Market Technician No 54

The Societys Dinner held at the National Liberal Club was rated a great
success.Many of the attendees said on the night how much they had
enjoyed it and we have subsequently had a number of emails saying the
same thing.After pre-dinner drinks in the library,dinner was served in the
Victorian splendour of the David Lloyd George Room.Before introducing
the after-dinner speaker,the Societys Chairman,Adam Sorab,said a few
words about the importance of technical analysis in deciphering the fickle
markets of 2005. He also thanked the membership of the STA for their
continued support throughout the year and the many people who work
behind the scenes to ensure the STAs success.The guest speaker of the
evening was Martin Mallett,Chief Dealer of the Bank of England.He was
quick to admit that he was a supporter though not a practitioner of
technical analysis and acknowledged its usefulness.The Bank studies
technical conditions and also,where appropriate,employs a technical
approach to enhance its trading activities.During his address Martin
spoke broadly about his role as a Central Banker,peppering his talk with
very amusing asides. He also addressed some serious issues regarding the
currency markets in general and liquidity conditions in particular.
Inspired by Clive Lambert,we then played a variation of the game 'Stand
up,sit down',to decide a charity to which the Society should give 500.
The eventual winner was Neil Smith of RBS,who nominated Cancer
Research to receive the money.After the dinner the night owls adjourned
to the Club bar and other nearby watering holes.The general view was
that it had been a good evening,allowing members to get to know each
other and exchange market views in a very relaxed atmosphere.
The Society will be participating in two more technical analysis events.We
will be taking a stand at the Investors Chronicle's IX Investor Conference
at the London Olympia Conference Centre on 21 and 22nd October.A few
days later on 25th October,Robin Griffiths and David Sneddon will be
speaking at The Technical Analysts seminar,Technical Analysis in the
Commodity and FX Markets(for further details see
www.technicalanalyst.co.uk ).
The Canadian Society of Technical Analysts (CSTA) will be hosting the 18th
Annual IFTA Conference in Vancouver.The theme of the conference is
Digging for Gold,and the events programme includes a Gold Rush Gala
Dinner! The CSTA have put together a distinguished panel of speakers and
for those unable to attend,there will be a summary of the proceedings in
the next issue of the Journal.
Led by the fashion industry,autumn is the time of the year for makeovers
and David Watts has decided that it is time to give our website an
overhaul.He is looking for someone with website experience to assist in
this exercise and so if any member feels they can help or knows someone
who can,could they please contact David (DWattsUK@aol.com).
MONTHLY MEETING DATES
FOR 2006
11 January
8 February
15 March
12 April
10 May
14 June
5 July
13 September
11 October
8 November
6 December
IN THIS ISSUE
D.Watts Bytes and Pieces . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
D.Linton Ichimoku Charts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
W-K Wong and L.Chan
Lucky 13? Does the Singapore Equities
market move in 13-year cycles? . . . . . . . . . . . . . . 4
T.Plummer A theoretical basis of technical analysis . . . . . 6
COPY DEADLINE FOR THE NEXTISSUE
31st January 2006
PUBLICATION OF THE NEXTISSUE
March 2006
FORYOURDIARY
Wednesday,9th November (AGM) David Sneddon
Director,Fixed Income Research
Technical Analysis,CSFB
Wednesday,6th December Christmas Party
N.B.Unless otherwise stated,the monthly meetings will take
place at the Institute of Marine Engineering,Science and
Technology,80 Coleman Street,London EC2 at 6.00 p.m.
October 2005 The Journal of the STA
Issue No.54 www.sta-uk.org
TECHNICIAN MARKET
MARKETTECHNICIAN Issue 54 October 2005 2
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IFTA
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MARKETING
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REGIONAL CHAPTERS
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Networking
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Issue 54 October 2005 MARKETTECHNICIAN 3
A cursory observation of the Singapore equities market based on the SES
All-Share index suggests that the market possibly moves in 13-year cycles
with the first cycle being between January 1975 to December 1987 and
the second cycle being between January 1988 to December 2000.See
Figure 1.
Figure 1:13-year cycle pattern for the SES All-Share Index
The 13-year cycle is evident when the two 13-year cycles are juxtaposed
as seen in Figure 2.The interesting observation is that the two 13-year
cycles are almost mirror images of each other over their own 13-year
period,particularly from the 46th month onwards to the end of the cycle.
Figure 2:Juxtaposistion of the two 13-year cycles
Based on the anecdotal evidence regarding the previous two 13-year
cycles,it appears that the Singapore equities market could be in a third
13-year cycle which began in January 2001.The SES All-Share index has
been chosen as the benchmark indicator over the STindex as the STindex
has been subjected to changes in component stocks over the years and,
as such,may not be representative of the overall market direction.
Moreover,the STIndex also consists mainly of blue chips while small
capitalisation stock are not included,further limiting its use here as an
overall market indicator.
Double Vision?
From a purely technical analysis viewpoint,arbitrary market movement
patterns from January 2001 to December 2004 lend credence to our view
that the Singapore equities market is possibly on the third 13-year cycle
since the market is currently displaying similar arbitrary movement
patterns over the first 45 months to those observed in the first two
13-year cycles as can be seen in Figure 3.
On the assumption that the market is currently experiencing a third
13-year cycle,volatile range-bound trading is expected to dominate over
the next 12 months on the basis that the market was trapped in a
sideways band during the 46th month to 57th month of the first two
13-year cycles.
Figure 3:First 45 months market movement patterns for the three
13-year cycles
Analysis of the Cycle
There are few techniques which enable us to turn cycle analysis into
practical trading strategies.The most widely used method in the analysis
of cyclical patterns of data is Spectrum Analysis (see box on next page).A
classical example of applying Spectrum Analysis in cycle theory is the
study of sunspot activity;in which a cycle with a periodicity of around 11
years appears regularly.So assuming sunspot activity reaches its peak this
year,one may expect sunspot activity will peak eleven years later.
If cycle theory works well in the stock market,investors should be able to
generate significant profits.Spectrum Analysis allows investors not only to
determine the period of cycles but also their magnitudes.
Support from Spectrum Analysis
As shown in Figure 4,the Singapore stock market experiences a number of
cyclical patterns including cycles of 143 weeks (2.7 years) and 350 weeks
(6.7 years).A 13-year period is approximately double 6.7 years and hence
our spectrum analysis results suggest that the 13-year cycle may consist of
two 6.7 year cycles and hence within the 13-year cycle period,there may
be two peaks and two troughs.If the above analysis is correct,Figure 2
would suggest we are at the end of the first quarter of the cycle in which
there is not much movement in the Singapore stock market.Again
working from Figure 2,we would expect the stock market to peak at the
end of the second quarter of the cycle in three years time and then to fall
in the third phase which lasts longer than other phases due to the
asymmetric property of the cycle theory.But it should rally to a higher
peak in the final fourth phase of the cycle which should occur nine years
from now.
Figure 4:Spectrum for Singapore Straits Times Index from 1973 to
2004
Lucky 13?
Does the Singapore equities market move in 13-year cycles? By Wing-Keung Wong and Lanz Chan
P
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Lessons from the US stock market
Since the Singapore index yields insufficient data points (only 30 years) to
give a statistically significant test for a 13-year period we have looked at the
US stock market as an example of how the Singapore stock market might
behave.Stock indices for the US market go sufficiently far back (40 years) to
provide some useful conclusions about shorter term cycles for this market.
From figures 5 and 6,it can be seen that the cyclical patterns in the US stock
market have changed dramatically over time.In the first period (1965-1984)
there are cycles of around 200 weeks (3.8 years,about 4 years) and 55 weeks
(about 1-year) while they are around 115 weeks (2.2 years) and 70 weeks
(1.3 year) for the second period (1985-2004).
Figure 5:Spectrum for USStock Market from 1965 to 1984
Figure 6:Spectrum for USStock Market from 1985 to 2004
Are Cycles a Useful Investment Tool?
Like many other time series data,a stock index can be anatomized into
four parts trend,cycles,seasonal components and error term.In the time
series plot of the weekly S&P 500 as shown in figure 7,the most significant
component is the trend from 1965 to 2000.In this situation,the
knowledge of cycles may not play an important role in generating profit.
Investors could simply adopt the buy-and-hold strategy buying in 1985
and holding until 2000 would have generated a better profit than trying
to trade cycles within the trend.Thus,at certain times cycles become less
important in the investment decision.
FIgure 7:Plot of S&P 500 stock index from 1965 to 2004
However,for the Singapore stock market over the period 1975 to 2004 as
shown in Figure 8,there is a much stronger cyclical element to the
market.So for this market,investors who had been able to predict
precisely short-term cyclical patterns would have been able to enhance
their returns significantly.In practice,cyclical patterns in a stock market
can change over time as has happened in the US stock market.Also it
would seem that the cycles in the SIngapore stock market are formed by
the combination of many seedcycles.This will make the Singapore
market more volatile with a higher number of smaller peaks and troughs,
which in turn makes it harder for investors to time accurately the troughs
and the peaks of the cycles and consequently when to buy and sell stocks.
Figure 8:Plot of STI from 1973 to 2004
Discussion
Within the Singapore stock market there would appear to be a natural 13-
year cycle.The market is currently in a bull phase of that cycle and,based
on the experience of the previous two 13-year cycles,it should extend
considerably higher.However,as can be seen from the experience of the
US,shorter term man-made cycles such as the 4-year US Presidential
cycle can disrupt these longer term patterns.Furthermore particularly
strong trends can swamp cyclical activity.
Professor Wong is an Associate Professor in the Department of Economics,
National University of Singapore.He obtained his B.Sc.from Chinese
University of Hong Kong and M.Sc.from the University of Wisconsin-Madison
U.S.A.In 1989,he completed his Ph.D at the Wisconsin-Madison,majoring in
Business and Statistics.
Lanz Chan works with UBS Wealth Management serving Greater China
markets.He is the Managing Advisor for the Financial Economics Association
and the President and Faculty Advisor for the Financial Management
Association (Singapore Chapter).
Spectral Analysis
The spectral analysis includes both periodogramand spectral density analyses.
Periodogramanalysis assumes that a time series, Y
t
, can be expressed as a
linear combination of sinusoidal waves. The period and amplitude of these
cycles are determined through Fourier analysis. The basic equation of the
sinusoid may be written as follows:
Y
t
= R cos (t + ) + , = A cos t + B sin t +
where R is the amplitude; is called the angular frequency (in radians per
unit time); is the phase and , is a random distributed error. We note that A
= R cos and B = R sin .. The principle of least squares is to minimize the
following equation:
n1
T (A, B) =
(Y, A cos t B sin t)

2
t=0
and obtain the estimates for A, B and R.
The periodogramplots the sums of squares from each regression model
against the frequencies . That is, m (m = n/2 if n is even and m = (n-1)/2 if n
is odd) regressions are fitted on the data, and the sums of squares for each
regression model are calculated and plotted. These sums of squares are
called periodogram ordinates, which can be interpreted as the amount of
variation in Y at each frequency. The regression sums of squares for each
model are proportional to the sum of the squared sine and cosine
coefficients for each model, which can be written as n /2(A
2
+ B
2
).
If there is a significant sinusoidal component at a given frequency, then :
(1) the coefficients A or B, or both, will be large;
(2) the regression sums of squares will be large; and
(3) the periodogram will have a large ordinate at the given frequency.
If there is no significant sinusoidal component in the data, then the
periodogram will not have any large ordinates at any frequency, which
means the data is simply white noise and no cycle has occurred.
If time series changes contain any periodicity, their spectral density estimate
will display a dominant peak at the corresponding frequency and a
concentration in the neighborhood of the peak. In practice, the Tukey and
the Tukey-Hamming windows or the triangular weighting sequence are
usually used to smooth the periodogram using weights spectral window.
Readers may refer to Granger (1964), Priestley (1981) and Shumway and
Stoffer (2000) for more information on the spectral analysis.
The Ichimoku kinkou-hyou analysis technique has attracted more and
more attention among leading technical analysts recently yet there is
remarkably little written about the subject.Try a search on the internet
and you will see this for yourself.The reason for this is that it is a relatively
new as a technique,having been developed in the late sixties in Japan.
A number of definitions have surfaced including the translation one look
or equilibrium of the price at a glance. Ichimoku analyses the mid-points
of historical highs and lows to create a cloudthat is projected forward.
This cloud allows for wider support and resistance zones and decreases
the risk of trading false breakouts.The charts can be used in a similar way
to moving averages.It is essentially a trend-following technique.Once you
get the hang of reading these charts,they convey a great deal of
information on trend existence and direction along with support and
resistance areas,all at a glance.
The five main elements of the chart construction are:
Line 1 The mid-pointof the previous 9 sessions
Line 2 The mid-pointof the previous 26 sessions
Cloud Span 1 - The mid-pointof the last 52 sessions offset 26 bars
forward
Cloud Span 2 - The mid-pointof Lines 1 and 2 offset 26 bars forward
Lagging Span The price line shifted back 26 bars
Lines 1 and 2,called the turningand standard,can be treated and read in
much the same way as moving averages and give an indication of turning
points from extremes in the price.The cloud span is a support or
resistance area depending on where the price is in relation to the cloud.
Think of the cloud as being created by two averages 52 and 17 (though 17
is not the true calculation its the average of the 9 & 26 mid points) both
offset 26 bars forward.The area between these cloud boundaries is
shaded (normaly blue and red) as they snake across each other.The
lagging span is the final,and often overlooked,ingredient that gives the
last confirming signal as we will explain.
The chart shows varying degrees of bullishness and bearishness in the
following order:
Price above/below turning line
Turning line above/below standard line
Price above/below cloud
Turning and standard lines above/below cloud
Lagging line above/below cloud
The full bullish position occurs when price is above the turning line,the
turning line is above the standard line,and all are above the cloud
including the lagging line. A full bearish position is the inverse of this.In
between full bullish and full bearish,there are partial conditions where
perhaps the price has fallen below the turning line,or the turning line has
crossed below the standard line. These are short-term indications
provided they all stay above the cloud. Falling through the cloud turns
the chart from a bullish nature to a bearish nature.
Swapping between daily,weekly and monthly time frames will often give
a clearer picture than drilling down to all the conditions.Generally,weekly
Ichimoku charts give the clearest signals.The monthly charts provide a
very big picture while daily charts are normally too sensitive.Of the
various conditions that need to be satisfied to trigger a signal,the most
important is the price crossing the cloud.
As you use Ichimoku charts more and more you will begin to notice just
how clearly the price line can interact with the cloud.Touches on the
outer edge or the inner edge are very common.
Cloud thickness and steepness is a characteristic that is rarely discussed,
but just thinking about the construction we can make some observations.
One of the great advantages of Ichimoku is it allows for non-linear trend.If
the price accelerates,the cloud follows the price.We can see this from the
curve up in the cloud in the late 1990s on the FTSE-100 (chart 2 below)
when there was lots of indecision at the top with a thin cloud (this is quite
unusual).Where the cloud is thin,the market is normally moving quickly
such that the new highs (uptrend) or lows (downtrend) are big enough to
move the mid points on both time horizons (52 and 17) Thin clouds mean
acceleration.Thick clouds mean the short term is accelerating but not the
52 period.This is similar to the price action before and after a moving
average cross a decisive cut of short term through longer term.
Therefore wide clouds can be taken to mean periods of uncertainty and
potential turning points.Now for instance on FTSE-100 we may be at a
turning point - maybe.Look for the cloud widening (more uncertainty
more likely a turn) or narrowing (less uncertainty less likely a turn).
There are four main advantages to Ichimoku:
They gives Resistance Areas,less whipsaws
The trend position is clear Bull or Bear
Switching between daily,weekly and monthly charts works well
Cloud area is projected into the future

The 5th line is the lagging Line (or span) and is perhaps the most
interesting of all.It is the final condition that is met in a transition from
bearish to bullish trend or vice versa.This was the big thing to come out
of Rick Besignors Presentation at IFTA 2004 in Madrid.It is the true signal
for a complete cloud cross.Because it is shifted back 26 bars,it tends to
give signals at the thinner parts of the cloud so the move occurs quickly.
Ichimoku charts
This article is a summary of the presentation made to the Societys monthly meeting in May By David Linton
This can sometimes be at a point where the price is crossing but usually it
will cross the cloud after the price.Normally the price crossing does pull
the lagging line through,but not always.One tell-tale signal that the
lagging line will cross is the price testing the cloud from the other side i.e.
after a cross up,we start to see support on the cloud.Conversely,island
reversals often occur with the island outside the cloud.This appears to be
particularly true on Japanese stocks.
The clouds projection forward enables you to make quite bold future
predictions.Below is a monthly Ichimoku chart of the S&P 500 Index
(chart 3) with all five lines shown.First,notice how the lagging line found
support in the cloud.In the scheme of the long term picture,the US
market made a big correction within the trend.We can now see that the
S&P needs to be above 1200 points at the end of 2005 to be back out of
the cloud.The standard line has some work to do too.But the price is
already through the cloud and building a base on top of it.
Rather than rely on one particular time frame in isolation, I find looking at
the monthly (top right) weekly (bottom left) and daily (bottom right) gives
the long,medium and short term picture at a glance.For instance,on the
monthly chart (see chart 4) the sterling/dollar rate is still in long term
bullish territory above the mid$1.60s.It is just turning bearish on the
weekly charts with the lagging line falling through the high $1.70s The
daily chart has been fully bearish ever since the fall through $1.88 in April.
Ichimoku is not particularly effective in picking up intra-day moves unless
there is a very clear trend.The big moves tend to occur on the side of the
cloud you would expect when an instrument is trending on intra-day data
i.e.big bullish moves occur above the cloud,bearish below.Congestion
areas on these time frames give too much cloud interaction to provide
clear signals.
Another big advantage of Ichimoku is that cloud crosses are easy to scan
for.Typically,a scan of the Eurotop 300 will produce only a handful of full
cloud crosses each month.So you dont get too many signals just a nice
short list of stocks to investigate further.In scrolling instrument lists using
several different types of charts,I find Ichimoku are the quickest to read,
at a glance.
Using Ichimoku to screen tables for bullish and bearish criteria is again
very quick.Monthly,weekly and daily charts give long,medium and short
term timeframes and you can enter Bullish or Bearish under each of these
periods.You can take this further and create your own Ichimoku Market
Breadth.In May 2005,for example,the number of stocks that were bullish
on all three time frames versus bearish was 3 to 1 for the FTSE 100.For the
S&P 500 constituents it was 2 to 1.
One of the most common questions I am asked is,Have you back-tested
it?Having run tests on weekly charts,we have found if you take signals in
line with the monthly chart the results seem to be consistently good i.e.
with a monthly bullish Ichimoku chart only take the weekly bullish cloud
crosses for entry.
Finally,if the chart isnt giving a clear signal,dont use it.The market ideally
needs to be trending up or down.Ichimoku does not work well in long
term sideways trends.I would also suggest not relying solely on Ichimoku
signals.Use it in combination with other techniques or as a tool to find
shortlists.Look at all three time frames simultaneously and you will see
the trends within trends.But most importance should be attached to the
weekly charts which provide a different perspective from looking at noisy
daily line charts.Some people will find it a hard to accept you are using
these weird and wonderful charts to generate trading signals so it may be
a good idea not to tell anyone!
David Linton is founder and Chief Executive of Updata plc.For further
information see www.updata.co.uk
Introduction
I was recently asked to defend technical analysis to a UKSIP audience in a
forum entitled Technical Analysis:Astrology or Informed Analysis? This
was a challenge on a number of levels.First,it is not my view that the use
of planetary alignments or planetary cycles to strengthen entry and exit
rules implies uninformed analysis.On the contrary:there are many
important books that suggest that life on earth is directly influenced by
cosmic forces (Gaugelin,1969;Lieber,1979;Eysenck,1982).In fact,since the
giant planets (Jupiter,Saturn,Uranus and Neptune) usually pull the centre
of mass in our solar system outside of the physical body of the sun
(Landscheidt,1989),it would be amazing if the influences were not actually
quite significant.Furthermore,many successful traders including W.D.
Gann have explicitly used astrology to finesse their timing.
Second,there is the question of the degree to which astrology and
technical analysis can actually be categorised together.Many technical
analysts would argue that,even if astrology is a valid approach to markets,
technical analysis is still a distinct and separate discipline because it uses
different analytical tools.And this,in a way,points to the real challenge
implicit in the forums title:is technical analysis just as a set of tools that
sometimes work but sometimes dont? Or does technical analysis actually
have a genuine theoretical underpinning that justifies the use of certain
analytical tools?
What follows is part of my attempt to meet UKSIPs challenge.However,
there are two important qualifications.First,it only covers the
phenomenon of price patterns,it does not cover the extraordinary
influence of the Golden Ratio.Second,the analysis is offered only as a
small part of an evolving process rather than as an unassailable body of
theory.
Technical analysis and economic theory
The most fundamental definition of technical analysis is that it is the study
of past movements in asset prices in order to forecast future price
movements in those prices.However,since past price movements are the
outcome of various forms of investor activity,most analysts would also
understand that the study of past price movements also includes where
possible the study of various indicators relating to the supply of,and
demand for,the assets in question.This allows us to include not only
information such as volumes,open interest,and put/call ratios that can
be derived directly from the various bourses,but also information such
as opinion surveys and cash holdings in funds that can be gleaned from
external sources.I generally use this broader definition,but want to make
clear that excluding by definition does not mean excluding despite value.
After all,if a specific indicator helps to make money,why exclude it?
The basic idea underlying technical analysis is that human nature has a
consistency to it.This encourages certain general market phenomena,and
certain specific price patterns,to reproduce themselves through time.
Accordingly it is considered appropriate to formulate hypotheses about
market behaviour on the basis of historical data and to use these
hypotheses to anticipate the future.This process reproduces any other
form of scientific enquiry.
The problem,however,is that the assumptions about human behaviour
used by technical analysts are profoundly different from the assumptions
used by economic theorists.Technical analysts assume (usually implicitly)
that the market behaves as a coherent whole.Economic analysts assume
(very explicitly) that total market behaviour is no more than the arithmetic
sum of random decisions by individuals.
This difference in assumptions could not be better designed to foster
mutual hostility between the disciplines.Technical analysts are accused of
relying on some form of hocus pocus;economists are berated for living
in ivory towers.The result is that technical analysts tend to ignore the
influence of fundamental analysis on trends and that economists tend to
ignore the power of technical analysis to forecast turning points.The truth
is that both disciplines could usefully learn from one another.However,
there is a need first to establish a common ground for understanding the
phenomenon of financial markets.
The foundations of technical analysis
In any market,prices fluctuate up and down.The implicit assumption of
technical analysis is that these fluctuations are not random.The explicit
claim of technical analysis,therefore,is that non-random fluctuations
create patterns that repeat themselves.It is the repetition of patterns that
allows us to forecast or,better,to anticipate price movements.So there
are a number of questions that need to be answered:
(1) Are price movements random or non-random?
(2) If price movements are non-random,what patterns can we
expect to emerge?
(3) If patterned price movements are present,how quickly can we
decide which pattern is evolving?
Random or non-random behaviour
So much has been written on the subject of the randomness or otherwise
of price movements in financial markets that it seems dangerous even to
attempt to address the issue.However,using a methodology suggested
by the work of Baumol and Benhabib (1989),it is possible to look at the
subject pragmatically,without going into a detailed discussion of
statistical theory.
Figure 1 plots each days percentage change (ie,at time t) in the Dow
against the previous days percentage change (ie,at time t-1),for every
trading day since 2nd January 1990.In other words,movements in the
Dow are plotted in what is called t/t-1 phase space.The result is exactly
the sort of pattern that can be expected if daily movements were indeed
random that is,they are scattered widely throughout the phase space.
Nevertheless,what is also relevant is that the movements are actually
contained in a very limited area of that phase space.So,although the price
movements appear random,they are in some sense contained.This
becomes even more apparent if the scales on the chart are (say)
quadrupled.See Figure 2.It is clear that price changes tend not to move
out beyond a very specific two-dimensional region.Should they do so,
they tend to get pulled back in again towards the centre of that region.
Figure 1:Dow in t/t-1 phase space
Figure 2:Dow in expanded phase space
The operation of some sort of gravitational pull is particularly noticeable if
the chart is extended backwards in time to (say) January 1946.By
definition,the data set is a long one,not only covering an important
period of economic and social evolution,but also including the 1987
equity crash.See Figure 3.Importantly,the basic region of attraction for
the market remains unchanged,and the experience of 18th20th October
1987 stands out as an idiosyncrasy.It is arguable that,in one sense,the
1987 crash was the truly random event.
A theoretical basis of technical analysis
By Tony Plummer
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The point here is that the idea of randomness obviously has something to
do with perspective:the longer the time perspective being taken (or,if
you like,the broader the context),the less likely it is that fluctuations will
seem random.Anyone who has traded in financial markets for any length
of time will know when a price movement is unusual,based on his or her
experience.
Figure 3:Extended Dow data in t/t-1 phase space
Strange attractors
We can take this argument a stage further and look at the price changes
over periods that are longer than one day.Figure 4 shows an example of
the 5-day percentage changes in the Dow,in t/t-1 phase space.Here,the
5-day percentage change for a particular day is compared with the 5-day
percentage change the previous day.What is clear is that the formerly
circular bubblecontaining price movements begins to spread out along
an upward-sloping diagonal line.And this becomes even clearer for
longer time periods.Figure 5 shows 20-day percentage changes in the
Dow,in t/t-1 phase space.Oscillations in the Dow seem to be drawn
towards the upward-sloping diagonal,where the rate of change at time t
is equal to the rate of change at time t-1.Moreover,even though there are
obviously unusual events,such as the 1987 equity crash,the oscillations
are essentially bounded on the upside and downside.In the language of
chaos theory,a strange attractor seems to be at work.
It seems that,over longer time periods,changes in the Dow tend towards
a stable path of change;but the changes are also persistently induced to
accelerate and decelerate along this path.We can hypothesise that
something encourages investors to chase the market up until some form
of upper boundary is reached,and to chase the market down until some
form of lower boundary is reached.This,in itself,is highly suggestive of a
deep running ordered process at work.A related question is whether the
acceleration/deceleration itself has a cyclical element of some sort.If it
did,this would strengthen the case for non-random market behaviour.
Figure 4:5-day changes in the Dow
Figure 5:20-day changes in the Dow
Groups and crowds
Before we look more closely at the possibility of cyclical influences,we
need to consider the basis for an ordered process in human behaviour.
According to economic theorists,individuals make their decisions
independently of one another.Group behaviour is then considered to be
forecastable because,according to probability theory,a large number of
uncertainties somewhat spookily create a certainty.As James Surowiecki
has recently demonstrated in The Wisdom of Crowds (Surowiecki, 2005),
this is not only absolutely correct,but can yield answers and decisions
that are amazingly accurate.
The problem,however,is that once individuals start to be influenced by
each others behaviour,then their expression of individuality is much
reduced.Ultimately, deviation from some measure of average behaviour
becomes minimal.This presents a problem for theoreticians because,
although basic probability theory breaks down,it is highly likely that a
large number of people doing the same thing will produce a forecastable
outcome.
This,in a way,was one of the central findings of the late 19th century
French sociologist,Gustave le Bon,whose now-famous book,The Crowd,
analysed the French Revolution (le Bon,1895).Le Bon observed that,when
people came together in a common cause,the result was something
different to just the sum of the parts. People behaved differently to the
way that they would as individuals:they would focus on,and follow,the
dictates of a recognised leader;they would act to protect their beliefs;and
they would quickly see non-believersas enemies.In short,the act of
people coming together under a unifying belief system would foster
conflict.
The truth behind le Bons assertions is only too clear in the bloodied
history of the twentieth century.There is,however,an important aspect of
his analysis that is easily overlooked.This is that le Bon saw crowds,or
groups,as psychological phenomena whereby people behave in a unified
way once they adopt a shared set of beliefs.This is because belief systems
however unlikely and unreasonable they may seem mobilise powerful
inner emotions.Hence,crowds are held together,and energised by,
emotions rather than by cold logic.Moreover and this is important the
self-awareness of participating individuals is reduced (Neumann,1990).
The psyche is invaded by the values of the collective.Consequently,the
ability of individuals to make rational choices,evoke moral judgement
and engage in active reality testing is suppressed.This,of course,would
help to explain why outsiders have such difficulty in understanding and
interpreting group behaviour.Importantly,though,it might also help to
explain why stock markets bubble and crash,and why economies boom
and slump.Somehow,emotionally laden beliefs are increasingly
distributed throughout a market place and throughout an economy.
Co-operation
The suggestion here is that warfare and violence may actually be a
specific outcome of the more general tendency towards co-operation
amongst human beings.Indeed, this suggestion becomes seriously
compelling once account is taken of contemporary ideas relating systems
theory,group psychology,and natural evolution.Nature organises itself
hierarchically into ever-greater wholes:lower-order parts contribute to
higher-order wholes,and the wholes organise the parts.As a result,each
whole is qualitatively different to the mere summation of the parts.In
human beings,this organisational force finds expression in the need to
merge psychologically into a group.At one level this can be explained as
the need to reduce the sense of personal isolation.At another level it can
be explained as the need to have a sense of purpose. Either way,the
outcome is naturalin the genuine sense of that word.
However,the inner need to merge into greater wholes takes on a different
imperative when competition or conflict is involved.The associated threat
to each individuals psychological security is reduced when others are
involved in meeting that threat (Trotter,1947).Quite obviously,the greater
the threat,the more urgent it is that each individuals resources are
directed towards meeting the purposes of the whole.Acompetitive
environment therefore demands conformity from individuals (Bloom,
2000).Non-conformity is punished by exclusion from the group:
individuals are left to meet the threat alone.
The point is that,once account is taken of the inner dimension of human
existence, the need to do things together becomes a viable explanation
for a part of human behaviour.Evolution can then be seen in terms not
just of random mutation and survival of the fittest individuals but also in
terms of the perpetuation of the most adaptive groups in the face of
external threats.Nature is,ultimately,a collaborative enterprise.
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Conformity enforcement
Importantly,the idea that group beliefs can induce conformity has found a
great deal of support from independent researchers.In the 1950s,Stanley
Milgram was able to show that more than 60 per cent of ordinary people
could be induced to deliver massive electric shocks to apparent patients
just by being told by an authority figure in a white coat that it was alright
to do so.Fortunately,the patientswere actors and no electric shock was
actually involved.In the late 1970s,Ed Diener at the University of Illinois
published evidence that,in a group setting,people strongly identified with
other group members,had little sense of personal identity and tended to
act without prior thought.Other evidence notably from Bristol University
in the UK and from Harvard in the US showed that peoples perception of
non-group members and, indeed,of reality itself,could all too easily be
influenced by pressure from other group members.In the psychological
arena,therefore,a group can be less than the sum of its parts.
In recent years,the central ideas of self-organization,group conformity
enforcement, and non-rational collective behaviour have been used by a
number of important developmental theoreticians to explore the
processes of history.Foremost amongst these have been Arthur Koestler
(1978),Erich Jantsh (1980),Fritjof Capra (1982), Ken Wilber (1983),and
Howard Bloom (1997 and 2000).
Non-rational behaviour
What theory and research are both pointing to is the very real possibility
that economic and financial activities are,at heart,less rational than many
might want to believe.This does not mean that such activity is always
irrational just that it is essentially activated by deeply held psychological
needs.These needs are orientated towards obtaining security and
meaning,and are universal.Hence,non-random behaviour in economic
and financial markets may be the outcome of genuine group influences
rather than just the outcome of statistical interactions.This,in turn,would
mean that excesses (which are,in any case more easily observed after the
event than before it) could well be part of a forecastable spectrum of
behaviour instead of the unforecastable outcome of keeping up with the
Jonesesor of animal spirits.
The problem,however,is that a clearly defined body of theory that covers
this spectrum of economic and financial behaviour is not currently
available within the academic community.This suggests that some form
of paradigm shift is almost certainly looming as a result of the aftermath
of the financial bubble of the late 1990s. After all,how long can academics
continue to ignore the tendency of markets to diverge from,and oscillate
around,fundamental values? However,it also implies that we need to look
for guidance outside of the current rational expectationsparadigm that
embraces economics.
Financial markets
One way forward is to look for patterns that regularly emerge in financial
markets. There are three reasons for this.First,larger-scale movements in
financial markets basically reflect the evolving mood that embraces all
economic and social behaviour within a community.Second,financial
markets provide a continuous flow of uncontaminated data.Market price
action therefore provides a marvellous testing ground for hypotheses
about human behaviour.Third,recurring price patterns would (if found)
imply recurring behaviour.In other words,the patterns could be
interpreted.
This,indeed,is the route that technical analysts have chosen to take.The
result is a large body of industry literature confirming that (a) markets
oscillate in reasonably regular cycles,that (b) markets spend time in base,
top or holding patterns before entering a significant trend,and that (c)
these price patterns tend to incorporate certain predictive price
configurations,such as head and shoulder tops.The over-riding
impression is that market behaviour is not random.
Bubbles and crashes
A valid point of access for an analysis of market price patterns is to look at
investor behaviour during periods of emotional extremes.Traditional
economic theory regards such extremes as aberrations.However,insofar
as such extremes are actually part of a spectrum of behaviour,they are
likely to reveal the basic energies that drive all behaviour.Extremes of
behaviour are often noteworthy for their clarity of purpose.
Shown in the Figure 6 are the loci of US price action in the Dow Jones
Industrial Average from January 1921 to July 1934 and in the NASDAQ
from September 1995 to September 2002.The time periods involved are
different:the former covers a period of seven years,the latter covers a
period of three years.However,when the time elapse relating to the Dow
is placed on the lower horizontal axis and the time elapse relating to the
NASDAQ is placed on the upper horizontal axis,something very
interesting emerges:the patterns of the acceleration into the peak and
the subsequent collapse are very similar.
Figure 6:The Wall Street Crash and the NASDAQ Collapse
This similarity has been recognized by Didier Sornette,who is Professor of
Geophysics at UCLA.Sornette has shown how non- linear mathematics
can track and predict a stock market bubble and crash(Sornette,2003).
There are two distinct conclusions.The first is that the price acceleration
into the final peak is curvilinear, and that the time-elapse of oscillations
around that accelerating trend gets progressively shorter.The second is
that this specific phenomenon only works because of the impact of co-
operative self-organization.In other words,non- linear mathematics can
predict the timing of the peak (because the oscillations become so fast
that they effectively converge on zero),but such non- linear mathematics
only work because stock markets are naturalsystems.
Homogeneity
These conclusions are a dramatic confirmation of the impact of group
behaviour in financial markets;and it is almost no accident that they have
been generated outside of the discipline of economic theory.
Nevertheless,they need to be placed in a wider context of investment
behaviour.Professor Sornette notes that,as a stock market bubble
accelerates into a peak,investors take more and more notice of what
others are doing.Hence,behaviour becomes increasingly homogenous
and local information has long-distance effects.Ultimately,of course,the
market becomes satiated,or overbought,and extremely vulnerable to
small perturbations.So only a small amount of profit taking can initiate a
full-blown crash.
What Professor Sornette is,in fact,describing is a specific and
particularly dramatic example of a more general mechanism.This is the
mechanism that induces conformity from market participants and
thereby produces oscillations in financial markets.
Conformity enforcement in financial markets
Financial markets are characterized by inter- group conflict:it is a contest
between the bulls and the bears.Seen in this light,financial markets are
not just processes that encourage prices to converge on fundamental-
induced values.They are reflections of a collective movement between the
opposite polarities of optimism and pessimism. Hence,prices are likely to
overshoot fundamental values in both directions.One implication is that
market participants actually pay less attention to fundamental values than
is usually thought.Partly,this is due to the fact that such values are very
difficult to calculate in advance.Partly,though,it is due to the competitive
process. So much attention is ultimately given to ensuring that one
particular view is right (eg, prices are going up) that participants lose sight
of fundamentals.Energy is spent in generating propaganda to colleagues,
clients,other members of the profession and the media.The sub-conscious
intention is always to ensure that financial resources continue to
underwrite ones own view.What is missed,however,is that this is also
exactly what others are doing.Conformity enforcement is a very subtle
process which is why it is usually deemed not to exist.Nevertheless,it is
conformity enforcement that lies at the root of all price trends.
In modern financial markets,the pressure to conform has become
institutionalised. Market professionals are consistently monitored against
peer group performances: indices are constructed to show the sector
allocations of other funds,and deviations from that normare monitored
for success or failure.For the individual fund manager it is a risk to take a
marginally different view,let alone an alternative view.So,when a market
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The Wall Street Crash &
the NASDAQ Collapse
(Weekly closes)
Data sources: Economagic & Datastream
Dow Jones Industrials
(l.h.scale, lower time axis)
NASDAQ
(r.h.scale, upper time axis)
either begins to run ahead of perceived valuations,or even begins to
bubble,there is huge pressure to join in.Not to do so is a direct risk to
personal wealth and personal income.
Ultimately,however,it is this threat to personal status that provides the
main pressure to conform.Individuals participate in markets for reasons of
wealth,power and prestige in other words,to enhance control over
future resources.To be out of the market when it is going up,or in the
market when it is going down,threatens this control and generates fear.
Collective behaviour,of course,reduces fear.So,for the majority,it is easier
to trade on the evidence of actual price movements,than it is to invest on
the basis of theoretical valuations (which may,in any case,be wrong).
For whatever reason,the end result is that the psychological environment
of the market becomes dominated by a limited set of uncritically held
beliefs,known as memes.In a bullish market the meme is that prices are
going up;in a bearish market, the meme is that prices are going down.A
meme is the glue that holds otherwise disparate individuals together in
groups and crowds.
The basic mechanism
Figure 7 shows some of the basic principles involved.It demonstrates the
most likely pattern that will be traced out by a broad financial market price
index during the course of a complete bull-bear cycle.No account is taken
at this stage of the time scale involved.Starting at the lower left-hand side
of the chart,a market will be very oversold,probably after some form of
crisis.There will then be a bear squeeze of some sort as short positions are
covered.This need not entail a significant proportion of investors suddenly
becoming bullish it just needs some investors to close bear positions.
This will cause the market to jump sharply.The rise may continue for a little
while because investors do not all respond simultaneously.Crucially,they
will respond,not so much to fundamentalconsiderations,as much as to
the fact that prices are rising.In other words,price movements
particularly sharp movements are a critical item of information.
At some early stage,however,such technical buying dries up,and the
market begins to retrace back towards the lows.This is a re-testof the
lows and occurs while those who missed the initial rally will be
considering whether or not they now need to react. Investors will take
into account the fact that prices have rallied but they will also necessarily
re-assess fundamentals.Some may even decide that the market had
originally over-discounted fundamentals or that the fundamentals might
be shifting. This triggers another bout of buying,which eventually takes
the market out of whatever holding pattern it has been in.In other words,
a trend starts to materialize. As time progresses,either new information
becomes available that confirms that fundamentals are improving and/or
the rally in the market enters a feedback relationship with fundamentals
such that the latter improve anyway.
Figure 7:The basic mechanism
There are a number of very important points that emerge from this simple
model of market behaviour.First,a reversal materialises once a market has
gone too far.The market is,in some sense,satiated.Second,the reversal is
an information shock to the market.It reveals that the market may be out
of line with fundamentals and that the market can no longer attract
sufficient investor energy to continue the old trend.There is thus an
energy gap.Third,the subsequent re-test of the low occurs while
investors absorb the implications of what has just happened.Investors
learnthat something has changed.Fourth,the market signalsa trend
move by breaking out of the holding pattern.Since investors have,in
effect,learnt that fundamentals have changed,all subsequent information
will be seen in the context of that learning.Data that confirm the trend
will increasingly be acted upon;data that contradict the trend will
increasingly be ignored.Fifth,market participants will increasingly focus
their attention on price action rather than fundamentals.Finally,the
market will run ahead of fundamentals and will become overbought,or
satiated.This presents the conditions that will trigger a reversal.The whole
process then begins in reverse.
The role of prices
We thus have a three-phase mechanism that accounts for all the basic
behaviour within a financial market trend,whether up or down.We also
have a specific mechanism that accounts for market reversals.
Consequently,we can hypothesize the existence of a six- wave pattern in
a full market cycle three waves up and three waves down.This is an
important conclusion.However,there are other important inferences that
need to be drawn.The first,which has already been mentioned,is the
important role of prices.Individuals can process complex information,but
a group can only react to simple information.The most important piece of
information to a financial market group is the actual behaviour of prices.
The response of the group will be greater,the faster and more
pronounced is the change in prices.In a sense, therefore,prices will fulfil
the leadership role in a psychological group.The group will accordingly
react to this leadership and it will chase trends.The process is dramatically
enhanced when high profile individuals confirm their own personal
commitment to the trend.
This,of course,stands economic theory on its head.In economics a price is
determined by the behaviour of buyers and sellers.This is true,but is only
part of the process.When prices generate information,prices also
determine behaviour.So a feedback effect is involved.As the biologist and
philosopher Gregory Bateson has argued,feedback is one of the
characteristics of any living system (Bateson,1979).
The process of learning
This brings us to the second inference from the market model.In any
system that is oscillating in a feedback relationship with its environment,
any new information from that environment has to be assimilated and
absorbed.A process of learning is therefore involved.So it hardly seems
accidental that the mechanism just described mirrors the process of
learning that can be found in the human brain.In the early 1960s,Henry
Mills found that,although people would initially be very quick at picking
up the mechanics of a new task,they would inevitably go through a stage
where their ability to apply their new learnings would slow (Mills,1967).
Only after this slowdown could activity speed up again.
Normally this slowdownis missed because it is only temporary.
Nevertheless,it is a real phenomenon,which reflects something
important.At some stage during the learning process,information is
transferred from short-term memory in the forebrain to long-term
memory deeper within the brain.Learning thereby moves from the
conscious into the sub-conscious (Hebb,1949).This is both automatic and
necessary, and frees up consciousness for other tasks.However,energy
has to be diverted away from other processes in order to facilitate this
adjustment,and the ability of a person to do a conscious task actually
deteriorates temporarily.After the adjustment,people can apply their
learnt techniques to the new task and not even think about it very much.
Markets are exactly the same.At a top or bottom,markets will go through
a process of learning that fundamentals have changed.They respond to
new information, hesitate while that information is absorbed,and then
automatically apply the resulting learning during the thrust of a trend.
Markets as collective learning processes
Financial markets (and,with them,whole economies) can be viewed as
natural self-organizing systems that learn from their interaction with their
environment.They are a particular form of what Howard Bloom of New York
University calls collective learning machines (Bloom,2000).As such,they
organize their lower-order parts in a coherent fashion,oscillate rhythmically,
and express themselves in terms of a limited matrix of patterns.This is
essentially why the discipline of technical analysis has the power regularly
to generate effective buy and sell signals.Analysts will look at indicators of
investor energy in order to estimate the intensity of the markets hold over
investors.They know that the stronger the markets grip,the nearer the
market is to a turning point.Analysts will also look at the periodicity of
historical oscillations in order to forecast the timing of likely turning points
in the future.If a cycle has made itself felt in the past,it is likely to continue
into the future.And,finally,analysts will look at the current evolution of
price patterns,in the knowledge that certain patterns reproduce
themselves.Once the markets position in the context of a specific pattern is
known,it is possible to estimate what might happen in the future.Quite
obviously, the most powerful signals are going to be generated when each
of the three lines of analysis coincide.
Energy gap/
Information shock
Information
absorption
Information
absorption
Energy gap/
Information shock
Satiation
Satiation
Price cycles
Central to technical analysis procedures is the phenomenon of price
cycles.It was earlier noted that financial market oscillations might be
driven by a natural learning mechanism and that inflexion points might
be triggered by an energy gap that arose out of investor satiation.The
important point here is that an energy gap reverses the polarity of the
market from bullish to bearish,or from bearish to bullish.There are,
however,two important questions:First,does this mean that bear markets
are inevitable? Second,what determines the difference between a big
bear market,such as those that emerge in the form of a crash,and minor
setbacks?
In the context of financial market cycles (and,indeed,of economic cycles),
it is necessary to understand that downswings are as important as
upswings.Nature cannot evolve without periods of rest,because it needs
to replenish its energy.Hence,any period of activity will be followed by a
period of rest.So,despite the best attempts of governments,bull markets
will always be followed by bear markets,and economic expansions will
always be followed by recessions.What then determines the extent of a
downswing? One answer,of course,is the amplitude of the upswing:the
bigger the upswing,the bigger (potentially) the correction.However,it
also depends on the time span of the cycle:the longer the cycle,the
longer (potentially) the correction. Technical analysis has the capability of
determining the difference between big moves and small ones by putting
all moves into the context of history and accepting that this history has a
valid and vital role to play.Hence,for example,if there is strong evidence
that the Dow Jones Industrial Average has,for a very long time,oscillated
with a rhythmic periodicity of about 11 years (which it has),then there is
every reason to suppose that the oscillation will continue.This will give a
strong indication of when an important reversal can be expected and
what order of magnitude that reversal might take.The primary
presumption of cycle analysis,therefore,is that this time it will definitely
not be different.
Price patterns within cycles
An important inference is that cycles can be defined by their patterning as
well by the precision of their periodicity (Plummer,2003).This means that
the observed variability in cycle periodicities does not invalidate the
forecasting potential of cycle analysis because the evolution of a current
cycle can be tracked in real time against the pattern of a previous cycle.
An example of this is shown in Figure 8,which compares the pattern of
fluctuations in the Dow Jones Industrial Average between September
1990 and September 2001 with the pattern of fluctuations between
September 1957 and May 1970.Both periods represent one beat of the
11-year cycle in the Dow,and both periods embraced rapid change in the
US economy:1990-01 covered the revolution in information technology,
and 1957-70 covered the social revolution of the Swinging Sixties.In a
sense,therefore,the two periods are directly comparable.When the price
patterns of the two periods are overlaid on one another,by the simple
expedient of plotting each beat of the cycle on a separate time axis,a
remarkable similarity emerges.This is not unusual.Once the coincidence
of patterns is found,it becomes a simple matter of tracking a new cycle
beat against an earlier comparable one and tracking that cycle beat into
its final low.Any variations in the periodicity will not matter.
Figure 8:Patterns in the Dow
This,in a sense,is where technical analysis brings such great strength to
market analysis.It focuses directly on the patterns of market behaviour
both in terms of price movement and investor activity because its
working assumption is that such patterns are both non-random and
meaningful.
The fallacy of the rational individual
The small and simple shift in emphasis from the individual to the group
creates a massive shift in our understanding of economic and financial
motivation.Economic theory cannot properly explain why a large number
of people,who are assumed to be making rational decisions
independently of one another,end up (for example) buying red cars or
trying to move house,all at the same time.Mood may be regarded as
being part of the answer;but,then,by what mechanism can a change in
mood be made to swarm through a population of separate and rational
individuals?
Economic theory also cannot properly explain why particular patterns
emerge in financial markets.If individuals really do make decisions
independently of one another,then prices should just jump about in a
random fashion.There is no mechanism for explaining why markets should
generate the specific behavioural patterns that have so far been analysed.
Nor is there any mechanism for explaining why specific patterns recur.
Bearing this in mind,it is now appropriate to look at some of the findings
of technical analysts regarding specific price patterns.
Derivative price patterns
If a single beat of a cycle (of whatever length) contains a simple six-wave
(three-up/three-down) pattern,then it should be possible to isolate that
pattern from whatever trend is driving the market.Or,to put the same
thing another way,since a cycle beat consists of six basic waves,these
waves can only present themselves in a small number of ways when they
are subjected to a trend.Moreover,each trend will itself be part of the six-
wave structure of a higher- level cycle beat.If these conclusions are
correct,then not only are price patterns non-random and meaningful, but
also they are limited in number.
This is a significant claim.It means that technical analysis when properly
approached and applied is an extremely powerful method of interacting
with financial markets.This,indeed,is what some of the leading
proponents of technical analysis in the last one hundred years have
argued.One of these analysts,whose research spanned the traumatic
years of the first half of the twentieth century,was Ralph Nelson Elliott
(Elliott,1938).Elliotts work is usually ignored by economists for the very
reasons it is so powerful namely,it assumes non-random,patterned,
group behaviour.However,Elliott made two significant observations.First,
all impulsive movements,whether up or down,consist of five waves (three
in the direction of the trend,interspersed with two corrections).Second,
all corrections consist of three waves (two in the direction of the
corrective trend and one contra-trend move).
Five-three patterns and investor behaviour
At first sight,Elliotts five-three pattern appears to contradict the
hypothesis of a three-three archetype.However,the two are entirely
consistent,once (a) the role of trends is included and once (b) some
allowance is made for the possibility that Elliott himself may not have had
all the answers.Shown in Figure 12 is the formation generated when a
rising trend is applied to an otherwise balanced three-three cycle. The
cycle itself is notated as 1-2-3 up and A-B-C down.Once a trend is applied,
however,wave B (which is theoretically a re-testwave) actually makes a
new high. In other words,the basic three-three profile incorporates a five-
wave movement.
Figure 12:The effects of a trend
This is a very important insight and justifies a lot of the work that
technical analysts conduct in relation to market satiation.There are two
critical phases after a trend has developed.The first is when it is
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c
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a
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g
e
1957-1970
(l.h.scale, lower
time axis)
1990-2001
(r.h.scale, upper
time axis)
US Dow Jones Industrial Average
(Monthly closes, 1 year % change)
Data Source: Bloomberg
1
1
2
2
3
3
A
B
C
4
5
Cycle
plus
trend
Cycle
overboughtor oversold.This is the potential point of inflexion in a cycle,
and may be captured by indices such as overstretched momentum or by
indicators representing panic buying or panic selling.
The second critical phase,however,is when a fifth waveextends the
market into a new high or new low.There are two possibilities.First,the
fifth wave is not,by its very nature,truly impulsive.In this case,it may not
be confirmedby indicators of investor enthusiasm for the trend.
Momentum may be weaker,volumes may be lower, and open interest in
the relevant futures markets may be falling.Second,the fifth wave may be
dynamic enough to create an investor panic.In this case,investment
positions are finally driven to satiation.It is quite obvious that new highs
or lows that are either not confirmed or generate excesses (or both) could
be followed by a sharp reversal.
Note that some capitulation is likely to occur at the end of the third wave.
It can also occur at the end of the fifth wave.On rare occasions,it may
happen at the end of the first wave.Capitulation is therefore likely to
occur between one and three times in a specific trend.
Three-wave corrections
This particular model does not,of course,automatically generate a three-
wave correction.There was,however,something missing from Elliotts
original exposition. Elliott was intrigued by the patterning of markets and
did not look too closely into their causes.However,the foregoing
exposition places great store on the impact on investors of sharp price
movements.Such movements are information shocks.The impact of
energy gaps has already been discussed.These are contra-trend shocks.
There is,however,another class of information shocks.These are pro-trend
shocks, caused by a higher-level trend,where prices either move into,or
extend the length of, an impulse wave.The presence of a pro-trend shock
is recognizable by sharp price movements,increases in trading volumes,
price gaps between one days close and the next days open,and rising
open interest.
All shocks have to be absorbed by the market and therefore generate a
price retracement of some sort.The contra-trend shock produces a re-test
of the high or low,the pro-trend shock generates some form of
subsequent holding pattern.Figure 13 shows the influence of a pro-trend
shock.A break out from the base pattern indicates to investors that a
trend is now developing.This is an item of information to which they
respond,and buying volumes increase.Eventually,however,satiation sets
in and the market hesitates (and,in effect,waits for fundamentalsto catch
up).The market then moves ahead again,reaches its climax and turns
down into a relatively deep correction.
Figure 13:Pro-trend information shock
The combination of simple distortions to lower- level cycles and the more
dramatic effect of information shocks produced by high- level cycles yield
the basic five-three pattern observed by Elliott.Underlying this pattern,
however,is the operation of a three-three cycle.
Other patterns
This analysis is very brief and does not do justice to the forces involved.
Nevertheless, it already confirms two other aspects of technical analysis.
First,it confirms the influence of the famous head and shoulderpattern
that so often defines a reversal either out of a market high or away from a
market low.Figure 14 below shows the head and shoulders top formation
that was implicit in Figure 13.The top of wave 3 becomes the left shoulder,
the peak of wave 5 is the head,and the end of wave B is the right shoulder.
A line linking the lows of waves 4 and A become the neckline and a sell
signal is generated when prices fall through that neckline.
The reason why the pattern works so effectively is that in moving into a
trend,the market has probably responded to a higher- level information
shock.This means that the qualitative structure of the market has shifted
it has incorporated new information and has evolved.Therefore,when a
correction occurs at the end of the trend generated by the information,
that correction necessarily comes from a higher level.It necessarily is
longer in price and time than those that preceded it.This, indeed,is what
Elliott found.
Figure 14:The head and shoulders formation
Second,the analysis substantiates the presence of genuine trends in
markets.This, alone,is a hugely important conclusion.Markets enter a
trend when investors have learnt that circumstances have changed:they
are only applying learntbehaviour. Trends basically continue until
markets have run too far ahead of fundamentals.
The role of technical analysis
The discipline of technical analysis has been developed only gradually,over
a very long period of time.Its main driving force has been one of
profitability rather than theoretical nicety,and this has often militated
against effective communication with practitioners in other areas of
research,such as economics.Despite its apparent lack of theoretical rigour,
technical analysts have observed,catalogued and used a huge volume of
very effective tools and predictive techniques.There are,for example,no
known price patterns that lie outside of Elliotts classifications.
Once these tools and techniques are seen in the context of self-organizing
groups, which learn (both from their environment and from their own
behaviour) then much of it begins to make sense.Markets evolve in a
non-random fashion,according to patterned cycles.Different styles of
investor behaviour can be identified at each stage of these patterns,and
can therefore provide a strong clue as to where a market is in any
particular cycle.More to the point,technical analysis has the power
sometimes predictively,but always quickly to signal serious price
reversals.We have shifted from forecasting based on the arcane workings
of statistics to forecasting based on the extraordinary forces of Nature.
Bibliography
Bateson,G (1979) Mind and Nature: An Essential Unity.Wildwood House,London.
Baumol,W and Benhabib,J (1989) Chaos:Significance,Mechanism,and Economic
Applications in Journal of Economic Perspectives.
Bloom,H (1997) The Lucifer Principle. Grove Press,New York.
Bloom,H (2000) Global Brain: The Evolution of the Mass Mind From the Big Bang to the
21st Century. John Wiley,New York
Capra,F (1982) The Turning Point.Wildwood House,London.
Elliott,R N (1938) The Wave Principle.Elliott,New York.Reprinted in Prechter R.(ed.)
(1980) The Major Works of R N Elliott. New Classics Library,New York.
Eysenck,H and Nias,D (1982) Astrology: Science or Superstition? Temple Smith,
London.
Gaugelin,M (1969) The Cosmic Clocks. Paladin,London
Hebb,D (1949) The Organization of Behaviour,John Wiley,New York.
Jantsh,E (1980) The Self-Organizing Universe.Pergamon,Oxford.
Koestler,A (1978) Janus: A Summing Up.Hutchinson,London.
Le Bon,G (1895) Psychologie des Foules .Felix Alcan,Paris.Reprinted (1922) as The
Crowd. Macmillan,New York.
Lieber,A (1979) The Lunar Effect.Corgi,London.
Mills,H R (1967) Teaching and Training,Macmillan,London.
Neumann,E (1990) Depth Psychology and a New Ethic.Shambhala,New York.
Plummer,T(2003) Forecasting Financial Markets.Kogan Page,London.
Sornette,D (2003) Why Stock Markets Crash.Princeton University Press,Princeton.
Trotter,W (1947),The Instincts of the Herd in Peace and War.Ernest Benn,London
Wilber,K (1983) Up From Eden.Routledge & Kegan Paul.London.
3
2
1
4
5
Information
shock
1
2
Left
Shoulder
Information
shock
Right
Shoulder
Head
Neckline
Orthodox technical analysis teaches us that markets trend and therefore
the best way to profit from market movements is to identify the presence
of a trend and trade in that direction until the trend has come to an end.A
simple idea in theory,yet one which most traders find difficult to
implement.The problem with trend trading is that you are always late
joining and always late leaving the trend.
Top and bottom pickers have an almost opposite philosophy;these
traders try to identify the peaks and troughs in the market and attempt to
participate in the moment at which the market turns.This method of
trading is probably the hardest to implement but,if successful,can be
highly profitable.
The problem with both of these methods is the difficulty we encounter in
identifying when a trend has come to an end,and when one is beginning.
There are many popular methods that traders use to achieve this,
including moving averages,oscillator divergences and momentum
indicators.One way I have found of identifying the end of a trend is to use
what I call the naked bar.If I'm feeling particularly daring,the naked bar
will not only signal that the top or bottom is in place,but it will encourage
me to trade in the opposite direction to the recent trend.
The concept behind the naked bar is that when a trend ends or begins,it
should enter a new market environment.What we are looking for in the
naked bar is a bar which has broken away from the previous trend and
has,therefore,signalled the beginning of a new trend.It can also help
identify when a market is range bound and when it is trending.
Identifying the Naked Bar
The naked bar is simply the first bar that trades completely outside the range
of an extreme bar.What this means is that in an uptrend,we are looking for
the bar which has made the highest high so far,and following this the naked
bar will be the first bar which trades completely below the range of this
extreme bar (fig 1).The naked bar does not need to occur immediately after
the extreme,it can occur any number of bars after the extreme bar.In a
downtrend the naked bar is the first bar that trades entirely above the range
of the bar that has made the lowest low so far (fig 2).
Naked Bars and Congestion
In sideways moving markets the naked bar is a little trickier to identify.In
any period of sideways trading there will be an extreme high bar and an
extreme low bar,therefore the first bar that trades completely below the
range of the extreme high bar will be the naked bar indicating a
downside break,and the first bar trading completely above the range of
the extreme low bar will be the naked bar indicating an upside break (fig
3).Naked bars can be used to identify periods of congestion or sideways
trends.The traditional definition of a sideways trend is any period that
does not have both higher highs and lows or lower highs and lows.If
there are no naked bars within a certain period,for example 10 days,then
the market is in congestion (fig 4)
Trading the Naked Bar
The end of an uptrend is signalled by the appearance of a naked bar,but
it is advisable to wait for a breach of the naked bar to the downside as
your exit point.This should ensure you do not give back too much profit.
In a downtrend,wait for a breach of the naked bar to the upside before
exiting the trade.
The naked bar can also be used to initiate new trades.This can be done by
using the criteria suggested above,whereby a long position is taken after
the naked bar is identified in a downtrend and then breached to the
upside. The breach can be used to enter a long trade,and the lowest low
of the downtrend would be an excellent place to put a stop loss.The
opposite can be down to initiate a short position.
Although the naked bar can be used as a stand alone pattern,I find that it
is best used as a confirmation of a change in the market environment.This
has the disadvantage of losing more on entry,but it helps avoid trading
false breaks.
The naked bar can be used in any timeframe for any market.One use is to
trade intraday in the direction of a prevailing longer term trend.This
method works quite successfully since it allows for tight stop losses whilst
allowing the potential to participate in major market moves.
Conclusion
Once familiar with the basic technique,naked bars can be used as a base
around which trading systems can be designed.Naked bars are very
useful in defining trends and congestion areas and can be used to give
definite trading signals.
Furhaan Khan
furhaan@tradinglogically.com
The Naked Bar
By Furhaan Khan
Fig 1
Bar A is the extreme bar for the uptrend and therefore the first bar that trades
completely below the range of bar A will be the naked bar.Bar B is an example of
what an idealised naked bar would look like.
Fig 3
Bar A is the extreme upper bar for the congestion and therefore any bar that
trades completely below the range of bar A will be the naked bar (Bar C).Bar B is
the extreme lower bar for the congestion and therefore any bar that trades
completely above the range of bar B will be the naked bar (Bar D).Bar C would
indicate the beginning of a downtrend from a period of congestion and equally
Bar D would indicate the beginning of an uptrend.
Fig 2
Bar A is the extreme bar for the downtrend and therefore the first bar that trades
completely above the range of bar A will be the naked bar.Bar B is an example of
what an idealised naked bar would look like.

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