Professional Documents
Culture Documents
of
Technical
Analysis
Issue 61
Winter-Spring 2004
SM
Incorporated 1973
Table of Contents
The postponement of the Dow Award this spring had its repercussion with our Journal of Technical Analysis. We
normally publish the winning paper in this issue. However, it has turned out for the better. Not only are more excellent
papers being submitted for the award, but also this Journal is enlivened with some wonderful practical as well as
theoretical articles for your enjoyment and education.
As technicians, we like to believe that somewhere out there is a theoretical base that can explain what we have long
observed through our own experience and learned from the experience of others about open market behavior. In this
issue Dr. Henry Pruden, long time past editor of the Journal, and two French professors, Dr. Bernard Paranque and Dr.
Walter Baets, continue to investigate the connection between investor behavior and our technical principles utilizing
catastrophe theory and an experiment at Cal-Tech on irrational exuberance.
We also have two excellent articles of more practical nature: one on using a new configuration of an old, wellknown oscillator by Saleh Nasser from Egypt and the other on using the classic relative strength model on selecting
foreign stock markets and sectors for investment by Tim Hayes. Both of these gentlemen are CMTs.
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19
notes
Associate Editor
Michael Carr, CMT
Cheyenne, Wyoming
Manuscript Reviewers
Connie Brown, CMT
Aerodynamic Investments Inc.
Pawleys Island, South Carolina
Production Coordinator
Publisher
Barbara I. Gomperts
Manager, Marketing Services, MTA
Marblehead, Massachusetts
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A Cusp Catastrophe Model from the behavioral sciences provides a positive scientific theory as to the why of behavior in a stock market. Technical
market analysis furnishes a nominal theory of rules and principles about how
a trader or investor may profit from the behavior observed in a stock market.
Introduction
While watching the 1997 McNeil-Lehr Newshour Video depicting the California Institute of Technology Experiment on Irrational Exuberance in securities trading, we became intrigued by the apparent strong parallels between the
trading behavior exhibited in the video film and the idealized graphical model
of the Cusp Catastrophe Model presented in Christopher Zeemans 1977 book
Catastrophe Theory Selected Papers, 1972-1997 (See Figure 1). Investigative
attention was focused upon the fold or cusp in the model which captures the
transition from bullish behavior to panic conditions. As outside observers, we
agreed with all of the comments made by Professor Charles Plott (McNeil Lehrer,
1997) of Cal Tech during the experiment, except for one critical exception.
Professor Plott claimed that there was no way that a participant or observer
could have predicted the break in prices and, hence, no way for any of the
players who were in the experiment to have capitalized upon the bubbles burst.
We disagreed with Professor Plotts conclusion. Instead, we hypothesized that
according to Cusp Catastrophe Theory a dissipative gradient occurs in the
behavior pattern of the trades in the experiment just before the catastrophic
plunge in price. Hence, the break in price action could have been anticipated.
Furthermore, we anticipated that close examination of the price behavior within
the zone of the Cusp, or threshold, would reveal behavior patterns that could be
profitably analyzed and interpreted according to the rules and indicators of
technical market analysis.
Figure 1. A Cusp Catastrophe Model of a Stock Exchange
Technical market analysis and behavioral finance are similar in their roots.
Both are rooted in the assumption that man acts for behavioral reasons in ways
that, by the standards of classical economics, may seem irrational. Both approach the study of markets to identify patterns of human behavior that uncover opportunities for profits.
Technical market analysis has existed as a practice in real world financial
markets for over a century. It, too, has theoretical roots in psychology and sociology which are often overlooked by the practical men and women of action
who practice investing, trading and analysis. If we envision a theory-application
spectrum, we can see behavioral finance occupying the theoretical pole while
technical market analysis occupies the practical applications end of the spectrum.
Arguably practitioners and students of technical market analysis championed the center stage of behavioral finance long before the arrival of what recently has become known as behavioral finance. In his 1969 book, Stock
Market Behavior: The Technical Approach to Understanding Wall Street, Dr.
Harvey Krow defined technical analysis as synonymous with behavioral finance. In his preface to that book, Dr. Krow identified three competing schools
of thought in finance: fundamental analysis, the random walk, and the behaviorist. Technical analysis fell within the behaviorist or behavioral school, concluded Dr. Krow.
The prominence of behavioral finance grafted to technical analysis was
boosted by October 9, 1993 issue of the Economist magazine. In that article,
the author Matt Ridley observed the linkage between technical analysis and
behavioral finance. Mr. Ridley stated that a combination of computer horsepower and mathematical brainpower had made it possible to find new sources
of profit in the forecasting of financial markets. As the author stated:
What the new mathematicians are mining for is not inefficiencies in the
flow of information but something entirely different. They have found new
meat in the familiar fact that traders are a diverse bunch; by unearthing
some of its previously unrecognized effects...the most popular idea for explaining it has to do with the heterogeneity of traders in particular, the fact
that people reason differently about the information they receive, that they
have different time horizons...and that they have different attitudes to risk...
The efficient-market theory is...right that efficiency will delete time-arbitrage opportunities based on who does not have information, but wrong to
conclude that therefore the market cannot be beaten.
Ridley emphasized, Prices do contain hints of what they will do next. Computers have resuscitated chartism.
As the Ridley article emphasized an appreciation that technical analysis
was evolving through the attempt to predict prices using computers to study
market behavior. For example, moving average timing and break out signals
produced profits by more than by chance.
As Ridley concluded, Chartists who prefer to be called technical analysts
justify their techniques with quite reasonable arguments about the behavior of
investors. They do not claim to predict the behavior of the index so much as the
behavior of the people who trade in the market...a rising price is a band wagon.
And there are models from behavioral science that capture band wagons. Technicians were studying the behavior of people who make markets run.
When the internet bubble burst there was a massive opportunity to make
serious money through short selling or at least avoiding losing money already
earned. A predictive theory that would have alerted a trader to the potential
collapse would have been extremely valuable.
The Cusp Catastrophe Model could have been that predictive theory. The
Cusp-Catastrophe Model is based upon behavioral science/behavioral finance
to explain types of non-linear, discontinuous behavior. It is especially models
behavior of rapid change, such as a stock market bubble bursting. Catastrophe
theory has revealed that sudden change and behavior extremes are not only
natural and interrelated but, if one were to see the early warning signs, a collapse would be predictable.
The Cusp Catastrophe Model posits that behavior is driven by fear and greed.
In the case of a stock bubble, price climbs along the top layer of the Cusp
Figure 4 depicts the overall results of the experiment. It shows the average
value of the company as it depletes the oil (line A) and the absolute maximum
value of the company with oil at its maximum potential market value (line B).
Line A should represent the average stock price and line B should be the maximum price over achieved. Stock prices beyond line B were not rational because
everyone in the game knew that the value above line B was beyond any underlying asset value. At set intervals, the dividends were paid. These dividend
payment intervals are shown in Figure 4 by the dashed vertical lines. All participants in the experiment knew this information before the game was played.
The prices established by the buyers and sellers in the experiment did not
drop as would have been expected from the logic of rational economic analysis
of the situation even though all players were rational and had the same information. The traders in the Cal Tech experiment persistently traded at a prices that
were greater than the fundamental value indicated the company was worth. As
the experiment progressed, the traders in the experiment ignored the average
value line and then, surprisingly, crossed the maximum value line. The students
in the experiment paid for the stock in the experiment well beyond what even
the most optimistic investor should have paid. Apparently, chasing dividend distribution dates, they continued to trade was based upon the greater fool theory. It
was rational to buy overvalued stock so long as someone else would buy their
overvalued stock later on, after the dividend had been collected, thus allowing
the trader to continue to profit from dividends with little risk.
Eventually, as the oil well neared depletion, the market began to show signs
of nervousness. This nervousness by players in the experiment was very evident on the videotape since Professor Plott had tied price bids to purchase the
stock to lower sounds on the musical scale. The high notes on the chart reflected sell offers while the low notes were bid orders (See Figure 5). As the
market neared extreme upside valuations, there arose heightened nervousness
evidenced by a striking increase in the intensity of the lower notes. Both sellers
and buyers were shifting their expectations downwards apace with lowering
tones and the sound volume level increased rapidly. Such a change in the sound
of the market, the sentiment, has been often noted by traders on the floor of the
exchange as a harbinger of a reversal of price trend. As the experiment progressed the buy offers that were well below the existing price began to increase, although the price level itself stabilized into a horizontal trend channel.
Ultimately there occurred a sudden, sharp drop the catastrophic jump in the
transaction price in the experiment. The market changed suddenly and swiftly;
sentiment flipped from bullish to bearish as the price plunged to its underlying
economic asset value.
It should be mentioned that this experiment was conducted without exogenous factors. There were no news or media reports, no external noise, and no
one was allowed to voluntarily enter or leave the game. These restrictions may
have contributed to the stability of the price data along a horizontal trend channel rather than prompting price to oscillate upward and downward as time progressed.
sentiment played on key. Additionally, the picturing of the fear and greed variables sentiment as opposing forces in the Cusp Model was brought into dramatic display by two high notes versus the low notes in the Cal Tech experiment. The Cusp Model revealed a new and powerful way for practicing technicians to display and interpret indications of sentiment.
A tight trading range of channel of price behavior, predicted by the Cusp
Model, was created by the student investors in the Cal Tech experiment (Figure
6). That the price behavior adhered so closely to a linear trend channel was
surprising to the author, who expected to see broader and more jagged up and
down swings in price. The linear trend channel of price behavior occurring
during the experiment upheld the technical analysis practice of drawing linear
trend lines of support and resistance. The breaking of a support line drawn
along the horizontal price bottoms of the price channel created during the experiment constituted the crossing of the Cusp and the onset of the catastrophic
downward plunge in price.
FIGURE 5. FEAR VS. GREED JUXTAPOSED
Even though Professor Plott asserted that the sudden and dramatic shift that
was not predictable, looking at the data with the aid of the Cusp Catastrophe
Theory reveals that there was a tip-off before the tumble. This tip-off was to be
expected by the curve of the dissipative gradient at the cusp of the model.
Catastrophe Theory began with the ideas of Rene Thom in the early 1960s.
Both the mathematics and the applications were present from the beginning,
each stimulating the other, as can be seen in Thoms classic book on Structural
Stability and Morphogenesis. The concept was then popularized by the various
works of Christopher Zeeman, most notably in his 1977 book, Catastrophe
Theory: Selected Papers 1972-77. Then in 1979 Pruden described the logical
linkages between Catastrophe Theory, a dimension within behavioral finance
and technical market analysis. The Cusp Model of Catastrophe Theory presents a behavior path flowing along the top sheet until a threshold, a cusp, is
reached as the underlying emotions shift toward fear overcoming greed, then
suddenly the market price will jump downward. The clues given by the shift
toward dominance by supply over demand during the latter stages of a trading
range will presage the development of a bearish trend in stock prices. But up
until that transition phase threshold point, the market would remain high and
delay its descent until remaining pockets of demand were exhausted.
Let us fast forward to the stock market shown in the Cal Tech Experiment
and then zoom in on the behavior brought about by bullish emotions vs. bearish
emotions during the latter phases in a trading range market. The moral of the
jump story applies directly. During the trading range the alternating price swings
up and down reflect the struggle between greed and fear, so the analyst - trader
must respect the fact that the market could jump either way...its behavior is bimodal. So to be effective the trader must remain neutral until the testing phase
on the right hand side of a stock market trading range. Before we reach a
conclusion regarding future trend direction, the market should be allowed to
define the line of least resistance and then and only then should a position, long
or short, be entered. The breakdown was anticipated by the descending price
peaks, the dissipative gradient, as shown on the Cusp Catastrophe Model.
Behavior changes gradually before the breakdown. On the top sheet of the
cusp catastrophe model one can see a slight curling over of the behavior path.
Stock market behavior would likely show, for example, a series of descending
peaks in price. Similarly on the bottom sheet of the cusp model one can see a
gradual curling upward of the bottom behavior sheet before the upward jump
(breakout) by a series of ascending bottoms during the ending stages or the
right hand side of a trading range. These descending price peaks and ascending
price bottoms are powerful, but under-appreciated, technical tools.
References
10
11
12
Introduction
Figure 1
The major aim of the Deviation Oscillator, or DO, is to track minor changes
in the strength of a trend. It usually does not track major reversals; however, it
can be very suitable with countertrend corrections. The DO moves in an unbounded range above and below a zero level and it can be used alone and/or
with other indicators. Its objective is to detect weakening bulls or bears as soon
as possible. Sometimes sellers begin to weaken, while the price is still declining; the DO will recognize this weakness and will begin showing some bullish
tendencies, even before prices begin to rise.
This indicator is derived from a chart with three moving averages; a moving average of the close, a moving average of the high, and another one of the
low. It can be observed that the MA of the close deviates between the MA of the
high and the one of the low. When prices rise the MA (close) approaches the
one of the high, when prices decline, it approaches the moving average of the
low. This confirms the notion that during a rise the price usually closes near the
high of the day, and vice versa. Based on this observation, the DO was created.
Thus, the DO calculates the deviation of the moving average of the close of a
certain issue from the moving average of the high and from that of the low.
Whenever the moving average of the close of a certain period deviates from the
low towards the high it indicates strength. When it deviates from the high towards the low it indicates weakness. The DO is very useful when used with
other indicators like MACD, momentum, and the stochastic oscillator. This
paper explains its calculation, its basic interpretation, how it can be used in
combination with other indicators.
The most important aspect of this indicator is divergences. When a divergence occurs it means that a countertrend move should occur. The DO can be
used along with momentum as a confirming indicator, and to filter some of its
bad signals since at times DO diverges with momentum. It can also be used
with MACD as a setup. A MACD buy signal will be triggered when accompanied by a positive divergence between DO and the price. This gives superior
results as opposed to using MACD crossovers alone.
Another oscillator that was extracted from DO is the RCDO. It is the
Rate of Change of the Cumulative function of DO. This oscillator is mainly
used for overbought and oversold conditions. This oscillator and its uses are
also explained in this paper.
The Calculation
1. Calculate a moving average of the close, a moving average of the high and
a moving average of the low. These calculations use simple moving averages
and a time span of 20 days.
2. Calculate the distance between the moving average of the high and the
moving average of the close (MA(high)- MA (close)). The greater the
difference, the closer MA (close) goes towards MA (low).
3. Calculate the distance between the moving average of the close and the
moving average of the low (MA (close) - MA (low)).
Figure 1 shows two lines that intersect with each other. When line 1 (MA
high-MA close) crosses line 2 (MA close-MA low) to the upside, then the moving average of the close is closer to the moving average of the low than that of
the high. When line 1 crosses line 2 to the downside, the moving average of the
close is nearer to the moving average of the high.
Microsoft chart with DO, after inverting the y-axis. Note that trading on
zero crossovers is not recommended as it suffers from whipsaws. Now a break
of the zero line to the upside (after the scale is inverted) means that the moving
average of the close is closer to MA high than MA low and vice versa.
A short cut for the calculation: to avoid inverting the scale, a simpler
calculation can be used. (MA close - MA low) - (MA high - MA close). We
will not have to invert the scale by using this calculation.
Buying when DO crosses above the zero line and selling when it crosses
below it proved to be a losing technique, resulting in a total loss of 27.05% for
the 30 Dow stocks from 1999-2003. Results improved when a buffer zone was
13
placed at 0.2 and -0.2. Thus the buy signal was not triggered until the upper
buffer zone was broken to the upside and the position was closed when a violation of the lower boundary occurred. The loss was reduced to 20%. The results
were worst when shorts were added; covering shorts and buying longs above
zero and closing longs and building shorts below zero with a loss of 35.5%
which was reduced to a loss of 24% by using a buffer zone.
Divergences
This is the most important aspect of the Deviation Oscillator. Even when
using DO with other oscillators, divergence analysis is employed. Divergence
is very important as it shows that there is hidden weakness or strength in the
market that is not apparent in the price action.
First type of divergence occurs when DO is rising and the price is still
declining (positive divergence) or the DO curve is declining while the price
is rising (negative divergence). This means (in the case of a positive
divergence) that despite that prices are still declining; the closing price is
getting closer to the high. The 20-day MA of the close is moving away from
the MA of the low and approaching that of the high. The decline is losing its
strength, as buyers are able to bring the closing price away from its lows.
If the price is declining and DO rising, buy at a breakout of a minor top,
with a stop loss below this top or below the nearest minor bottom, depending
on risk tolerance. Use this divergence as a setup and buy at a breakout.
Usually such a breakout will not be false because it was preceded by some
strength. If another indicator confirms this positive divergence, the signal
will be stronger. The same holds true when DO declines while the price is
still rising. It means that the bears are getting stronger as they are able to
bring the closing price away from the highs.
One of the most bullish signals appears when DO rises vertically, while the
price is still in a trading range or slightly declining.
Second type of divergence appears more often: it occurs when the price
makes a lower low while the DO follows a higher low (in the case of a
positive divergence), or when the price forms a higher high, while the DO
triggers a lower high (in the case of negative divergence). A positive
divergence in this case means that during the second bottom the MA of the
close was nearer to the MA of the high than during the first bottom. The
price violated support but with weaker sellers.
Figure 3
Philip Morris (MO) shows a very interesting story. During March 2003, the
DO witnessed a positive divergence with the price. During April and May, the
stocks price began to form a higher low, confirming the previous divergence.
In May, while the price was trading sideways, the DO moved sharply upwards,
hinting of a continuation of the rise. At the end of the stocks rise, from 18 June,
to early July, the DO began to move downwards, while the stock was still rising, signaling potential weakness that came later.
14
The chart of JP Morgan Chase shows the One cross buy signal. During
February 2002, a positive divergence occurred between DO and the price action. Following this divergence, a bullish MACD crossover occurred (see the
vertical line). Only one MACD buy signal occurred after the DO divergence.
The two vertical lines show the buy and sell signal. As stated, the exit signal is
triggered with the first MACD bearish crossover after a buy is signaled.
Two cross system occurs when MACD triggers two buy signals. The
first crossover coincides with the first DO bottom, while the second MACD
crossover coincides with the second DO bottom. During this time, the DO triggers a higher bottom, while the price follows a lower bottom formation (positive divergence). What really happens is that during the first DO bottom the
MACD gives a buy signal. During the second DO bottom, an MACD bearish
crossover, followed by a new bullish crossover occurs. The trick of this tactic is
that it gives us a false bearish crossover; however, using DO in conjunction
with MACD will eliminate such a whipsaw. Even if the trader is whipsawed by
selling at the MACD bearish crossover, he will quickly re-enter with the new
buy signal as it coincides with a positive divergence in the DO.
Thus, the buy signal will be triggered at the second MACD bullish crossover after a positive divergence between the DO and the price. Exit will take
place at the first bearish MACD crossover.
The rationale of the two cross system is that more strength appeared before the actual buy signal. A bullish MACD crossover during the first DO bottom tells us that there was more strength in the market than the first one cross
system. Obviously, as the market makes a lower low, the MACD will trigger a
bearish crossover, which will be followed by a new bullish crossover while the
DO diverges with prices.
Figure 6
The S&P 500 chart shows an example of the two cross system. During
February and March 2003, DO witnessed a positive divergence with price action. In February, during the first bottom, MACD triggered a bullish crossover.
As the price declined during March, MACD witnessed a bearish crossover,
followed by a new bullish crossover, which coincided with a higher DO bottom. This is a positive divergence between DO and the price action, followed
by a MACD buy signal. The only difference here is that the MACD witnessed
two bullish crossovers instead of one. The letters A and B on the chart
show the two MACD crossovers. The two vertical lines show the buy and exit
signal. This trade was profitable, however, prices continued moving to the upside after the exit was triggered. As was mentioned previously, the main drawback of this system is that it gives a premature exit signal.
Cross and a test system should be expected to give the best results as
the MACD witnesses a bullish crossover during the first bottom, but does not
witness a bearish crossover afterwards. During the second bottom, and while
the DO is positively diverging with prices, the MACD line declines slightly to
test its signal line, before rising again. The buy signal is triggered as soon as a
positive divergence between the DO and the price is identified and the MACD
line moves upwards after testing its signal line. The logic of this system is that
there was strength from the beginning (bullish MACD crossover during the
first bottom) but the temporary weakness was much less than that of the two
cross system, as the MACD line did not witness a bearish crossover. It only
tested its signal line and moved upwards again. The buy will be triggered the
second day as the MACD line begins moving upwards once again.
Figure 7
15
During February and March 2003, McDonalds chart shows the DO witnessed a positive divergence with price. MACD triggered a bullish crossover
during the first bottom, and a test between the MACD line and its signal line
took place during the second bottom. No bearish crossovers occurred. The buy
was triggered at point B and the exit signal took place with the first bearish
crossover afterwards. This system is very profitable and it has the merit of
being objective. Its drawback is the premature exit signals that often occur.
The DO and MACD system was tested across the 30 Dow stocks from 1999
through 2003 with relatively good results. The two cross and cross and a
test gave a superior results compared to the one cross in terms of % profit
per trade. On the other hand, the one cross was better in terms of % of profitable trades than the two cross. Most of the buy signals fell in the category of
one cross and two cross. A small percentage triggered the cross and a
test system. Usually when the MACD gives a buy signal and begins to decline
again, it will witness a temporary bearish crossover before witnessing a new
buy signal.
Overall, 41.4% of the buy signals were triggered by the one cross system;
48.7% were triggered by the two cross; while only 9.7% were cross and a test.
tive. The result is an oscillator that moves slower than the normal Deviation
Oscillator but can show overbought and oversold conditions when used in combination with other oscillators.
The ROC of the Cumulative Deviation Oscillator moves faster and when
used with the stochastic oscillator it serves as a confirming indicator for overbought and oversold conditions. Obviously, the indicator can be used in many
ways and with other indicators; here it used as a confirming indicator for the
stochastic and Bollinger Bands. When all three indicators confirmed each other,
a buy was triggered. The upper boundary of the Bollinger Bands was used as an
exit signal. Obviously, exit signals were not perfect, but the important thing is
that nice profitable moves followed buy signals. The technician should find
other exit tactics than the ones used here, especially when profitable moves
occur.
A buy signal is triggered when the stochastic reaches oversold, the RCDO
reaches oversold, and the price tests the lower boundary of the Bollinger Bands.
There is a small problem here. The RCDO is unbounded, unlike the stochastic,
so oversold can be identified after a certain area is touched at least two times.
There are no pre-defined levels to be used as oversold and overbought.
Figure 8
OVERALL RESULT
% of positive trades
(profits above 5%)
% of negative trades
(losses above 5%)
% of even trades
(less than 5% trades)
73.17%
6.5%
20.33%
% Profit/ trade
% loss/ trade
17%
7%
73% of the trades were profitable with an average profit of 17% per trade. On the
other hand, 6.5% of the trades were negative, with an average loss of 7% per trade.
The rest, 20.33%, were even trades with almost no profit or loss. Some of these even
trades witnessed sharp rises afterwards, but only after the MACD gave an exit signal.
No. of days
for profitable trades
No. of days
for negative trades
30
18
No. of days
for even trades
23
This shows us the average number of days in each trade. Profitable trades were held
almost a month, on average, before selling.
Largest profit
Largest loss
53.2% (INTC)
10.88% (AA)
% profit/ trade
74.51%
13.36%
2. two cross
% of profitable trades
% profit/ trade
68.33%
18.23%
% profits/ trade
91.67%
BUY when the stochastic oscillator reaches oversold, the RCDO reaches
oversold and the price touches the lower boundary of the Bollinger Bands.
EXIT either when the price touches the upper boundary OR when it violates
the 20 days moving average to the downside (after rising from the lower
boundary and breaking the moving average upwards).
Stop loss should be placed below the lower boundary of the Bollinger Bands.
This system was tested on the Dow 30 stocks and the results were promising. While 22% of the trades were breakeven trades (plus or minus 5%), 62.5%
of the trades were profitable with an average profit of around 14% per trade,
while 15% were losing trades with an average loss of 9.1% per trade.:
All of the testing was done with visual inspection. More precise testing
might be slightly different from the results presented here.
19.95%
RCDO
RCDO is an oscillator extracted from the Deviation Oscillator that is mainly
used for overbought/oversold purposes. The RCDO is the Rate of Change (ROC)
of the cumulative function of the Deviation Oscillator, in this paper a 5-day
ROC is used. RCDO smoothes the Deviation Oscillator. While the cumulative
function alone can be used to show longer-term trends, the cumulative curve,
does not provide actionable information. Taking its ROC makes it more sensi-
16
DETAILED RESULTS
1. one cross
% of profitable trades
Novellus (NVLS) shows the price, the DO, the RCDO, and the stochastic.
During December 2000- September 2001, there was three times where the stochastic and the RCDO reached oversold, while the price was testing the BBs
lower boundary. A rise followed this situation in all three instances.
Conclusion
The DO is a tool that can be added to the technicians arsenal. It is by no
means a full system of its own. As all other technical indicators, the DO is a
subjective indicator that can be interpreted differently from one technician to
another. This paper did not examine weekly and monthly charts, but at times,
major divergences are revealed in long-term charts. Figure 9 shows the weekly
S&P 500. Bullish action in the weekly DO occurred during October 1990 and
Jan 1991, as it was rising sharply, hinting that a big rise in the stock market
might be under way.
Metastock Formulas
Figure 9
h-c: Mov(H,20,S)-Mov(C,20,S)
c-l: Mov(C,20,S)-Mov(L,20,S)
Deviation Oscillator: Fml(h-c)-Fml(c-l)
(Do not forget to invert the scale of the DO)
RCDO: ROC(Fml(CDO),5,$)*100
This paper used a 5-day ROC of the CDO. Other values can be used to
change the sensitivity of the RCDO.
Biography
The DO can be used as a confirming indicator or as a setup for other technical tools (as shown with the DO-MACD system). The default time period for
daily charts is a 20-day simple moving average for the high, low, and close.
Changing this time period can be done to increase or decrease the sensitivity of
the indicator.
It is important to note that one of the strongest signals that the DO presents
occurs when price is moving sideways (or slightly declining) while the DO
witnesses a vertical move to the upside. This action indicates that the moving
average of the close is quickly running towards the moving average of the high,
despite the apparent stability in price action. This is a very strong signal of a
potential strength.
A final note that is worth repeating here is that the DO proved to be more
useful in signaling price strength. A positive divergence is much more important than a negative divergence. DO is best used as a tool to enter the market;
however, exits should be based on other tools.
Saleh Nasser, CMT is the Chief Technical Analyst for Commercial International Brokerage Company (CIBC) in Cairo, Egypt. His main job is to
recommend to brokers and investors of the company what to buy/sell and
how to manage their positions. CIBC is the largest brokerage firm in Egypt.
Saleh began working in the stock market using technical analysis in
1997 at United Brokerage Corporation, a small brokerage company based
in Cairo. He then worked as Chief Technical Analyst for Fleming CIIC,
also in Cairo, Egypt. Saleh is the head of the education committee in the
Egyptian Society of Technical Analysts (ESTA), as well as the Treasurer
and Member of the Board of Directors of ESTA. He conducted many courses
and seminars, teaching brokers, investors, and undergraduate students about
technical analysis. Saleh was graduated from Cairo University in 1995 with
a BA in Economics.
17
18
Table 1
Global Market Ranking System Ranking Statistics
Overweight Performance
% gain per annum
% of weeks outperformed universe
Standard Deviation (annualized)
Information Ratio*
Universe Performance
%gain per annum
Standard Deviation (annualized)
Underweight Performance
% gain per annum
% of weeks outperformed universe
Standard Deviation (annualized)
Information Ratio*
In-sample
1/23/94 - 2/11/96
Out-of-sample
2/11/96 - 8/19/99
Real-time
8/19/99 - 6/29/03
Entire period
1/23/94 - 6/29/03
25.1
57.9
21.1
1.12
38.4
65.8
21.0
1.90
9.6
55.7
17.5
1.05
23.1
60.0
19.7
1.34
3.3
9.1
11.6
15.0
-2.5
13.8
3.8
13.4
5.0
50.5
15.4
0.17
4.9
41.3
23.7
-0.29
2.5
50.2
20.6
0.51
3.9
47.0
20.8
0.11
*The information ratio measures the excess return per unit of risk. It is calculated by dividing the annualized average of the one-week excess returns
by the annualized standard deviation of the one-week excess returns.
19
Table 2.
Global Market Ranking
Rank
Overweight
Previous Week
4 Weeks Ago
Composite
Reading
Market
Position
Entry Date
Entry Price
Current
Current Price Gain/Loss (%)
1
2
3
1
2
3
3
3
2
210.45
169.43
124.57
9/22/2002
6/30/2002
6/16/2002
7347.61
350.65
1252.08
13852.41
733.85
2075.77
88.53
109.28
65.79
102.36
1/26/2003
1559.49
1826.61
17.13
102.36
2.33
1/12/2003
6/15/2003
628.36
5540.84
677.28
5626.86
7.79
1.55
-3.40
-3.56
7/28/2002
6/15/2003
484.70
1948.02
434.80
1940.66
-10.30
-0.38
Underweight
Ranked 30-39 After Reaching Ranks 40-42 - Continue to Underweight
33
39
34
39
34
32
42
39
40
41
40
42
Full Rank
Rank
Previous Week
4 Weeks Ago
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
1
2
3
4
8
6
5
7
9
11
14
10
17
15
13
16
12
22
20
18
21
25
19
31
32
23
35
24
30
28
29
27
34
33
38
26
37
36
39
40
42
41
1
3
2
4
12
6
10
7
5
15
16
9
11
22
13
21
8
31
17
26
18
24
35
40
28
19
41
20
25
36
38
37
34
30
14
23
29
27
32
42
39
33
20
Market
Country
Venezuela
Argentina
Colombia
Peru
Sri Lanka
Israel
Thailand
Indonesia
Brazil
India
Mexico
Chile
Austria
Philippines
Poland
Spain
Czech Republic
Norway
U.S.
Taiwan
Canada
Sweden
Singapore
Germany
Denmark
Italy
Greece
New Zealand
Malaysia
Japan
France
Switzerland
South Korea
U.K.
Hungary
China
Australia
Ireland
Finland
Netherlands
Belgium
South Africa
** = Developed Market
Composite
Current Price
210.45
169.43
124.57
102.36
82.64
81.55
74.25
66.76
66.74
57.66
51.63
49.83
43.15
43.07
41.68
40.93
35.42
35.25
27.38
23.61
23.50
20.79
20.54
20.45
19.55
19.38
17.11
16.57
15.75
14.34
13.17
9.25
7.59
7.01
5.47
5.21
3.21
2.48
2.33
-3.40
-3.56
-25.36
13852.42
733.85
2075.77
1826.61
1051.43
459.42
457.51
506.78
13024.12
1810.34
7083.45
5958.84
1313.11
1236.60
15930.57
728.03
535.50
500.84
976.22
976.22
6979.12
156.66
1477.73
3224.66
217.65
18615.00
1901.48
2108.22
691.45
903.06
3109.02
3459.41
677.28
4067.80
7858.58
9657.21
3018.00
4257.11
5626.86
434.80
1940.66
8347.23
Sectors
Ranked
Automobiles
4
Banks
10
Basic Resources
5
Chemicals
4
Construction
7
Cyclical Goods & Services
10
Energy
5
Financial Services
9
Food & Beverage
8
Health Care
7
Industrial Goods & Services
12
Insurance
8
Media
8
Non-Cycliacal Goods & Services 8
Retail
5
Technology
8
Telecom
6
Utilities
7
Country
Australia
Canada
Denmark
France
Germany
Greece
Hong Kong
Italy
Japan
Netherlands
Singapore
Spain
Sweden
Switerland
U.K.
U.S.
Sectors
Ranked
11
16
1
8
8
1
10
6
18
3
6
3
2
4
16
18
Chart 2
Of course, not all of the overweights continue to perform well. Some exit
the list with a loss. But a reassuring quality of the system is that, by staying
with strong markets for big gains and dumping decelerating markets with nothing worse than a small loss, it holds to the adage, let profits run and cut losses
short. And as exemplified by the Argentina example, it cares not about why a
market is doing what its doing, or whether its doing what it should be doing
based on the fundamentals. Rather, its only objective is to identify relatively
strong momentum and get on board, without the fundamental distractions.
21
22
Table 5
Global Sector Ranking
Rank
Previous 4 Weeks
Week
Ago
Sector
Country
Composite
Reading
Position
Entry Date
OVERWEIGHT
Ranked 95-100 Buy/Overweight:
100
90
98
Telecom
Canada
94.50
09/29/2002
99
75
69
Technology
Canada
93.74
11/10/2002
98
78
100
Telecom
U.K.
90.53
05/18/2003
97
98
32
Technology
Singapore
88.70
06/22/2003
96
96
79
Media
Canada
88.09
03/23/2003
*96
82
84
Utilities
Canada
82.44
06/29/2003
*95
87
87
Construction
Australia
82.29
06/29/2003
Ranked Greater Than 60 and Less Than 95 After Reaching Ranks 95-100 Hold/Continue to Overweight:
93
91
96
Banks
Australia
80.00
03/30/2003
91
97
30
Cyclical Goods & Services
Italy
77.86
06/22/2003
90
65
99
Technology
U.S.
76.34
05/11/2003
90
74
52
Insurance
Canada
75.88
06/08/2003
88
83
64
Banks
Canada
73.74
10/20/2002
87
95
85
Utilities
Spain
72.67
12/08/2002
87
100
83
Financial Services
Germany
72.67
05/04/2003
80
94
72
Industrial Goods & Services
Denmark
68.40
04/27/2003
79
80
44
Technology
Germany
67.79
06/08/2003
78
96
77
Banks
Spain
66.87
04/06/2003
77
93
60
Banks
Italy
66.11
04/27/2003
76
68
88
Technology
U.K.
65.50
05/18/2003
70
99
75
Banks
Greece
62.14
05/11/2003
69
61
91
Media
Australia
61.83
04/06/2003
67
67
83
Media
France
60.31
05/25/2003
66
64
68
Technology
France
59.85
01/19/2003
61
63
87
Financial Services
U.K.
55.57
06/15/2003
61
77
80
Retail
Germany
55.57
05/04/2003
UN DER WEIGHT
Ranked Greater Than 5 and Less Than 40 After Reaching Ranks 0-5 Continue to Underweight:
33
34
16
Cyclical Goods & Services
Australia
41.37
03/23/2003
32
15
8
Insurance
Japan
40.92
06/15/2003
29
3
9
Non-Cyclical Goods & Services
Singapore
38.32
05/04/2003
25
9
6
Retail
Japan
36.03
06/08/2003
22
7
26
Telecom
Hong Kong
33.44
03/30/2003
12
10
3
Health Care
Australia
27.18
05/25/2003
10
22
3
Media
Japan
25.50
11/17/2002
9
6
25
Utilities
Hong Kong
24.73
04/20/2003
8
6
27
Media
Hong Kong
24.43
04/20/2003
7
9
36
Food & Beverage
U.S.
23.05
05/18/2003
6
22
1
Health Care
Japan
22.44
05/04/2003
Ranked 0-5 Sell/Underweight:
4
2
2
Media
Netherlands
16.18
05/11/2003
*3
17
12
Food & Beverage
U.K.
15.88
06/29/2003
3
4
48
Utilities
Japan
15.57
06/22/2003
2
3
18
Chemicals
U.S.
10.53
06/15/2003
1
1
9
Basic Resources
U.K.
7.33
03/30/2003
0
0
0
Chemicals
Switzerland
1.22
03/02/2003
* = New Overweight or Underweight
Entry
Price
Current
Price
Current
Gain/Loss(%)
56
143
261
69
244
201
410
93
212
290
66
302
201
410
67.0
47.7
11.2
-3.4
24.0
0.0
0.0
633
98
1727
1446
271
1324
2401
3857
2476
1363
368
345
422
825
1110
756
902
371
790
95
1855
1412
365
1695
2748
4636
2406
1596
413
355
497
970
1147
950
845
394
24.7
-2.3
7.4
-2.4
34.9
28.0
14.5
20.2
-2.8
17.1
12.4
2.7
17.9
17.6
3.3
25.6
-6.3
6.2
228
302
513
345
74
1767
488
526
79
1968
256
264
310
552
354
81
1843
475
570
91
2055
261
15.5
2.6
7.6
2.5
9.7
4.3
-2.6
8.3
16.0
4.4
2.3
346
587
369
740
402
2915
369
587
363
713
465
2949
6.6
0.0
-1.8
-3.7
15.5
1.2
23
additional overlay, useful for assurance that the sector rankings indication of
market relative strength has longer-term confirmation. If, for instance, the sector ranking would indicate relative strength among Japanese sectors, we would
gain more confidence in the staying power of that relative strength if Japans
Topix Index would rise to overweight status in the market ranking. More broadly,
with sectors from Asia Pacific countries dominating the overweights of the
sector ranking, our longer-term confidence would increase if the regions market indices would dominate the market rankings overweights.
Separately or in conjunction with one another, the sector and market rankings
are thus useful for identifying changing themes, information thats essential
when developing global market strategy and making allocation recommendations. The rankings can also be used as screens and for input to the decisionmaking process i.e., whether to buy a certain ETF, a country fund, or a stock
in a specific sector. The next generation of these systems would combine a
global sector ranking with a ranking of individual stocks that can be bought
upon rising to overweight, sold when dropping from overweight, shorted upon
falling to underweight, and covered when rising from underweight. Such an
executable, long-short system would be especially appealing to hedge funds,
demonstrating that in leading price, momentum leads to profits as well.
Chart 3
Conclusion
This paper has demonstrated how relative momentum can be used to develop a ranking of 42 markets around the world, a ranking that has proven
effective in identifying winning markets. The paper has also shown how relative momentum can be used to develop a ranking of global sectors, a ranking
that has held its own in identifying relative strength in a down market while
proving adept at identifying underperformers. Moreover, based on our realtime experience using these systems, we can say that they certainly deserve to
be the starting point for identifying new themes and emerging leadership. Knowing that a market or sector is emerging as a momentum leader is far more important than knowing why it is doing so, a determination that often can only be
made in hindsight. Rather, understanding the markets current dynamics, that
the current differences in relative momentum will lead to differences in performance that momentum leads price is the most valuable and useful knowledge that one can have.
Chart 4
Endnotes
eight Technology sectors. And the bottom two clips plot the sectors advance/
decline line and percentage of issues at 30-day new highs. Chart 4 uses weekly
data to feature the global Technology sector along with the percentages of the
sectors stocks that are above their 10-week and 40-week moving averages.
The sectors relative strength would have short-term breadth confirmation with
its advance/decline line above it 50-day moving average and moving higher
with a rising percentage of 30-day new highs. And the sector would have longerterm breadth confirmation with more than 70% of the sectors stocks above
their 10-week moving averages and more than 55% above their 40-week moving averages.
For regions and countries, the Global Market Ranking could serve as an
24
Biography
Timothy Hayes, CMT, is the Global Equity Strategist for Ned Davis Research. Tim oversees the firms global and U.S. equity allocation services,
authoring the firms weekly Stock Market Focus and International Focus publications. He also is editor of the firms bi-monthly Investment Strategy. Tim
holds the Chartered Market Technician designation and is an MTA member.
He has written a book, The Research-Driven Investor, published in November
2000. He is a regular guest on CNBC television and is often cited in The Wall
Street Journal and other publications. In 1996, Tim won the Charles H. Dow
Award for groundbreaking research in technical analysis.