
Volume very light on series of lower lows on Shakeouts. No new supply on #3 spring.
Demand showing dominance as stock comes off spring.
Phase D: Shows continuing pattern of demand in control. Gives us sufficient evidence to
add to our longs on pullback
Phase E: Stock Marking Up. Demands in control.
Phase A: Shows Buying Climax stopping previous up move and more pronounced preliminary support and selling climax facilitating accumulation into stronger hands.
Phase B: Inconclusive evidence but does show us evidence of rally on good spread and
volume.
Phase C: Shows final low on diminished volume compared to ST and holds support area
above climax low. Move off of low shows pattern on expanding spread and volume.
Phase D & E: Continues pattern of Demand in Control.
Distribution
Distribution
Phase A: Shows us PSY and Push to new highs (BC) on falling volume. ST fails and closes
below BC high. The subsequent downward immediately precedes. The next attempt,
a few days later, is on poor volume and cannot reach previous light.
Phase B: Gives us some early clues that supply is in control. Bearish activity is evident
showing a SOW on increased volume and the rallies on comparatively low volume
indicating a lack of demand. Phase B also shows a breakthrough the TR Support Lines.
Subsequent rallies are also on poor volume. Additional Breaks of Support line on
even higher volume.
Phase C: We break through the ice and manage to rise above it, however, volume in unconvincing. We can only rise to meet resistance at the supply line and the bottom of our
initial trading range. This gives us as LPSY and an opportunity to take a short position
with a well-delineated risk just about the previous high at 19 1/2.
Phase D: We fall through the ice again, but on significantly higher volume. We have no
rallying power and a feeble attempt to reach the ice fails. Supply has continued its
dominance. We are given a last opportunity to add to our short position on the rally
back to the ice.
Phase E: Markdown accelerates and supply is in control.
MTA JOURNAL
Phase A: We see the up-move stopped by PSY and the BC. We have and AR and an ST.
Phase B: In phase B relative equilibrium on low volume. No clear indications seem revealed by a #3 spring before the upthrust.
Phase C: As in our #3 Schematic, MTA however shows us a UTAD and then quickly returns
to the trading range. The UTAD follows the right side of the TR in phase C.
Phase D: Shows a progression of declines and rallies with higher volume on the down
swings. A Supply Line is evident. Breaks through the ice.
Phase E: Our rally back to the ice fails and markdown accelerates.
Fall-Winter 2001
29
30
MTA JOURNAL
Fall-Winter 2001
THIS ARTICLE APPEARED IN THE MTA JOURNAL, SPRING-SUMMER 1996
ANSWERING THE BELL OF SENTIMENT INDICATORS

Brent L. Leonard
The purpose of this review paper is to list, explain, and evaluate several
well-known stock market sentiment indicators over many periods of time. These
indicators include Option put/call ratios, advisory letters, short interest, mutual fund cash, and other contrary, against-the-crowd statistics.
The reason that this is a Review article rather than Research is that there
has been much written on these indicators by the experts of the industry (although very little recently, which I hope to update). Each indicators peaks
and troughs will be juxtaposed with the appropriate index or average. I intend to first define and describe each Indicator and assess its efficacy; then, in
a Discussion section. I place each on a Bell/Growth Curve model in its appropriate place in time.
These findings should be of use to anyone who needs to ascertain market
direction and reversals for trading.
some cases intentionally misleading) is not important; rather what

the public is really doing, as manifest in the Technical signals of Price
and Volume over Time. Unfortunately, just as the media and economists range widely in their beliefs and advice, so do technically-oriented gurus and letter writers. As Hadady points out, extreme examples (70% or more) occur less than once a year. If 80% are of one
mind, only 1 of 5 traders (especially in zero-sum Futures markets)
hold a contra position therefore they are the strong hands of Richard Wyckoffs Composite Operator, or the Big Money that controls
markets), impervious to margin calls or scared money and in no hurry
to get out without a large profit when the majority is sated as indicated when favorable news now has no effect. It is at this point that
shorts are covered, margins are full, and complacency is rampant.
In summation then, by way of paraphrasing into an anagram,
Edwin Lefevre in Reminiscences of a Stock Operator, the motto
F.I.G.H.T. could represent Fear, Ignorance, Greed, and Hope over
Time exemplifying the emotions which we need to control to be the
ultimate, dispassionate Composite Operator, or ideal trader.
One way to analyze markets by the notion that there is a controlling factor or Wyckoffian Composite Operator behind market movements was portrayed in a white paper written by Dr. Henry Hank
Pruden for a class at Golden Gate University. He likens the market
to a clothing Fashion Cycle wherein one or more top designers in the
haute couture world decides a new dress length, style, color is needed,
it is then created and diffused throughout the fashion elite, adopted
and imitated by the general public, until the last housewife in a farm
community in the Midwest has given in to the new look. Magazines,
stores, media shows have told the public what to wear, driving existing dresses, ties, and other clothing into premature obsolescence.
Indeed, if print and television media can hype or market athletic
events, songs and movies, why not glamour stocks, mutual funds and
other securities?
Much has been written over the years about contrary opinion; it
has become widely accepted and clever to go against the crowd
When everyone looks one way, look the other! Although primarily
a true concept, there are a few considerations I would like to bring to
light. Most serious investors are familiar with the South Seas Bubble
and Tulip Bulb Mania from Mackays Extraordinary Popular Delusions and the Madness of Crowds. Although history repeats itself, it
almost never does it exactly in the same way. Try developing a tulip
craze in Holland today, or, observe the Deutschbanks tight stance
against inflation after the wheelbarrows of DMarks decades ago.
In his talk at the 1994 annual TSAA conference in San Francisco,
John Bollingcr stressed how important it is to know against whom to
be contrary. Should one take a position against the world being round,
or the sun rising tomorrow? Rather, the successful investor has to
establish, through introspection, an internal monitor which will warn
him when he has stopped doing his own analysis and has begun relying on peers, media items, or a guru for opinions, tips, and timing.
In his book, Humphrey Neill explains that contrary opinion is
not necessarily cynical or negative, but sees both sides of an issue
using ones experience and logic to see reality. Just as some oscillators can be useful in the middle of a trend but wrong at the extremes,
so are the majority often correct during a Bull or Bear market but
manically wrong when it reverses, especially when they are required
to act, like buy or sell, rather than just observe. Examples of herd
logic at these junctures are This time it is different, or What can
possibly go wrong. or at the nadir, This company is doing everything wrong its hopeless. In the following pages I would like to
illustrate which indicators are the most effective in forecasting markets, individually and in combination.
One category of sentiment measurement is the surveys found in
Barrons and elsewhere on advisors, letter writers and investors. Although the majority or these surveys only go back a few years, their
roots can be found (according to Neill) in an SEC poll before the
Crash of 46 where advice from Brokers and Advisors showed a bearish percent of only 4.1%. Earl Hadady of the Bullish Consensus feels
so strongly about this indicator that he feels (in his excellent article
in the 1986 MTA Journal) that Polling is a third and most important
method of analysis, above Technical and Fundamental. The basic
question of why investors bought or sold (the public needs answers,
the media attempts to fill that need, either in honest attempts or in
MTA JOURNAL
THE INDICATORS
The odd-lot short ratio is derived by taking odd-lot purchases added
to odd-lot sales, dividing by two (much like open interest in Futures
is obtained), and dividing that into odd-lot short sales. I did not find
this indicator an effective contrary tool, especially in relation to its
success before the current bull market, for the following reasons:
only 2 major spikes above 15 occurred in this 12-year time frame (see
chart 1). Although both proceeded large up moves, they were the
result of a sideways trading range (1986) and a sharp sell off (1990).
However, seven other smaller spikes above 10 did not render bull
markets. Conversely, low readings did not indicate down moves in
the market with three exceptions 1987, 1990, and mid-1991 versus several that preceded up moves. Other reasons might include
these: smart money was shorting in sma1l odd-lots to avoid the uptick
rule, now extant in over-the-counter stocks; some shorting was used
in a derivative fashion to hedge and box positions, more than in the
past; many odd-lotters with scarce money moved to index and equity
options over the past fifteen to twenty years.
Fall-Winter 2001
31
the 17-18-year trading range cycle and started the current bull market of 1982, things noticeably changed: shorting became and remained excessive, again mostly due to derivative hedging wherein
shorts do not have to be covered and strong hands do not have to
meet margin ca1ls. Another factor to consider is that currently over
10% of the NYSE is Closed End funds, mostly bond and country types.
Sti1l, as the arrows continue to show, rising spikes seem to jibe with
up moves on the S&P 500, with the one exception.
Chart 1
Specialist Short Sales Vs. Public
Merrill Lynch data 1978-94

What appears to be a better indicator of shorting sentiment, although far from perfect, is the Specialist versus Public ratio, shown
below (Chart 3). Specialists are the closest persons to buyers and
sellers decisions, although there is a one- to two-week delay in finding their actions. We can observe that not only are the Buy and Sell
signals mostly accurate (B & S not mine), with an occasional misfire
(0), but over the long haul, timing market trades would afford you
better than 50% gain over buy-and-hold. The middle clip in Charts
4 & 5 refers to the areas between the dotted lines, lower half.
Mutual Fund Cash Ratio
ICI Ned Davis Research 1978-93

Chart 4 illustrates how excessive cash can power
markets upward while, at least in a major Bull market, too little doesnt always correlate to a major decline. One reason for this is that the pressure of shortterm performance, especially with Money Management Consultants demanding low cash ratios for clients, poses the threat of moving them to another
money manager who will rotate the cash into another sector.
In addition to the fact that excess mutual fund
cash does precede rallies, the reciprocal occurrence
of mutual fund buying climax (as depicted in the Ned
Davis chart 5) precedes either substantial declines,
or at least long, sideways trading ranges. Inversely,
from the 1987 Crash until well into 1989, Mutual Fund
redemptions exceeded sales throughout that up market, just in time to buy (A) into the next decline (B).
Chart 2
Margin Debt 1967-93
Chart 3
Merrill Lynch data

As the long-term chart indicates (Chart 6 with the
opposing arrows) Margin Debt has historically been
a correct indicator of major tops, especially in 1973,
just before 1982 and dramatically in 1987. After the
1990 correction caused the last Margin debt reconciliation or covering, the chart shows a straight up
trend, reflecting the investing consumer's,
governments and even global appetite for spending
on credit. Although accurate, like many oscillators
the trend can stay in its extreme mode seemingly indefinitely only warning of its imminent bursting.
As I mentioned earlier in the odd-lot short paragraph, when the option market got popular, especially in March 1983
with the advent of the OEX (S&P 100 Index), the least accurate of
traders, the under-financed public, switched from odd lots of stock
to options on stocks and indices. At the present time, more than
1500 stocks, or 75% of the stock market capitalization, have equity
options. The number of sector indices has also burgeoned dramatically. It has been commonly thought that when put volume heavily
outnumbers call volume, this is a contrary indicator that the market
or underlying entity will rise. This is true for the short-term day trader;
NYSE Short Ratio; S&P 500
Merrill Lynch data 1965-94

Looking at monthly data on NYSE short interest ratio and its effect on the S&P 500 Index, historically this was an accurate measure
of contrary opinion, where the early adopters of trend were correct
and profitable, and those at the manic end (see arrows on the left
side of the bottom part of Chart 2) were 180% wrong. Sharp rallies,
abetted by short covering, ensued in cyclic fashion. Once we ended
32
MTA JOURNAL
Fall-Winter 2001
John Bollinger, and others in slightly different ways),

I was quite surprised by these findings. Obviously further study using moving averages, and daily data abstracts are necessary to verify this conundrum. Looking at current daily data in the next chart, we do see a
more positive correlation between high put volume,
both in the OEX and all-equity CBOE charts, and upward price movement. This is fine for day and short
term trading, but I cannot use a high coefficient in
my Intermediate, positive-trading Master Indicator, for
which I am currently collecting data and fine-tuning,
possibly for a future paper.
Chart 4
VIX Index
CBOE 1983-91
Just a brief word about the VIX index, which measures the Volatility of the OEX index (S&P 100) from
mid 1985 on, as shown in Chart 8 above. It actually
depicts the implied volatility of 8 OEX options, in and
out the money, near months. Since it has only been
around in a Bull market, its only consistent behavior
seems to be: down or nonvolatile during moves of the
major uptrend, with sharp up spike when the market
declines, and flat or coiling during trading ranges.
Chart II shows the historical high of 150 in the Crash
of 1987, and single digit lows during 1993 and 1994,
possibly an harbinger of things to come. Although the
VIX is very good for trading strategies (buying or selling options depending on the volatility), I find it less
useful than the Option Premium Ratio, which combines put/call sentiment with volatility (see next page).
Chart 5
Option Premium Ratio

by Christopher Cadbury, 1986-94
Stocks & Commodities Magazine

A rather recent indicator that has established many
valid instances, primarily due to extensive research and
several articles by Christopher Cadbury (to whom I owe
much gratitude for endless data), is the Option Premium Ratio (OPR). This can only be found in the
Sentiment Window, Chart Page of Investors Business
Daily, item #5, and essentially combines Put/Call Option sentiment with Implied Volatility of the VIX, only
it includes all equity options, not just the OEX index.
Based on data from 10 years, (although listed Options
have been around over twenty) dividing put premiums
by call premiums has ranged from .03 to a high of 1.74.
Cadbury established that values below .29 and above 1.18 indicate a
continuation of the trends down and up respectively like extreme
levels of other oscillators. Conversely, OPRs from 30 to mid-60s generate buy signals and levels to 1.18, sell signals in about 200 different
combinations of occurrences.
Most of these abstracts are proven almost unanimously by 10 to 20
test examples, such as, Four consecutive days of gains or unchanged
values for the OPR starting from .32 to .51 have always produced
significant rallies in the stock market. A few, however, such as Identical values for the OPR in the range between .80 to .88 separated by
5 to 7 days have always produced significant declines in the stock
market have insufficient testing and border on the whenever I wear
a red tie on Friday the market goes up for 3 days category. Table 1 is
a data table of one of the most heavily tested pattern recognition
examples: it includes the date the 5-7 day series began and the OPR
values; the next four columns list the number or Dow Jones points
however, looking at the history of the OEX on a weekly basis (Chart

7), the opposite seems to be true. Over the 12 years, using Reuter's
parameters of below 0.75 OEX put/call ratio as bearish and over 1.50
being bullish, we can see the high numbers are almost always at the
top, providing the put buyers correct. Similarly, the lower numbers
consistently occur at or near the bottoms, when the call buyers would
benefit, especially in the mid-1985-86 span.
Curiously, from August 17, 1987 to October 16, 1987 the OEX
put/call ratio was locked in a 60-100 range, actually rising into the
last few days before the crash (theoretically bullish). The highest
reading ever was in late 1983 9.28 interestingly, just before the big
decline of January 1984 of some 30 OEX points.
Being a veteran Option Specialist for the OEXs largest trading
firm and author of an article in the 1993 MTA Journal (#41) on
V.O.I.C.E., a treatment of OEX Volume, and Open Interest input into
a TRIN formula with excellent results (as did Jim Martin, Ray Hines,
MTA JOURNAL
Fall-Winter 2001
33
Chart 6
Chart 7
and days just before the event, and the number of points in the subsequent rally with the number of days or weeks to complete it. More
will be heard from on this excellent indicator I intend to include it
in my Master Indicator.
Sentiment Indicators Opinions
Barron's Polling Surveys

The following section discusses the derivation of the 4 major Sentiment surveys from newsletters along with charts which show Buy
and Sell signals and their respective effectiveness, as shown by %Gains
- again this paper is to review, not to research the gathering details.
Most effective, I found, were the Market Vane and AAII Newsletters.
1. Investors Intelligence 1966-95. Investor's Intelligence is published
by Michael Burkes Chartcraft, and expresses the opinions of over
100 advisory letters every week on CNBC and later in Barron's.
Since 1966, this has been an excellent contrary indicator with its
trading range giving its best signals from high 30s (% of Bulls)
as a Buy signal and mid-70s as a Sell. Although the Buy signals
have proven very consistent, the Sell indications, which before
1989 were quite consistent although very early (sometimes several months), have been effective in signaling trading ranges as
our strong market ensues.
2. Consensus, Inc., 1984-94, Kansas City, MO. The Bullish Consensus, from Consensus, Inc. in Kansas City, MO, also uses opinions
from advisory services, mostly investment advisors from major brokerages using house organs versus newsletters. These figures also
appear on a 900 line and Barrons on Saturday. As Chart 12 shows,
there were a few very minor price reversals on major Sell signals,
34
MTA JOURNAL
especially in the coiling action of both the S&P 500 and the indicator the last 3 years. Still, profits would have bested the market
as measured by the Buy-Hold strategy (see upper left corner of
chart). As I write this paper, this indicator has reached a four-year
high of 67 (twice), versus a 71 in the first quarter of 1991.
3. Market Vane Corp., 1980-94, Pasadena, CA. An even better sentiment indicator is found in the Market Vane of Market Vane Corp.,
Pasadena, CA. Comprised of 100 of the top Investment Advisors
from Brokers, and obtained on Monday each week, information
appears on a 900 phone number and in Barrons on Saturday of
that week. Chart 12 indicates a more precise correlation between
reversals, although again the sell signals in a strong Bull market
tend to be more of a re-accumulation trading range than SAR
(stop and reverse). Once more, the last several years resemble
Fall-Winter 2001
Chart 8
most perfect correlation exemplifying the aforementioned

crowd syndrome. Gains Per Annum show more than 3 to 1
improvement over buy and hold.
DISCUSSION SECTION
In assembling and analyzing all of the above data, what
becomes increasingly evident is the difference in the time
factor of each. After working nearly a year on constructing a
Master Indicator from the most successful of these Sentiment
Indicators, it is very apparent that each of them has a different time frame. For example, the timing of the Put/Call OEX
ratio is much more short-term than Margin Debt or Mutual
Fund Cash. Not only that, the optimum position on the Bell/
Growth Curve (taken from the work of Everett in 1970) on
the next page is quite different. It is only through a corroborating nesting of several indicators that we can hope to validate the Master Indicator, which would be a great topic for a
future paper. Using Table 2 as a guide, with help from data
by Yale Hirsch in his book Don't SeIl Stocks Monday, I will try
to place each Indicator on the Curve on Chart 14 somewhere
between A and E. The graph is a model illustrating a homogeneous population of investors and sentiment indicators, and
not an actual frequency distribution. The Growth line represents a Price line and an accumulation of the aggregate Indicators, while the Bell Curve depicts Volume as well as the timing phases. Beneath the Bell and Growth Curves I have listed
the indicators under study.
Odd-lot shorting would be the highest early in A, with
Public entering in the C segment they would have to cover
by C, with the Specialists starting to short at E.
Mutual Fund Cash would be large at A, fueling the run
through D, when it would drop into the single digit percentage. Conversely, Margin would be at its low at A, becoming
manic at C and D, where the rising slope is sharpest. After an
intensive study of the history of the OEX Index, I can only find it
useful in a contrary way on a very short-term basis. Another look at
Chart 7 shows that in almost all cases, except in tops of 1986 and
1987, high numbers were found at tops, low at the bottoms, meaning
traders were correct in the long view. I must say that our current Bull
market has had high numbers from hedging and from those speculators trying to call the top of this market. Similarly, the VIX Index
and the Option Premium Ratio, derived from option premiums rather
than volume, are short-term, and would therefore be difficult to place
on the Chart.
Finally, Bearish Sentiment and gloom from investment letters and
media (magazine covers, financial newspapers and TV) respectively,
would be persuasive coming into A; they would gradually mutate into
complacency through C, and outright euphoria and certainly by E.
Chart 9
coiling action (extension waves of lesser degrees) with lower highs

and higher lows in the Indicator. The chart ends with the spring
of 1994 correction as the O/P line portends a large up move in
the near future. During the writing of this paper, it rallied up to
62 for the first time since 1987. At this time, March 25, 1995, it is
curiously near midrange, or 47 to 53 area, not forecasting the
selloffs of the previous 3 indicators.
4. American Association of Individual Investors Survey -1987-95. The
final Indicator of the Barron's group is the AAII, or American Association of Individual Investors of Chicago, IL, the true retail
trade. With 25 postcards mailed out each day of each week, nearly
100 come back with each investors opinion of the market for the
next six months. As might be expected, this indicator has an al-
MTA JOURNAL
CONCLUSION
In conclusion, what I have learned in researching and writing this
paper is that although the basic concepts of Sentiment and all of
Technical Analysis are eternal, some things do change as markets
change. For example, sentiment indicators such as Odd-Lot Shorting were rendered less effective by other inexpensive derivatives, such
as options.
Also, just as some Oscillators change parameters in Bull versus
Bear markets, Sentiment indicators are less reliable in cases like the
present, where the stock market does virtually nothing but rise, with
an occasional sideways trading range. Nonetheless, the most effective of the previously reviewed categories, newsletter polling results,
Fall-Winter 2001
35
NYSE and Specialist Short Sales, Merrill Lynch Data

Investment Company Institute - Mutual Funds
Ned Davis Mutual Fund Buying
VIX Chart, CBOE (Chicago Board of Options Exchange)
Option Premium Ratio by Christopher Cadbur y
Merrill Lynch charts on Investor's Intelligence, Consensus, Inc.,
Market Vane Corp., and American Association of Individual Investors
OEX put/call ratio data, Bloomberg News
OEX charts -Reuters/Quotron Advantage AE
BIOGRAPHY
Brent L. Leonard is an Options Specialist at Schwab 500 in
San Francisco, is Vice President of the Technical Securities Analysts Association of San Francisco, and is completing his Masters
in Finance and Level 3 of the CMT designation.
Brent has taught classes in tcchnical analysis at Golden Gate
University and Schwab University and has lectured before various groups such as A.A.I.I. He has written several articles on technical analysis both locally and nationally.
Brent attended Stanford University and University
of the Pacific, receiving a degree in education, later
completing a business curriculum with honors at Mesa
College in San Diego.
Chart 10
mutual fund cash, specialist short selling, and even option put/call
ratios, should be monitored for giving reversal signals at extreme
excesses, in conjunction with other technical tools such as cycles, oscillators, and support/resistance.
Sentiment is as important as any other technical tools used by
Technical Analysts, and will continue to be so as we enter the area of
Behavior Finance employing Neural Networks to quantify the Psychology of Investing.
BIBLIOGRAPHY
The Crowd by Gustave LeBon, 1982. Cherokee Publishing Co.
The Art of Contrary Thinking by Humphrey B. Neill, 1992, Caxton
Printers
Reminiscences of a Stock Operator by Edwin Lefevre, 1923, Doran,
Fraser Publishers
Dont SeIl Stocks on Monday by Yale Hirsch, 1986. Facts On File
Publications
MetaStock Technician Odd-lot, 1982-94
Trendlines Odd-lot Short Sales, 1991-95
36
MTA JOURNAL
Fall-Winter 2001
Chart 11
Chart 12
MTA JOURNAL
Fall-Winter 2001
37
Chart 13
Chart 14
38
MTA JOURNAL
Fall-Winter 2001
THIS ARTICLE APPEARED IN THE MTA JOURNAL, WINTER-SPRING 1998
COMBINING TECHNICAL ANALYSIS WITH FUNDAMENTAL VALUATION

TO CREATE A RISK INDICATOR FOR THE STOCK MARKET
Jurrien H. Timmer, CMT
ABSTRACT
earnings will used from here on in order to make it a true leading

indicator. Because the earnings estimates begin in 1982, that will be
the beginning of the study.
It is a widely held assumption among stock market professionals that the two
principal fundamental drivers of stock market performance over the intermediate term are earnings and interest rates, the combination of which form
the dividend discount model. The goal of this paper is to create such an
indicator for the S&P 500, and, through traditional technical analysis,
develop a trend/momentum-based timing indicator that signals periods of
intermediate term risk. This timing indicator is intended for investment
managers for hedging purposes.
Chart 1
The idea of developing the indicator described in this report was inspired by
Paul Macrae Montgomerys presentation at the 1996 MTA Seminar.
PART I: THE FUNDAMENTAL INPUTS

The oldest and most traditional method of "fundamental" valuation in the stock market is the dividend discount model. This model
takes actual or expected earnings or dividends (D) and divides that
number by a discount rate (I) in the following formula to arrive at a
"fair value" for stocks (P):
P = D/[1+I/100]
The numerator and denominator, earnings and interest rates, comprise the principal inputs for this fundamentally-driven valuation
model. For the technical analyst, it may be useful to combine this
kind of fundamental valuation with traditional technical analysis in
the form of trend and momentum studies in order to identify specific
time periods during which the stock market is at risk on the basis of
earnings and interest rates.
In doing so, we first have to chose the fundamental inputs to be
used for our study. The two primary options in terms of the numerator are earnings and dividends. Both are a manifestation of the same
underlying fundamental condition of a stock or stock index, but earnings tend to fluctuate a bit more than dividends (because the latter
are set quarterly by companies). As a result, earnings are probably a
better gauge for valuation purposes, as long as they are taken over
more than one quarter. The next decision is whether to use actual
earnings or expected earnings. Actual earnings are conventionally
looked at on a quarterly or four-quarter trailing basis (in order to
smooth out quarter-to-quarter fluctuations), making it a backwardlooking or lagging indicator. Since expected earnings are by definition forward-looking (making them a leading indicator), they offer a
better guide for valuation purposes as long as the forecasts are reliable.
Reliable in this case means reaching a critical mass in terms of earnings estimates by taking the consensus of major research analysts.
Since the early 1980's, two firms have been providing consensus earnings expectations for the S&P 500 by polling the estimates of major
Wall Street firms for the earnings of the S&P 500 on a 12-monthforward basis. The companies are I/B/E/S and First Call. For this
paper, the data from I/B/E/S are used. Chart 1 shows both the lagging and leading earnings figures for the S&P 500. The top clip depicts a weekly bar chart of the stock index, going back to 1982. The
middle clip shows the expected earnings on a 12-month-forward basis, and the bottom clip shows actual quarterly earnings. While Chart
1 shows both estimated earnings and actual earnings, only expected
MTA JOURNAL
The next step is to look at the denominator: interest rates. Because

equities are long-term assets, a long-term interest rate should be used,
such as the 30-year Treasury or Moody's long-term BAA corporate
bond yield. For the purpose of this exercise, the Treasury long bond
is used because data are widely available and because the bond is
always about 30 years to maturity (whereas the Moody's yield reflects
an index which changes over time, making it unclear whether the
duration has remained stable over the past 15 years). Now that the
interest rate vehicle has been established, we have to determine how
we are going to discount the earnings numbers. The conventional
(orthodox) method divides the earnings number by [1+I/100]. Another way, however, was recently demonstrated by Paul Macrae Montgomery at the 1996 MTA Seminar, and consists of simply dividing the
earnings number by [I/100]. Well call this the unorthodox method.
Chart 2 shows both measures. The middle clip shows the orthodox
method (right scale) while the bottom clip shows the unorthodox
(left scale). The discount factors have been inverted to show their
correlation to stock prices.
Fall-Winter 2001
39
the course of interest rates in a much more pronounced way. Thus

rather than just reflecting the earnings outlook, this series now truly
combines the effect of both earnings expectations and the course of
interest rates. Because we want to create an indicator that uses both
of these drivers, the unorthodox discounting formula of D/[I/100]
is the one we will use to build our technical indicator.
Now that we have created the time series (which will be called "E/
I" from now on) on which to build our trend/momentum indicator,
it is useful to show what the correlation actually is between our computed study and the S&P 500. Chart 4 shows both time series on a
log scale.
Chart 2
Chart 4
Note that, while both series look exactly the same, the bottom
number is much larger (e.g. 14.14 vs. 0.934 as of September 13, 1996).
As a result, when both series are multiplied by the numerator (or
when the inverse is divided), the latter approach will cause a much
bigger impact on the product of the discounting equation. The effect of both methods is shown on Chart 3.
Chart 3
The chart nicely illustrates how the stock market usually correlates with E/I, but that there are times when significant bearish divergences occur between the two, creating periods of risk. The 1983/84
correction, the 1987 crash, the 1990 correction, the 1994 correction
and the sell-off in July 1996 all stand out as such periods. As was
described earlier in this paper, the goal here is to identify these periods through the application of technical trend and momentum studies. The product of these studies will be an indicator that gives the
appropriate warnings signs when these divergences reach dangerous
levels.
First, however, we should quantify the reliability of E/I by performing a linear regression (using the least squares approach) in order
to determine what the correlation is between E/I and the S&P 500.
Table 1 shows the output of this regression (using the computer program "Econometric Views"), and below that is a graph depicting the
independent variable (E/I), the dependent (fitted) variable (S&P
500), and the residual.
The top clip shows again the weekly S&P 500. The middle clip
shows expected earnings using the orthodox approach, and the bottom clip shows the effects of the unorthodox approach. It becomes
immediately apparent that the second discounting method reflects
40
MTA JOURNAL
Fall-Winter 2001
Table 1
For example, the ROC (column G) of E/I (column F) as of 9/13/96

(row 52) is [566.20 575.26] -1 * 100 = -1.575, meaning that E/I is
1.575 pct lower than it was 6 months ago (row 26). This is a useful
measure for indicating positive or negative momentum in E/I.
52-wk STOCH: This is a more complicated momentum measure,
and comprises the following calculations: First, we calculate Fast
%K (column M) through the following formula:
Fast %K = {E/It52 - min(E/I t1:E/It52)} {max(E/It1 :E/It52) min(E/It1:E/It52)} * 100
Then we calculate the slow %D (column N) by taking a 3-week
smoothed moving average (SMA) of the fast %D (the MA is smoothed
by taking the sum of the previous three fields, subtracting the most
recent MA, adding the latest value, and dividing the result by 3). A
slow %D (column O) is calculated by taking a 9-week SMA of the Fast
%D. Finally, Column P shows the difference between column N and
column O in order to indicate whether STOCH is on a buy or sell
signal. A buy signal is given when the fast %D is above the slow %D,
and vice versa.
For example, the latest week's fast %K value is (566.2 - 554.6)
(632.9 - 554.6) = 14.76. The 3 week SMA is [(52.15+20.67+10.99) 32.51 + 14.76] 3 = 22.02. The slow %D is 42.93, thus creating a sell
signal. Besides giving buy or sell signals, this study is also useful in
gauging whether the absolute momentum level is high or low. For
instance, a level of less than 50 combined with a sell signal would be
quite bearish.
MACD: This is a useful trend study which consists of the spread
between two exponentially smoothed moving averages (ESMA)
of E/I. The conventional approach is to take 13 weeks and 26
weeks as the two M/A's. The 13-week exponentially smoothed
M/A (column H) is calculated as follows:
ESMAt14 = ESMAt13 - 0.153846 * (ESMAt13 - E/It14)
where ESMAt13 is the first MA in the series and consists of a simple 13
week MA. The number 0.153846 is the product of a smoothing con-
LS//Dependent Variable is S&P

Date: 09/14/96 - Time: 14.48
Sample: 5/07/1982 9/13/1996
Included observations: 750
Variable
C
E/I
R-Squared
Adjusted R-squared
S.E. of regression
Sum squared resid
Loglikelihood
Durbin-Watson stat.
Coefficient
-0.037291
1.035041
0.95239
0.952330
0.043162
1.393470
1293.900
0.048247
Std. Error
t-Statistic
Prob.
0.020610
-1.809403
0.0708
0.008461
122.3276
0.0000
Mean dependent var
2.476477
S.D. dependent var
0.197685
Akaike info criterion
-6.282943
Schwarz criterion
-6.270623
F-statistic
14964.05
Prob. (F-statistic)
0.000000
The key statistic to look at in Table 1 is R-squared, which measures the success of the regression in predicting the values of the
dependent variable within the sample. An R2 of 1.0 means that the
regression fits perfectly while a reading of 0 means that it fits no better than the simple mean of the dependent variable. In our regression the R2 is 0.95239, which is an excellent fit. This means that 95
pct of the behavior in the S&P 500 can be explained by the behavior
of E/I. This is encouraging, because when we build our trend/momentum indicators, we will have confidence that we are barking up
the right tree, as it were.
Chart 5
Chart 6
PART II: THE TECHNICAL INDICATOR

Now that the input has been created and tested for reliability using quantitative analysis, we can get to the juicy part as technicians
and build a risk indicator for the S&P 500. Three traditional technical studies are calculated. Two are momentum studies: a 26-wk rateof-change (ROC) and a 52-wk slowed stochastic (STOCH). One is a
trend study: a 13-wk/26-wk Moving Average Convergence/Divergence
(MACD). The time frame for these studies is the intermediate term
(3-mo-12-mo), given that the intended audience for this indicator is
portfolio managers.
Table 2 shows the one years worth of data and formulas. Column
C shows the weekly closing levels for the S&P 500. Column D shows
the I/B/E/S earnings estimates. Because the series is monthly and
our study is weekly, the same number is repeated for all the weeks in
any month. Column E shows the 30- year Treasury yield and Column
F shows our indicator E/I. Columns G through P show the output
for the above stated studies.
The technical studies are calculated as follows:
6 mo ROC: This is a simple rate of change indicator using the
formula:
ROC = (E/It26 E/It1) -1 * 100
MTA JOURNAL
Fall-Winter 2001
41
Table 2
A
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
9/21/95
9/28/95
10/5/95
10/12/95
10/19/95
10/26/95
11/2/95
11/9/95
11/16/95
11/23/95
11/30/95
12/7/95
12/14/95
12/21/95
12/28/95
1/4/96
1/11/96
1/18/96
1/25/96
2/1/96
2/8/96
2/15/96
2/22/96
2/29/96
3/7/96
3/14/96
3/21/96
3/28/96
4/4/96
4/11/96
4/18/96
4/25/96
5/2/96
5/9/96
5/16/96
5/23/96
5/30/96
6/6/96
6/13/96
6/20/96
6/27/96
7/4/96
7/11/96
7/18/96
7/25/96
8/1/96
8/8/96
8/15/96
8/22/96
8/29/96
9/5/96
9/12/96
C
S&P
500
D
Exp.
Earn.
E
30yr
Tsy
F
E/I
587.3
588.2
586.8
588.2
589.7
578.7
582.5
594.5
601.2
601.6
608.3
618.3
622.8
618.4
615.9
616.7
601.8
611.5
621.6
635.8
656.4
650.4
659.1
644.4
633.6
641.4
650.6
645.5
655.9
636.7
645.1
653.5
643.5
654.9
671.5
680.6
667.0
673.8
665.9
666.8
670.6
675.9
651.0
638.7
635.9
662.5
664.1
663.1
667.0
660.9
653.9
671.1
36.7
37.2
37.2
37.2
37.2
37.2
37.5
37.5
37.5
37.5
37.9
37.9
37.9
37.9
38.0
38.0
38.0
38.0
38.2
38.2
38.2
38.2
38.2
38.4
38.4
38.4
38.4
38.5
38.5
38.5
38.5
38.5
38.9
38.9
38.9
38.9
39.4
39.4
39.4
39.4
39.5
39.5
39.5
39.5
39.5
39.9
39.9
39.9
39.9
39.9
40.0
40.0
6.53
6.57
6.45
6.40
6.32
6.35
6.30
6.29
6.27
6.26
6.19
6.04
6.07
6.12
6.00
6.00
6.12
6.01
6.06
6.08
6.13
6.11
6.39
6.45
6.47
6.68
6.67
6.65
6.68
6.88
6.80
6.79
6.96
7.02
6.87
6.84
6.93
7.03
7.09
7.10
6.89
7.00
7.11
7.00
7.02
6.94
6.75
6.77
6.84
7.03
7.11
7.07
562.3
566.1
576.6
581.1
588.5
585.7
594.6
595.6
597.5
598.4
612.4
627.6
624.5
619.4
632.9
632.9
620.5
631.9
631.1
629.1
623.9
626.0
598.5
595.8
593.9
575.3
576.1
579.6
577.0
560.3
566.9
567.7
559.6
554.8
566.9
569.4
568.3
560.2
555.4
554.6
573.1
564.0
555.3
564.0
562.4
574.3
590.4
588.7
582.7
566.9
563.3
566.2
G
6mo
ROC
24.5
24.8
24.9
25.7
27.3
26.0
24.4
20.5
19.5
18.1
15.7
17.7
17.8
15.5
18.7
18.5
16.0
22.8
23.8
19.9
19.4
19.8
13.4
8.4
6.6
2.0
2.5
2.4
0.1
-3.6
-3.7
-3.1
-5.9
-6.9
-5.1
-4.9
-7.2
-10.8
-11.1
-10.5
-9.5
-10.9
-10.5
-10.7
-10.9
-8.7
-5.4
-6.0
-2.7
-4.8
-5.2
-1.6
H
13wk
ESMA
I
26wk
ESMA
538.62
542.85
548.05
553.14
558.58
562.75
567.66
571.96
575.88
579.36
584.45
591.09
596.24
599.81
604.91
609.22
610.96
614.18
616.79
618.68
619.48
620.48
617.11
613.82
610.76
605.30
600.81
597.56
594.40
589.15
585.72
582.95
579.35
575.57
574.24
573.49
572.69
570.76
568.40
566.29
567.33
566.82
565.05
564.90
564.52
566.02
569.77
572.68
574.21
573.09
571.58
570.75
515.49
519.39
523.79
528.20
532.84
536.91
541.35
545.52
549.52
553.28
557.83
563.20
567.92
571.89
576.58
580.92
583.97
587.65
591.00
593.92
596.23
598.52
598.52
598.31
597.97
596.23
594.68
593.52
592.26
589.80
588.03
586.47
584.40
582.12
580.95
580.06
579.15
577.69
575.98
574.34
574.24
573.46
572.06
571.44
570.75
571.02
572.51
573.76
574.44
573.86
573.05
572.52
stant 2 divided by the M/A period of 13. The 26 week ESMA is calculated in similar fashion (column I). The MACD is a simple spread
between the 13-wk ESMA and 26-wk ESMA (column J). To create
buy and sell signals, a 9-wk ESMA is taken of the spread (column K).
Finally, column L shows the difference between columns J and K,
indicating whether MACD is on a buy or sell signal. Also, the absolute level of MACD is important to identify the magnitude of rising
and falling trends.
For example, the latest value for the 13-wk ESMA is 571.58 (0.153846 * (571.58 - 566.2) = 570.75. The 26-wk ESMA is 571.58 -
42
MTA JOURNAL
J
MACD
K
9wk
ESMA
L
up/
down
M
Fast
%K
N
Fast
%D
O
Slow
%D
P
%SD<
%FD
23.12
23.46
24.25
24.93
25.74
25.84
26.31
26.43
26.36
26.07
26.61
27.89
28.32
27.92
28.32
28.30
27.00
26.53
25.79
24.75
23.25
21.96
18.58
15.51
12.79
9.08
6.13
4.03
2.15
-0.65
-2.31
-3.52
-5.05
-6.55
-6.71
-6.57
-6.47
-6.93
-7.58
-8.05
-6.91
-6.63
-7.01
-6.55
-6.23
-5.00
-2.74
-1.08
-0.23
-0.77
-1.47
-1.77
22.51
22.72
23.06
23.48
23.98
24.39
24.82
25.18
25.44
25.58
25.81
26.27
26.73
26.99
27.29
27.51
27.40
27.20
26.89
26.42
25.71
24.88
23.48
21.71
19.73
17.36
14.87
12.46
10.17
7.76
5.53
3.52
1.61
-0.20
-1.65
-2.74
-3.57
-4.32
-5.04
-5.71
-5.98
-6.12
-6.32
-6.37
-6.34
-6.04
-5.31
-4.37
-3.45
-2.85
-2.55
-2.37
0.61
0.74
1.19
1.46
1.76
1.45
1.49
1.26
0.92
0.49
0.80
1.62
1.59
0.93
1.04
0.79
-0.40
-0.68
-1.10
-1.66
-2.46
-2.92
-4.90
-6.20
-6.94
-8.28
-8.73
-8.43
-8.02
-8.41
-7.84
-7.03
-6.66
-6.35
-5.06
-3.83
-2.90
-2.62
-2.54
-2.34
-0.94
-0.51
-0.69
-0.18
0.11
1.04
2.57
3.29
3.22
2.08
1.08
0.60
99.07
100.00
100.00
100.00
100.00
98.67
100.00
100.00
100.00
100.00
100.00
100.00
98.64
96.39
100.00
100.00
94.44
99.53
99.19
98.16
95.65
96.58
82.96
80.32
79.35
68.15
68.63
70.28
67.35
57.40
61.26
61.17
52.67
43.61
50.29
49.66
47.41
40.84
36.99
36.35
51.31
43.99
36.90
43.99
42.69
46.86
61.50
59.92
52.15
20.67
10.99
14.76
99.97
99.70
99.79
99.76
100.08
99.53
99.71
99.65
99.67
100.11
99.96
100.01
99.54
98.50
98.85
98.73
97.37
98.87
98.10
97.74
98.26
97.11
92.08
87.81
83.80
75.66
73.60
70.94
67.82
65.28
63.67
61.17
57.11
53.87
51.29
48.31
47.55
46.88
42.67
39.64
41.95
42.23
42.11
44.70
40.96
43.16
50.63
53.45
55.66
46.19
32.51
22.02
93.62
94.23
95.17
96.16
97.44
98.35
98.99
99.49
99.73
99.81
99.80
99.83
99.8
99.66
99.54
99.47
99.21
99.15
98.99
98.74
98.58
98.27
97.48
96.38
94.83
92.44
90.07
87.23
84.18
80.91
77.43
73.82
70.34
66.95
63.72
61.04
58.44
56.06
53.53
50.96
48.83
46.96
45.50
44.65
43.59
43.14
43.53
44.22
45.58
46.16
45.05
42.93
6.35
5.47
4.62
3.60
2.64
1.18
0.73
0.17
-0.05
0.30
0.17
0.18
-0.26
-1.17
-0.70
-0.74
-1.85
-0.29
-0.89
-1.00
-0.32
-1.17
-5.40
-8.57
-11.03
-16.78
-16.47
-16.29
-16.35
-15.63
-13.76
-12.65
-13.23
-13.09
-12.42
-12.72
-10.89
-9.17
-10.86
-11.32
-6.88
-4.73
-3.40
0.05
-2.64
0.02
7.09
9.23
10.08
0.03
-12.53
-20.91
(0.076923 * (573.05 - 566.2) = 572.52. The MACD is the spread:

570.75 - 572.52 = -1.77. The ESMA is -2.37, creating a sell signal.
Chart 6 depicts these studies. Chart 6 nicely shows what happens
to these indicators when E/I gets into the danger zone as a valuation
model for the S&P 500. The major periods of correction/consolidation in the stock market all were signaled by negative readings in the
ROC, MACD and STOCH. However, eyeballing these studies to determine risk in the S&P 500 is not very scientific, and a more systematic approach is needed. We accomplish this by establishing certain
conditions on the three technical studies. The most straightforward
Fall-Winter 2001
approach is to define an "if-then" condition for each study, and then

combine the results into a composite trend/momentum signal.
are depicted in Table 3 in column E.

STOCH SIGNAL: Here we need to add a twist to account for the
fact that this indicator can not only be on a buy or sell signal, but
can also be overbought or oversold. Therefore, we tell the computer to return TRUE if STOCH is on a sell (i.e. the slow %D is
below the fast %D) AND STOCH is below 50, indicating that momentum is below neutral (STOCH oscillates between zero and
100). If neither of these conditions is met, the computer returns
FALSE. Column F shows the results.
MACD SIGNAL: For MACD, we also set two conditions: return
TRUE if MACD is below zero, AND it is on a sell signal, meaning
that MACD is below its 9 week ESMA. Otherwise, return FALSE.
Column G shows the output.
Finally, we set a last if-then condition to return TRUE when all
three individual conditions are true. If only some are true, or if none
are true, return FALSE.
A TRUE therefore will signal those time periods when all three
technical studies tell us that the underlying trend and momentum
conditions of our indicator E/I are reaching dangerous levels for the
S&P 500.
Given that the stock market can ignore rising rates and deteriorating earnings momentum for some time without correcting (as was
the case in 1987), it is important to note again that the objective of
this signal is to flash a warning to get out of stocks (by hedging) when
E/I's trend and momentum conditions get really dangerous, rather
than every time the slightest negative divergence occurs.
Bringing all of this together, Chart 7 shows the S&P 500, our indicator E/I and those periods of risk as defined by our trend/momentum signal. As has been the case with all charts, the S&P 500 and E/
I are charted as a log in order to show price changes in equal proportion.
Table 3
A
C
S&P 500
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
9/21/95
9/28/95
10/5/95
10/12/95
10/19/95
10/26/95
11/2/95
11/9/95
11/16/95
11/23/95
11/30/95
12/7/95
12/14/95
12/21/95
12/28/95
1/4/96
1/11/96
1/18/96
1/25/96
2/1/96
2/8/96
2/15/96
2/22/96
2/29/96
3/7/96
3/14/96
3/21/96
3/28/96
4/4/96
4/11/96
4/18/96
4/25/96
5/2/96
5/9/96
5/16/96
5/23/96
5/30/96
6/6/96
6/13/96
6/20/96
6/27/96
7/4/96
7/11/96
7/18/96
7/25/96
8/1/96
8/8/96
8/15/96
8/22/96
8/29/96
9/5/96
9/12/96
587.3
588.2
586.8
588.2
589.7
578.7
582.5
594.5
601.2
601.6
608.3
618.3
622.8
618.4
615.9
616.7
601.8
611.5
621.6
635.8
656.4
650.4
659.1
644.4
633.6
641.4
650.6
645.5
655.9
636.7
645.1
653.5
643.5
654.9
671.5
680.6
667.0
673.8
665.9
666.8
670.6
675.9
651.0
638.7
635.9
662.5
664.1
663.1
667.0
660.9
653.9
671.1
D
E/I
E
ROC
F
STOCH
G
MACD
H
COMP
562.3
566.1
576.6
581.1
588.5
585.7
594.6
595.6
597.5
598.4
612.4
627.6
624.5
619.4
632.9
632.9
620.5
631.9
631.1
629.1
623.9
626.0
598.5
595.8
593.9
575.3
576.1
579.6
577.0
560.3
566.9
567.7
559.6
554.8
566.9
569.4
568.3
560.2
555.4
554.6
573.1
564.0
555.3
564.0
562.4
574.3
590.4
588.7
582.7
566.9
563.3
566.2
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
TRUE
TRUE
TRUE
TRUE
TRUE
TRUE
TRUE
TRUE
TRUE
TRUE
TRUE
TRUE
TRUE
TRUE
TRUE
TRUE
TRUE
TRUE
TRUE
TRUE
TRUE
TRUE
TRUE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
TRUE
TRUE
TRUE
TRUE
TRUE
TRUE
TRUE
TRUE
TRUE
TRUE
TRUE
TRUE
TRUE
TRUE
TRUE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
TRUE
TRUE
TRUE
FALSE
TRUE
FALSE
FALSE
FALSE
FALSE
FALSE
TRUE
TRUE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
TRUE
TRUE
TRUE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
FALSE
Chart 7
The conditions will be very simple so we can determine if there is

method that works (i.e. gives reliable signals) without having to get
into back testing and optimization.
ROC SIGNAL: For ROC, we simply tell the computer to return
TRUE if the latest reading is below zero, that is E/I is below its
level of 6 months ago. Otherwise, return FALSE. The results
MTA JOURNAL
Fall-Winter 2001
43
Table 4
Date
Portfolio Value
-unhedged
6-Apr-84
13-Apr-84
20-Apr-84
27-Apr-84
4-May-84
11-May-84
18-May-84
25-May-84
1-Jun-84
8-Jun-84
15-Jun-84
11,333,853
11,309,883
11,466,629
11,508,444
11,666,897
11,599,331
11,424,371
11,125,815
11,004,428
11,269,946
11,042,683
Value of
1 contract
78,135
79,150
79,370
80,395
79,860
78,585
76,460
75,555
77,310
75,680
#
contracts
SELL
145
CLOSE
Value of
hedge
11,329,575
11,476,750
11,508,650
11,657,275
11,579,700
11,394,825
11,086,700
10,955,475
11,209,950
10,973,600
Initial
Margin
Transaction
Margin
Finance
Commission Adjustment Charges
-1,812,500
-1,812,500
-1,812,500
-1,812,500
-1,812,500
-1,812,500
-1,812,500
-1,812,500
-1,812,500
-1,812,500
PART III: IMPLEMENTING THE HEDGING STRATEGY
MTA JOURNAL
-2,320
-147,175
-31,900
-148,625
77,575
184,875
308,125
131,225
-254,475
236,350
Weekly
Pct P/L
-0.02%
-1.33%
-1.61%
-2.93%
-2.25%
-0.63%
2.08%
3.23%
0.98%
3.05%
-690
-690
-690
-690
-690
-690
-690
-690
-690
Portfolio Value
-Hedged
-0.02%
-1.31%
-0.29%
-1.32%
0.68%
1.62%
2.71%
1.15%
-2.24%
2.07%
11,333,853
11,307,563
11,316,412
11,325,088
11,331,701
11,342,961
11,356,053
11,366,717
11,373,236
11,392,487
11,398,413
the start and end values for the S&P 500, the percentage change in
the S&P 500, and finally the total effect of hedging the S&P 500 portfolio with futures contracts.
Before evaluating the success of our hedging strategy, certain assumptions need to be set regarding its implementation.
1. The study beginning with a portfolio of $10,000,000 in January
1983. That date reflects the beginning of the various technical
studies that are in use. Since they are trend and momentum based,
there is by definition a lag between the beginning of the indicator
E/I and its studies STOCH, ROC, and MACD.
2. The cash portfolio is indexed to the S&P 500 index, and the timing signal is executed through the short sale of S&P index futures.
3. The timing model is updated every Friday afternoon at 3:30 pm
to allow for enough time for any transactions to be executed in
the market as of that week. This is not entirely scientific because
the indicator historically reflects end-of-week values, but it will have
to do for the purpose of this study. Waiting for the next Monday
leaves too large a gap in terms of potential price swings.
4. When a signal is generated (i.e. when all three study conditions
are TRUE), a transaction is immediately executed consisting of
the short sale of S&P 500 futures equal to the total market value
of the portfolio at that time. This is done as follows: The market
value of the portfolio is divided by the product of $500 and the
price of the S&P 500 index. An example illustrating the first signal in 1984 is shown in the table below. On Friday, April 13th,
1984, a signal is given. At that time, the value of one S&P contract
is $500 x 156.27 = $78,135. The number of contracts needed to
hedge the portfolio is therefore 145 (11,309,853 78,135).
5. Transaction costs associated with the short sale are as follows: The
commission is $16 for a round-trip, and a financing spread of 2
percentage points is applied to the cost of the initial margin. The
question of margin is tricky, because if cash on hand is available,
then by definition the entire portfolio is not invested in the S&P
500. Therefore, for simplification's sake, it will be assumed that
the margin is borrowed at a cost of 2 pct over and above what the
margin amount will earn in the futures account. Additional margin will be applied directly to the cash account, however. Table 4
shows the cumulative drawdown/profit for the hedge.
6. When the signal ends (when the condition is FALSE again), the
145 contract short sale is covered. However, this will not be known
until the end of that week when the closing figures are inputted
into the model. Therefore, when looking at the history of signals,
the P&L calculations start with a one week lag and continue for
an extra week. The final column shows the portfolio value on a
hedged basis.
Table 5 gives the details of all the signals: each observation with
start and end date, the number of weeks that the signal is in effect,
44
Cumulative
Drawdown
PERFORMANCE
There have been 9 observations, each of which has lasted anywhere from 3 weeks to 11 weeks. The average period lasted about 7
weeks. Six out of nine signals were profitable, or 67 pct. The biggest
gain from hedging occurred during the 1987 crash (26.13 pct), while
the largest drawdown occurred in 1990, totaling 5.75 pct. The average gain from hedging is 4.57 percentage points. The difference between the change in the portfolio value and the return of the hedge
can be attributed to transaction costs and the rounding up or down
of the number of contracts that need to be sold short.
Table 5
9 Observations
#1
#2
#3
#4
#5
#6
#7
#8
#9
begin
end
begin
end
begin
end
begin
end
begin
end
begin
end
begin
end
begin
end
begin
end
Summary of Observations
Date
4/13/84
6/15/84
4/10/87
6/5/87
9/4/87
10/30/87
3/16/90
5/25/90
8/24/90
10/19/90
4/24/92
5/15/92
5/6/94
7/22/94
10/7/94
11/25/94
6/28/96
7/19/96
# Weeks
Average
ex-1987
7.4
7.4
9
8
8
10
8
3
11
7
3
S&P 500
156.27
151.36
322.36
292.06
322.36
238.14
338.30
357.74
317.10
303.83
410.17
414.89
451.39
453.28
455.46
452.65
668.18
634.91
Chg in
S&P 500
Pct P/L of
Hedge
-3.14%
3.05%
-9.40%
9.29%
-26.13%
26.43%
5.75%
-5.75%
-4.18%
4.13%
1.15%
-1.16%
0.42%
-0.45%
-0.62%
0.59%
-4.98%
4.96%
-4.57%
-1.88%
4.57%
1.83%
Since the beginning of this study in 1983, the average annual total
return of a buy-and-hold portfolio has been 15.90 pct, while the average annual return of an actively hedged portfolio using this timing
indicator has been 19.64 pct. Hence, the average yearly excess return
is 3.74 percentage points.
Fall-Winter 2001
Chart 8
Chart 8 shows the cumulative total return of our hypothetical portfolio on an actively hedged basis. The dotted line shows the total
return on a buy-and-hold basis.
ANALYSIS
A few issues arise when we look at the results.
The biggest problem is immediately apparent when looking at
the bottom two rows of the table as well as the chart with the cumulative total returns: while it is desirable that our indicator captured the 1987 stock market crash, the problem is that it accounts
for a big part of the overall profitability. Including the crash, the
average excess return is 4.57 pct, but excluding the crash, the excess return is only 1.83 pct. However, from the standpoint of eliminating market risk from a portfolio from time to time, this is still
an acceptable performance (because all were giving up is upside
performance, as opposed to being outright short).
The study only includes the bull market of the 1980s and 90s, and
therefore we are unsure whether it will stand the test of bull and
bear markets. The problem is that we want a forward-looking
indicator and are limited by the availability of earnings estimates,
leaving only 1982 and after. However, we can go back farther in
time to assess the validity of the unorthodox discounting method
using actual earnings instead of expected earnings. If the correlation of the indicator stands up over a longer period of time
(through the same regression analysis as before), we can at least
ascertain that the fundamental idea behind E/I is valid. Chart 9
shows E/I using expected earnings after 1982 and actual earnings
before 1982. The regression study (not shown) reveals an R2 of
92 pct, which is still pretty good for a period of 35 years. As a
result, we can maintain confidence that the idea behind the E/I
indicator is valid.
CONCLUSION
We know that the correlation of E/I is 95 pct, meaning that 95 pct
of the action in the stock market has been explained by E/I. That is
pretty valuable. Therefore, if we compliment the timing indicator
with traditional technical analysis (on both E/I as well as the stock
market itself), perhaps we can increase its value in identifying risky
periods in the stock market, as well as periods during which a fullyinvested portfolio stance should be adopted. Complementing our
indicator with traditional measures such as the Advance-Decline Line,
Lowrys Buying Power, Cash Flows into mutual funds and other sentiment measures should nicely round its effectiveness.
One example of performing additional ad hoc analysis on E/I is
shown in Chart 10. There have been four major corrections in E/I
(excluding the 1996 decline), each of which retraced between 46 pct
and 52 pct of the preceding advance. The average correction is 48
pct. This falls right in the middle of the traditional Fibonacci
retracement objectives of 38.2 pct, 50.0 pct, and 61.8 pct. Note also
that out of those four corrections, three were doubles (two sell signals). Hence, there is a repeated pattern evident in the behavior of
E/I, and that can be very valuable. For instance, we can deduce that
the July 96 correction was perhaps only the first of two correction
phases, and that the stock market will remain at risk until E/I corrects by the 48 pct average. It will be up to the technical strategist to
Chart 9
MTA JOURNAL
Chart 7 on shows that while the signal captured some corrections

perfectly (namely the 1987 crash and the sell-off in July 96), it
has been on the late side in other instances, such as 1990 and
1994. It appears that the sharp price corrections are handled well
by our indicator, while the more triangle shaped time-based corrections are handled with less success. By the time the signals
occur in the latter type corrections, it seems a better time to buy
than to sell. The problem is that if the three studies used for this
exercise are made more sensitive (by giving an earlier signal), the
sharp advances prior to the 1987 crash and July 96 sell-off are
hedged out, leaving profits on the table. The latter point is a valid
one, and the performance table does shows a rather large maximum drawdown of 5.75 pct in 1990. One way to improve the
effectiveness of the signal is to try different indicators and to run
them through a computer spreadsheet (Microsoft Excel was used
for this study).
The indicator has not only been adept in signaling risk periods,
but was very effective in signaling market bottoms as well. The
chart shows that while E/I peaks well in advance of the S&P 500
index, it bottoms at the same time as the index. In other words, it
is a leading indicator at tops and a coincident indicator at bottoms.
Relating to the previous point, we see that E/I was also valuable as
a confirming indicator of a rising stock market. Knowing that E/
I tended to peak well in advance of the stock market, we can assume that as long as E/I is in its uptrend (making new highs, uptrend lines intact, etc.), it is safe to be aggressively invested in stocks
(note the 1995 period). In other words, the indicator worked
both ways. When both stocks and E/I are rising and making new
highs, stay invested. When the bearish divergence first occurs, it
is OK to remain invested, but caution is warranted. As the divergence gets progressively worse and the retracement of E/Is preceding advance deepens, it is time to get ready to hedge. When
the timing model kicks in, or when other technical studies indicate risk, the S&P is sold, at which point the end of the signal can
begin to be anticipated (in terms of the percentage retracement
and the time of the correction). Finally, the signal ends, and the
S&P is bought back.
Fall-Winter 2001
45
Chart 11
combine his or her skills with the knowledge that E/I is a valid leading indicator of stock market peaks. Anything from trendline analysis to time cycles may be of value here.
The indicator developed in this paper, E/I, can be of use when
investing in the stock market in several ways. For portfolio managers
and position traders alike, utilizing a fundamentally oriented indicator with a 95 pct correlation to stock prices is useful, either through
the use of a timing indicator as done in this paper, or merely as an
indicator of risk in combination with other indicators. The indicator
works both as a risk indicator and as a fully invested indicator. While
this paper has focused on portfolio managers who can use E/I to
hedge during high risk periods, obviously it can be equally valuable
to position traders who can use stop-reverse strategies for either a
long-neutral strategy or a long-short strategy. Written in August 1996.
Chart 10
REFERENCES
Paper written by Paul Montgomery for 1996 MTA seminar where

he was the featured speaker
John Murphy, Technical Analysis of the Futures Markets
CQG, Inc.
Welles Wilder, New Concepts in Technical Trading Systems
BIOGRAPHY
Jurrien Timmer, CMT, was born and raised in Aruba, and
came to the U.S. to attend Babson College in 1981. He graduated with a B.S. in finance & investments and went to work for
ABN/AMRO Bank, where he worked for 10 years and ended up
running a fixed income trading & sales desk. It was there he
developed an interest in technical analyis, and started to write a
weekly report for institutional clients. His interests changed from
trading/sales to research. Currently he is a senior technical analyst at Fidelity Investments, and advises the investment professionals on developments in the financial markets (stocks and
bonds, as well as sectors and industry groups). He applies quantitative methods to back up his technical ideas, since he believes
drawing trend lines is not enough to add any value to the investment process. He writes several in-house reports and holds
monthly technical reviews for the investment professionals.
UPDATE - ONE YEAR LATER

Updating the model from the reports initial publication in August 1996, we find that no further sell signals have been issued since
the June/July 1996 signal that captured that sell-off so well. While
the indicator E/I did not issue a sell signal going into the April 1997
correction, a more subtle warning was evident in that a bearish divergence occurred at the final high leading into the correction. This
reinforces my point that the value of E/I as an indicator is not limited to a buy/sell algorithm, but rather that traditional technical analysis can be performed just as would be appropriate for an advancedecline line for example. Since the correction in April 97 was so
short lived, in retrospect the failure of E/I to issue a sell signal probably worked out for the better. Since the April 14th low, the indicator has been making new highs, thereby confirming the bullish price
action. August 18, 1997.
46
MTA JOURNAL
Fall-Winter 2001
THE STORY OF THE THREE STOCK MARKET BOTTOMS:
The Papa Bottom, The Mama Bottom and The Baby Bottom
Kenneth Safian
The most unique aspect of this stock market that many investors
may be telling their children or grandchildren is the three distinct
stock market bottoms that have occurred since March 2000. As page
7 illustrates, more than 50% of the Standard & Poors 500 Index
groups reached new 52-week lows at the 1987 and 1990 bottoms. Just
under 50% reached new lows in 1998. In April 2000, 50% of the
groups reached new lows as our Technology Average had its final
advance. Investors, therefore, dramatically reduced their more conservative holdings and heavily purchased technology company shares.
This was the larger sector bottom for the market since more groups
reached their lows at that time.
The second bottom occurred in October 2000 when worse economic statistics were released and investors heavily sold their cyclically sensitive issues. At that time, 25% of the Standard & Poor's 500
Index groups reached new lows. This sector low was discounting
unfavorable economic conditions and the liquidation was for fundamental rather than psychological reasons as was the case in the earlier bottom. Finally, the technology issues reached their lows this
March when the media declared Lucent and some other corporations being close to bankruptcy. Fifteen percent of the S&P 500 Index groups hit new 52-week lows at that time. This was a larger psychological bottom due to short selling, but a smaller actual bottom
since fewer groups reached new lows. These stocks were no longer as
important to the total market because they had already declined so
much in dollar values. The media focused on this bottom as being
the bottom because of the interest in technology issues.
The table below shows the performance of some industry groups
during these time periods. These different bottoms in price can also
be seen for the breadth series we maintain for our averages (see charts
10 to 14).
Third Bottom
Group
Technology Avg.
Net Working
Semiconductor
Rally Period
Date
Price
% Change
Date
Price
Food Average
3/17/00
564.2
7/21/00
815.8
44.6%
Life Insurance
3/17/00
364.0
6/2/00
543.6
49.3%
Property & Cas.
3/10/00
455.1
5/26/00
755.6
66.0%
Electric Utility
3/10/00
732.8
4/28/00
908.5
24.0%
Drugs
3/24/00
2458
7/14/00
3633
47.8%
Group
Second Bottom
Bottom
Rally Period
Date
Price
Date
Price
% Change
Cyclical Average
10/20/00
327.9
3/9/01
480.4
46.5%
Capital Goods Avg.
10/20/00
258.3
3/2/01
379.6
46.9%
Paper
10/20/00
520.2
1/5/01
822.0
58.0%
Retail
10/31/00
553.7
2/2/01
867.6
56.7%
MTA JOURNAL
% Change
Price
4/6/01
322.8
4/27/01
485.4
45.9%
3/16/01
1336.5
4/20/01
1994.5
45.9%
4/6/01
661.7
5/4/01
1102.9
66.7%
This perspective brings up some interesting points. First, the Federal Reserve eased dramatically at the end of 1999 and the beginning
of 2000 fearing a year 2K problem could occur. Additional funds
were available in the system and investors pushed up the prices of
more aggressive (technology) stocks compounding the bubble. A
year-over-year gain of more than a 150% occurred for our Technology Average in early 2000 while industrial production for technology
industries grew at a peak annual rate of gain of 60%. Prior to that,
both series grew about the same. It is noteworthy to re-emphasize
that most S&P 500 Index groups reached new lows at the same time
that our Technology Average reached its peak.
The diversity within the economy, the fiscal drag created by the
large budget surplus of our government during the mid-to-late 1990s,
and the raising of interest rates by the Federal Reserve when the business conditions were too strong also strengthened the dollar. These
conditions were quite unfavorable for commodity cyclical industries.
Despite those trends, the price of energy was able to rise due to the
energy policies of our government and those comprising OPEC.
Given these trends, why should there not have been diversity within
the economy and stock market and why should they not continue?
Finally, if all groups reached their lows, had their good bounces, and
the first bottom occurred over one year ago, why should there be an
urgency to rush out and buy stocks generally? The technology sector
may rally further since that group reached its low most recently.
However, most groups backed off after the rally from their bottom
was over and we would expect the same situation for technology stocks
once their rally is exhausted. Additionally, the rebounds in groups
following their lows were about 45% and our Technology Average
has rallied that percentage.
The graphic section of our recent study highlights the current
technical and fundamental environment. More technical indicators
suggest an approaching overbought condition. For example, while
more groups were oversold than overbought several weeks ago, there
is now an equal number if both the intermediate and long term categories are included. Most recent oversold conditions have been
offset by overbought conditions indicating a neutral environment.
Investor sentiment data have generally moved to more optimistic attitudes but they are not yet at dangerous levels.
Mutual Fund data clearly reflect the divergent trends discussed
earlier in this report. There were relatively large net conversions out
of aggressive growth funds in February and March, but growth and
income funds were getting net inflows. Money managers were also
net buyers of stocks and net sold securities other than common stocks
First Bottom
Bottom
Rally Period
Date
Price
Date
Copyright 2001 by Safian Investment Research, Inc. www.safian.com
Safian Investment Research Averages

Group
Bottom
Fall-Winter 2001
47
Components of the Smilen & Safian

Aggressive Growth Average in 1968
which did not indicate bearish attitudes by the mutual fund managers. Net flows into growth and income funds continued in March
2001. From a fundamental point of view, March inventories of technology products still seemed high and new orders of technology products fell below year ago levels for the first time since 1991. The data
for the Purchasing Managers Survey seemed mixed and may suggest
some stabilization. Employment data for April seemed more diverse
than generally expressed in the media. For example, the percentage
of industries that recorded a greater number of workers on a monthto-month basis has stabilized over the past three months. Structural
changes seem to be taking place in our labor force since the number
of women workers are falling and men are rising slightly. Additionally, there have been large declines in employment in the personnel
agencies category.
We continue to believe the government is and will be the major
determinant of economic and sector trends. Congress is now in the
process of trying to pass a budget resolution and the Republican leadership must compromise in order not to have that resolution defeated
in the Senate. A defeat of a budget resolution in the Senate would
mean that future budget resolutions could be filibustered. It seems
the government monetary and fiscal stimulus may abort the recession signal given by our Composite Forecasting Index and related
data in August 2000 and that greater inflationary pressures should
unfold. Our investment policy is unchanged. We would be more
diversified but concentrate more in those companies that will benefit from increased government fiscal stimulus and somewhat higher
inflation rates. Portfolios should be structured in a similar manner
as our Suggested Equity Portfolio for Large Institutional Accounts.
Yearly Percentage Changes of the Averages
Components
Traditional
Growth
Average
Cyclical
Average
S&P
500
Dow
American Hospital Supply Co.

AMP, Incorporated
SECTOR ANALYSIS
Automatic Retailers of America, Inc. 1957
+14.7
-20.2
-14.3
-12.8
Avon Products, Incorporated
1958
+65.5
+37.6
+38.1
+33.9
Control Data Corporation
1959
+44.0
+16.8
+ 8.5
+16.4
EG&G, Incorporated
1960
+25.8
-18.5
- 3.0
- 9.3
Hewlett-Packard Company
1961
+36.5
+24.3
+18.2
+23.1
+18.7
I.B.M. Corporation
1962
-26.1
-26.3
-12.2
- 11.8
- 10.8
Itek Corporation
1963
+81.7
+21.1
+18.2
+18.9
+11.8
Litton Industries, Incorporated
1964
+ 0.1
+ 5.7
+12.0
+13.0
+13.9
Perkin-Elmer Corporation
1965
+68.2
+29.1
+11.2
+ 9.1
+10.9
Polaroid Corporation
1966
+18.4
+ 4.1
- 25.1
- 13.1
-18.9
Sanders Associates, Inc.
1967
+69.7
+33.4
+17.5
+20.1
+15.2
Syntex Corporation
1968
- 4.8
+ 0.7
+12.8
+ 7.7
+ 4.3
Teledyne, Incorporated
Sector analysis is an approach that Ken Safian and Ken Smilen

(who died several years ago) formally developed in the early 1960s.
They developed the Dual Market Principle which first divided the
stock market into two major groups traditional growth and cyclical
and several satellite sectors which included primarily regulated companies or ones strongly influenced by the government such as airlines, utilities, defense, oil and gas. They maintained many fundamental and technical series for these two major groups just as technicians and analysts kept them for the entire market or economy: price,
volume, breadth, short interest, odd lot series, dividend yields, P/
Es, valuation measures, etc. Some of these indicators can no longer
be maintained because data are either unavailable or no longer relevant. However, other series and relationships are available and are
maintained.
In the mid-1960s when increased government stimulus and coming financial speculation, seemed probable an aggressive growth average started, due to a slowing economy. This index proved to achieve
extraordinary price gains almost equaling those of the late 1990s (see
table). That average was discontinued because there were so many
mergers and restatements of earnings.
48
Date
Aggressive
Growth
MTA JOURNAL
Texas Instruments, Inc.

Xerox Corporation
Zenith Radio Corporation
In 1971, when President Nixon instituted wage and price controls,

it appeared there would be a distinct difference in earning and price
performances between consumer related companies and capital goods
companies. Two new averages to track these sectors were immediately started. The performance between the Consumer Related Average and the Capital Goods Average was tremendous in 1973: The
former average was down more than 38% and the Capital Goods Average was up 22%. Divergences between sectors are nothing new. In
1957, our Cyclical Average declined more than 20% while the Traditional Growth Index increased almost 15%. In our judgement, the
current period is a magnification of the sector work started by our
firm many years ago and the great degree of change has been caused
by the transition within our economy. Our firm now has about 50
individual sector averages for which prices, volume, breadth and other
related series are maintained. Our Technology Average data were
extremely helpful in detecting the deteriorating technical conditions
in early 2000.
Breadth of the stock market can be kept in a number of ways, but
the most common method is to merely compute the difference between the number of advances and declines, on a daily or weekly
basis and cumulate those figures. If the trend in these breadth series
vary from price or the direction of that trend changes, investors can
detect transitions within the stock market. Breadth series for most of
our sector averages have been very helpful in detecting weaker or
stronger technical conditions for individual groups of stocks.
Fall-Winter 2001
CONCLUSION
The important question regarding the recent, unique occurrence
of the differing bottom periods for groups of stocks is whether this
will develop again. Will it become a more common technical condition at both market tops and troughs? We believe the answer is: probably so. As economic conditions become more complex and world
business characteristics differ, we believe there are increased chances
for major disparities within the stock market to occur. Furthermore,
as more funds for the stock market are in retirement accounts, there
are reduced probabilities for these savings to be withdrawn from the
stock market, as are regular savings that can go toward the purchase
of a house or a car. Therefore, money stays in these accounts and the
money managers move funds from one group or type of stock to another. Given these factors, we think varied sector trends will become
an increasing probability and should be a major part of technical
analysis.
BIOGRAPHY
Kenneth Safian is President of Safian Investment Research, a
firm that has provided investment strategy to major institutional
investors here and abroad for almost forty years.
Ken began his investment career at Dreyfus & Co. in 1958
where he was responsible for the Investment Management Division. He co-authored a text in 1960, which first introduced to
the investment community the relationship between growth and
cyclical stocks. His firm has been referred to as a think tank
since it has originated many new investment and economic concepts.
Ken is a graduate of the Wharton School at the University of
Pennsylvania, a past director and member of the New York Society of Security Analysts, a member of the National Association of
Business Economists, a member of the Investment Policy Committee of Edward D. Jones & Company and formerly served on
the Special Firms Committee of the New York Stock Exchange.
He has been a member of the MTA since 1977. Ken has spoken
at numerous investment and economic forums, is frequently
quoted in the media and continually consults with various government officials in Washington, D.C.
Please see over for the Breadth Series Charts

MTA JOURNAL
Fall-Winter 2001
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Fall-Winter 2001
EXPLOITING VOLATILITY TO ACHIEVE A TRADING EDGE USING

AN AVERAGE-TRUE RANGE (ATR) SECOND FILTER:
Market-Neutral/Delta-Neutral Trading Using the PRISM
Trading Systems
10
Jeff Morton, M.D., CMT and Randi Schea, M.D.
ABSTRACT
management rules significantly improved the theoretical returns while

simultaneously decreasing the drawdowns when compared to the
original study. This improved volatility-based, market-neutral, deltaneutral (gamma positive) trading strategy yielded a very substantial
positive return across a large number of large-cap stocks and across a
broad 5-year period. These results demonstrate the potential positive returns that can be obtained from a market-neutral/delta-neutral strategy. The benefit of a market-neutral strategy as demonstrated
here is of significant importance to institutional portfolio managers
in search of non-correlated asset classes.
Purpose: Previously, we have shown that the theoretical returns

for a simple non-directional option strategy initiated after a sudden
and significant volatility implosion of an underlying stock has a positive expectation with an average return per trade of 4.25%. This
study was designed to evaluate whether the addition of a second entry signal based on the average-true-range (ATR) of the daily stock
prices could improve the theoretical returns or decrease the drawdowns experienced in the first study.
Methods and Materials: The 30 Dow Jones Industrial Average
stocks from November 1, 1993 through May 30, 1998, were chosen
for this study. Delta neutral/gamma positive straddle options positions were initiated on the opening price of the stock after two sequential signals were satisfied. The first signal was generated when
the near-term historical volatility of the stock had significantly imploded relative to its longer-term historical volatility. The second
signal was generated when the daily ATR of the stock began to increase. Any signals generated in the same stock before the 6-week
termination date of a prior trade were ignored. On the date of calculation, the options prices were determined with the actual implied
volatility using the Black-Scholes model, assuming moderate slippage.
All trades were equally weighted. The value of the options positions
were calculated based on the closing stock price at the 2-, 4-, and 6week periods respectively. Two trading systems were evaluated. In
the first system (time based system), time was the sole determinant
used to determine when the option positions would be closed out.
In the second trading system (money management system), simple
money management rules were added to reduce drawdowns and to
lock-in profits in profitable trades. Given the wide variability of
brokerage fees, the results are presented without commission costs
deducted.
Results: A total of 230 trades were generated between 11/1/93
and 5/30/98. For the time-based trading system (trading system 1),
the 2-week, 4-week, and 6-week cumulative return was +88%, +255%,
and -151% and the average return per trade was +0.38%, +1.11%,
and -0.65% respectively. For the money management trading system
(trading system 2), the 2-week, 4-week, and 6-week cumulative return
was +219%, +979%, and +1470% and the average return per trade
was +0.94%, +4.26% and +6.39% respectively. The use of a simple
money management system significantly reduces the drawdowns of
the system.
Conclusions: The addition of a second entry filter, ATR, did not
improve the theoretical returns of a simple time-based volatility trading strategy that previously had been shown to produce a positive
return for positions held four weeks. The addition of the ATR filter
did, however, significantly decrease the drawdowns that precluded
the original systems viability as a useful trading strategy in its own
right. As in the original study, the addition of some simple money
management rules had a dramatic impact on the results. The addition of the ATR filter in combination with some very simple money
MTA JOURNAL
INTRODUCTION
For options-based trading, the price action of any freely-traded
asset (e.g., stocks, futures, index futures, etc.) can be grouped into
three generic categories (however defined by the trader): (a) bullish price action; (b) bearish price action; (c) congestion/trading
range price action.
Specific options-based strategies can be implemented which results in profits if any two out of the three outcomes unfold. For example, the purchase of both call and put options on the same underlying asset for the same strike price and same expiration date is termed
a straddle position (e.g., buying XYZ $100 strike March 1999 call
and put options = XYZ $100 March 1999 straddle). This straddle
position can be profitable if either (a) or (b) quickly occur with
significant magnitude (i.e., price volatility) prior to option expiration. In this sense, a straddle trade is non-directional since it can
profit in both bull and bear moves.
Price volatility can be described by several common technical indicators including average-true-range (ATR), average-directional index (ADX), standard deviation, and statistical volatility (also called
historical volatility). Volatility has been observed to be mean-reverting. Periods of abnormally high or low short-term price volatility
are followed by price volatility that is closer to the long-term price
volatility of the underlying asset.(1,3) A short-term drop in price volatility (volatility implosion) can be reliably expected to be followed by
a sudden volatility increase (volatility explosion). Connors, et. al. have
shown that multiple days of short-term volatility implosion is a predictor of a strong price move.(1,2)
The volatility implosion does not predict the direction of the impending price move, but only that there is a high probability that the
underlying asset is going to move away from its current price and by
a significant amount. In a previous study(4) we showed that a simplestraddle, options-based strategy designed to exploit a sudden implosion of a stocks volatility, combined with a simple money-management strategy, with time as the only existing criteria produced superior returns and, therefore, could be used as the basis to develop
trading strategies capable of producing superior returns without the
need to correctly predict the direction of a given stock, commodity
or market being traded. However, the volatility implosion does not
predict when (how quickly) the explosion price move will develop.
Further analysis of the previous study indicated that volatility can re-
Fall-Winter 2001
55
main low and even continue to decrease for several weeks. Thus, not
infrequently, the trade was stopped-out just before the volatility exploded. It appeared that we were successful at defining periods of
low volatility but needed a way of better predicting when the period
of low volatility was ending. In this study we investigated the use of a
second entry filter based on the average-true-range (ATR) of the recent daily prices as a way for trying to better define the end of the
low period of volatility and thereby improve the overall returns obtained using the basic option straddle strategy. At PRISM Trading
Advisors, Inc., this strategy has been successfully implemented to generate superior returns at lower risk than traditional investment portfolio benchmarks.
implied volatility, and the yield of the 90-day U.S. Treasury Bill were
used to calculate the price of the options. The professional software
package, OpVue 5 version 1.12 (OpVue Systems International), was
used to calculate the options prices assuming a moderate amount of
slippage. For the purposes of this analysis, it was assumed that each
trade was equally weighted and that an equal dollar amount was invested in each trade. Based on the closing stock price, the value of
the option straddle positions were then calculated using the same
method described above after 2-weeks, 4-weeks, and 6-weeks respectively. Any trading signals generated in a stock with a current open
option straddle position before the end of the 6-week open trade
period were ignored. To minimize the effect of time decay and volatility, options with greater than 75 days to expiration were used to
establish the straddle positions. The positions were closed out at the
end of the 6-week time period with more than 30 days left until expiration. To further minimize the effect of volatility, options were purchased at or near the money. Given the current large variability of
brokerage fees, the results were calculated without deducting commission costs.
System 2 (Money-Management Strategy): As in the original study,
a second trading strategy was explored. It was identical to the first
trading strategy above except that a set of simple money management rules were added. The rules were designed to 1) cut losses
short, 2) allow profits to run, and 3) lock in profits.
Rule #1: A position was closed immediately if a 10% loss occurred.
Rule #2: If a 5% profit (or greater) was generated, then a trailing
stop of one-half (50%) of the maximum open profit achieved by
the position was placed and the position closed if the 50% trailing
stop was violated.
Rule #3: If neither Rule #1 or #2 was violated then the position
was closed out after either four weeks or six weeks.
METHODS AND MATERIALS

System 1 (Time-Based Strategy): This strategy was tested from
November 1, 1993 through May 31, 1998 using the stocks that make
up the Dow Jones Industrial Average as a representative sample of
the broader market. They were chosen because they are a well-known
group of stocks that have been designed to represent the market at
large. Volatility is defined by the price statistical volatility formula:
s.v. = s.d.{log(c/c[1]),n} * square-root (365); where:
s.v. = the statistical volatility.
s.d. = the standard deviation.
c = the closing price of the stock on that day.
c[1] = the closing price of the stock of the previous day.
Statistical (or historical) price volatility can be descriptively defined as the standard deviation of day-to-day price change using a
log-normal distribution and stated as an annualized percentage.
Detailed information on statistical volatility is available from the references.(1,2,3)
Another measure of volatility is the average-true-range (ATR). It
is the average of the true-range (TR) of the daily prices over a specified period of time. True-range (TR) is defined as the greater of:
the difference between todays high and todays low,
the difference between yesterdays close and todays high,
the difference between yesterdays close and todays low.
The rules to initiate a trade were as follows:
Rule 1: 6-day s.v. is 50% or less than the 90-day s.v.
Rule 2: 10-day s.v. is 50% or less than the 90-day s.v.
Rule 3: Both Rule #1 and Rule #2 must be satisfied to trigger
completion of the first trade signal.
Thus in this study, the first signal, a volatility implosion, occurred
when the 6-day and 10-day historical volatilities were 50% or less than
the 90-day historical volatility.
Rule 4: Rule #3 must be satisfied before proceeding to Rule #5.
Rule 5: The trend of the 14-day ATR, when the first trade signal is
triggered, must be flat or in a downtrend.
Rule 6: The 14-day (ATR) today must be greater than the 14-day
ATR yesterday.
Rule 7: The 14-day (ATR) yesterday must be greater than the 14day ATR two days ago to initiate the trade.
Thus the second signal, the beginning of an increase in volatility,
occurred when the 14-day ATR increased for two consecutive days.
When these conditions were met, a signal to initiate a straddle
position was taken the following trading day. The Black-Scholes model
was used to calculate the options prices that were used to establish
the straddle positions. The opening price of the stock, the actual
56
MTA JOURNAL
RESULTS
System 1 (Time-Based Strategy): A total of 230 trades were generated between 11/1/93 and 5/30/98. Numerous parameters of the
230 trades were analyzed. The results are summarized in Table 1.
The 2-week, 4-week, and 6-week cumulative returns were +88%,
+255%, and -151% respectively and are shown in Chart 1. The return of the DJIA over the same time period was +242% (3680.59 to
8899.95). The maximum drawdowns for the 2-week, 4-week, and 6week series were, -143%, (8/24/94 3/10/94), -249% (9/1/94 3/
13/94), and -640% (12/29/93 1/26/95). The maximum draw-ups
for the 2-week, 4-week, and 6-week series were, +312% (3/10/94
11/25/95), +557% (3/13/94 1/30/96), and +561% (1/26/95 4/
24/96). The results of the current study are compared with the results of the prior study in Charts 3 and 4.
System 2 (Money-Management Strategy): A total of 230 trades
were generated between 11/1/93 and 5/30/98. Numerous parameters of the 230 trades were analyzed. The results are summarized in
Table 2. The 2-week, 4-week, and 6-week cumulative returns were
+251%, +979%, and +1470% respectively and are shown in Chart 2.
The return of the DJIA over the same time period was +242% (3680.59
to 8899.95). The maximum drawdowns for the 2-week, 4-week and 6week series were -132% (8/24/94 3/10/95), -112%, (9/1/94 1/
19/95) and -125% (9/1/94 12/30/94). The maximum draw-ups
for the 2-week, 4-week and 6-week series were +223% (3/10/95 11/
24/95), +666% (2/7/95 4/24/95) and +939% (12/20/94 4/24/
96). The results of the current study are compared with the results of
the prior study in Charts 5 and 6.
Fall-Winter 2001
DISCUSSION
remain low and even continue to decrease for several weeks. Thus,
not infrequently the trade was stopped out just before the subsequent
and anticipated volatility exploded. It appeared that we were successful at defining periods of low volatility but needed a way of better
predicting when the period of low volatility was ending. It has also
been shown that unusually high volatility generally indicates that a
sustainable trend is underway. Price-range expansion, after a period
of unusually low volatility, indicates that a new sustainable trend is
beginning. In this study, we investigated the use of a second entry
filter based on the average-true-range (ATR) of the recent daily prices
as a way for trying to better define the end of the low period of
volatility and the beginning of a reversion of volatility back towards
its mean. It was hoped that the ATR filter would improve the overall
returns obtained using the basic-option-straddle strategy, while simultaneously decreasing the drawdowns experienced by the original study.
In the original study, the 4-week time-stop yielded the best results
since it was felt that the 2-week time-stop did not allow for sufficient
time for the anticipated price move to fully develop; total return of
+335% versus -191%. The 6-week time-stop allowed for the adverse
effects of time-decay, volatility, and price regression back towards the
stocks initial starting price that eroded the value of the straddle position; total return of +335% versus -84%. Since the addition of the
second ATR filter was intended to delay the entry into the trade until
the period of low volatility had ended, we were concerned that the
use of the same 4-week time-stop might experience some of the same
problems encountered in the original study with the 6-week timestop. This is in fact what was seen; the 2-week time-stop produced
significantly better results while the 4-week time-stop produced slightly
worse results when compared to the original study. If one compares
the time-based systems from the original study with the current study
(Table 3), one finds that for the 2-week time-stop the total return (191% vs. +88%), the average return-per-trade (-0.60% vs. +0.38%),
and the maximum drawdown (-424% vs. -143%) were significantly
improved. For the 4-week time-stop (Table 4), the total return (+335%
vs. +255%) and the average return-per-trade (+1.20% vs. +1.11%) were
slightly worse. The maximum drawdown again, however, was significantly improved (-451% vs. -249%). It was, therefore, concluded that
the addition of the second ATR filter had a significant positive effect
on the original trading system.
As in the original study, the application of a simple set of moneymanagement rules was again explored in the study. Once again, as
in the original study, the money-management rules dramatically improved the overall returns while simultaneously decreasing the drawdown experienced in the time-based strategy. The combination of
the money-management rules with the addition of the ATR filter further improved the results (Tables 5 and 6). For the 6-week time-stop
plus money management, there was a 24% improvement in total returns (1187% vs. 1470%), a 50% improvement in average return-pertrade (4.25% vs. 6.39%), and a 51% reduction in the magnitude of
the maximum drawdown (-246% vs. -125%).
The current study also continues to suffer from several limitations.
Although moderate slippage was used in all the calculations, the robustness of this study might have been improved if access to real-time
stock option bid-ask prices were available for all of the trades investigated. Unfortunately, such a large, detailed database is not readily
available. Given that the real-time bid-ask prices were not available,
the use of the Black-Scholes formula with the known historical inputs (stock price, implied volatility, 90-day T-bill yield) is an acceptable alternative thereby minimizing any pricing differences between
the actual and theoretical option prices systematically throughout
the time period used in the study.
The current study revealed that the addition of a second ATR fil-
It has been observed that short-term volatility will have a tendency

to revert back to its longer-term mean. (1,3) Connors et.al.(1) have published the Connors-Hayward Historical Volatility System and showed
that when the ratio of the 10-day versus the 100-day historical volatilities was 0.5 or less, there was a tendency for strong stock price moves
to follow.
In our previous study at PRISM Trading Advisors, Inc., we confirmed the phenomenon of volatility-mean reversion by presenting
the first large-scale, option-based analysis while maintaining a strict
market-neutral/delta-neutral (gamma positive) trading program(4).
We showed that a significant price move occurred 75% of the time
following a short-term volatility implosion (as defined in the Methods and Materials section).
In the previous study, we chose a relatively straightforward strategy of purchasing a straddle. A straddle is the proper balance of put
and call options that produce a trade with no directional bias. A
straddle is said to be delta neutral and will generate the same profit
whether the underlying assets price moves higher or lower. As the
asset price moves away from its initial price, one option will increase
in value while the other opposing option will decrease in value. A
profit is generated because the option that is increasing in value will
increase in value at a faster rate than the opposing option is decreasing in value. The straddle is said to be gamma positive in both
directions, because one is both long the call option and long the put
option.
This option strategy has a defined maximum risk that is known at
the initiation of the trade. This maximum risk of loss is limited to
the initial purchase costs of the straddle (premium costs of both put
and call options). There is no margin call with this straddle strategy.
There is an additional way that this strategy can profit. Because the
options are purchased at the time there has been an acute rapid decrease in volatility, one should theoretically be purchasing undervalued options. As the price of the asset subsequently experiences a
sharp price move, there will be an associated increase in volatility
which will increase the value of all the options that make up the
straddle position. The side of the straddle which is increasing in
value will increase at an even faster rate, while the opposite side of
the straddle which is decreasing in value will decrease in value at a
slower rate. So as to not further complicate the analysis, the exit
strategy for the first system (time-based strategy) for this study was
even more basic; using a time-stop exit criteria.
In the previous study we showed that a 4-week exit produced a
positive return over the study period (335%). However, the drawdowns precluded its use as a stand-alone system for real-time trading
(-451%). In that study, a simple set of money management rules
were added to the original system tested. These money management
rules were designed to close-out non-performing trades early before
they could turn into large losses and kept performing positions open
as long as they continued to generate profits. These goals were accomplished by closing out any position if its value decreased to 90%
of its initial value (i.e. a 10% loss). A position with open profits had
a 50% trailing stop of the maximum open profit achieved by the position at any time open profits exceeded 5%. If neither of these two
conditions occurred, the position was closed-out at the end of six
weeks. As predicted, the 6-week money-management strategy produced both a significantly greater total return (1189%) with a significantly smaller drawdown (-246%) than the 4-week non-money-management strategy. By closing positions when a loss of 10% had occurred, we were able to significantly decrease the amount of losses.
Further analysis of the previous study indicated that volatility can
MTA JOURNAL
Fall-Winter 2001
57
Table 2
ter to a simple straddle options-based strategy designed to exploit a

sudden implosion of a stocks volatility with time as the only existing
criteria, yielded superior results when compared to the same strategy
without the second ATR filter. Although improved, this strategy with
the second ATR filter continues to produce drawdowns that preclude
it as a viable trading strategy. The addition of some simple moneymanagement rules dramatically improved the overall returns while
simultaneously decreasing the excessive drawdowns that plagued the
original trading strategy, thereby transforming it into an applicable
trading system for everyday use. This volatility-based, delta-neutral
strategy also is independent of market direction. A market-neutral
strategy and portfolio may be considered as a separate asset class by
portfolio managers in the efficient allocation of their investment
portfolios to boost returns while simultaneously decreasing their risk
exposure.
In conclusion, this is the second large-scale, trading-research study
to be shared with the trading public that clearly demonstrates how
the phenomenon of price-volatility, mean-reversion can be exploited
by using an options-based, delta-neutral approach. By adding a second filter based on ATR to signal the end of the low volatility period, the results were significantly improved. Price, time and volatility factors using options-based strategies to further maximize positive
expectancy continue to represent active areas of real-time trading
research at PRISM Trading Advisors, Inc. These results will be the
subject of future articles.
System 2 (Money-Management System)

2-Week
4-Week
6-Week
Total Return
+251%
+979%
+1,470%
Average Return per Trade
+1.09%
+4.26%
+6.39%
Maximum Draw-Up
+223%
+666%
+939%
Maximum Draw-Down
-132%
-112%
-125%
Total # Winning Trades
84
100
105
Total # Losing Trades
146
130
125
Max. # of Consecutive Wins

Max. # of Consecutive Loses
11
Greatest Gain in One Trade
+85%
+105%
+112%
Greatest Loss in One Trade
-10%
-10%
-10%
Chart 2: System 2 (Money-Managment System)
Table 1
System 1 (Time-Based System)
2-Week
4-Week
6-Week
+88%
+255%
-151%
+0.38%
+1.11%
-0.65%
Maximum Draw-Up
+312%
+557%
+561%
Maximum Draw-Down
-143%
-249%
-640%
Total Return
84
86
100
146
144
130
11
23
+85%
+105%
+112%
-31%
-33%
-54%
Table 3
Comparison of Time-Based Systems
2-Week without ATR Filter
Chart 1: System 1 (Time-Based System)
2-Week with ATR Filter
Total Return
-191%
+88%
-0.69%
+0.38%
Maximum Draw-Up
+374%
+312%
Maximum Draw-Down
-424%
-143%
91
84
189
146
14
11
+88%
+85%
-48%
-31%
Table 4
Comparison of Time-Based Systems
4-Week without ATR Filter
58
MTA JOURNAL
4-Week with ATR Filter
Total Return
+335%
+255%
+1.20%
+1.11%
Maximum Draw-Up
+933%
+557%
Maximum Draw-Down
-451%
-249%
106
86
174
144
+132%
+105%
-52%
-33%
Fall-Winter 2001
Table 5
Comparison of Money Management Systems
4-week without ATR Filter
4-week with ATR Filter
Total Return
+993%
+979%
+3.55%
+4.26%
Maximum Draw-Up
+641%
+666%
Maximum Draw-Down
-188%
112%
120
100
160
130

+132%
+105%
-10%
-10%
Table 6
Comparison of Money Management Systems
6-week without ATR Filter
6-week with ATR Filter
Total Return
+1189%
+1,470%
+4.25%
+6.39%
Maximum Draw-Up
+704%
+939%
Maximum Draw-Down
-246%
-125%
117
105
163
125

+109%
+112%
-10%
-10%
REFERENCES
1. Connors, L. A., and Hayward, B.E., Investment Secrets of a Hedge
Fund Manager, Probus Publishing, 1995.
2. Connors, L. A: Professional Traders Journal. Oceanview Financial Research, Malibu, CA. March 1996, Volume 1, Issue 1.
3. Natenberg, S., Option Volatility and Pricing. Advanced Trading
Strategies and Techniques, McGraw Hill, 1994.
4. Morton, J. D.: Exploiting Volatility to Achieve a Trading Edge:
Market-Neutral/Delta-Neutral Trading Using the PRISM Trading Systems. The MTA Journal, Issue 54, pp. 9-12, 2000.
MTA JOURNAL
Fall-Winter 2001
59
NOTES
Notes
Notes
NotesNotes
Notes
Notes
Note
60
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THE ART OF TECHNICAL ANALYSIS

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