journal of technical analysis (jota). issue 08 (1980, may)

Market Technicians Association

JOURNAL Issue 8 May 1980

MARKET TECHNICIANS ASSOCIATION JOURNAL

Issue 8

May 1980

Published by: Market Technicians Association 70 Pine Street

New York, New York 10005

Copyright 1980 by Market Technicians Association

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Market Technicians Association Journal

Editor: William DiIanni, V.P. Wellington Management Co. 28 State Street Boston, Massachusetts 02108

Associate Editor: Cheryl Stafford Wellington Management Co.

Editorial Advisor: William S. Doane Fidelity Management & Research

Thanks to the following MTA members and subscribers for their part in the creation of this issue:

Robert J. Farrell Bernard J. Fremerman Charles D. Kirkpatrick II D. Bruce McMahan Robert R. Prechter, Jr. Henry 0. Pruden Ph.D. Alan R. Shaw David L. Upshaw

MARKET TECHNICIANS ASSOCIATION MEMBERSHIP and SUBSCRIPTION INFORMATION

REGULARMEMBERSHIP - $50 per year plus $10 one-time application fee.

Receives the Journal, the monthly MTA Newsletter, invitations to all meetings, voting member status and a discount on the Annual Seminar Fee. Eligibility requires that the emphasis of the applicant's professional work involve technical analysis.

SUBSCRIBER STATUS - $50 per year plus $10 one-time application fee.

Receives the Journal and the MTA Newsletter, which contains shorter articles on technical analysis, and the subscriber receives special announcements of the MTA meetings open to The New York Society of Security Analysts and/or the public, plus a discount on the Annual Seminar Fee.

ANNUAL SUBSCRIPTION TO THE MTA JOURNAL - $35 per year.

SINGLE ISSUES OF THE MTA JOURNAL (including back issues)

are available for $10 to regular members or subscribers $15 to non-members and non-subscribers

The Market Technicians Association Journal is scheduled to be published three times each fiscal year, in approximately November, February and May.

An Annual Seminar is held each spring.

Inquiries for Membership should be directed to:

Fred R. Gruber, V.P. United Jersey Bank 210 Main Street Hackensack, New Jersey 07602

INDEX

Market Technicians Association Journal - May 1980 Page

EDITORIAL. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7

INDICATOR ANALYSIS

Does The Tail Wag The Dog? -Revisited . . . . . . . . . . . . . . . 9 D. Bruce McMahan and F. Martin Koenig

GENERAL TOPICS

Broad Bottom Configurations . . . . . . . . . . . . . . . . . . . . . 21 William S. Doane

Relative Price Analysis - With A Twist . . . . . . . . . . . . . . . 31 G. Edward Noonan

Point And Figure Charting . . . . . . . . . . . . . . . . . . . . . . 39 Alan R. Shaw

Is Traditional Market Timing Passe? . . . . . . . . . . . . . . . . . 49 Robert J. Farrell

Solar And Economic Relationships . . . . . . . . . . . . . . . . . . 53 Bernard J. Fremerman

R. N. Elliott's Most Famous Call . . . . . . . . . . . . . . . . . . 57 Robert R. Prechter, Jr.

STATISTICALLY SIGNIFICANT

Is The Four-Year Market Dead? . . . . . . . . . . . . . . . . . . . . 61 Charles D. Kirkpatrick II

Catastrophe Theory: A Practical Application . . . . . . . . . . . . . 69 Henry 0. Pruden Ph.D.

PROFILES

Alec Ellinger: England's Pioneer Technician . . . . . . . . . . . . . 81 by David L. Upshaw

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EDITORIAL: AND SO IT GOES

It should come as no surprise to anyone that technical analysis or market timing goes in and out of fashion. Some even hold it in perpetual disdain.

One respected member of the investment community has even gone so far as to call it "technical gobbledegook." As the art is practiced at times, he is probably right. And recently, a writer in a popular magazine questioned the merits of the subject completely, but later admitted to some usefulness regarding sentiment readings and knowledge of the market or stock's current position versus their past.

These criticisms are not entirely without foundation. Unfortunately, during the past few years, we have witnessed many forecasts of wild Dow objectives in both directions . . . from 2700 by some to 200 by others; both sides ignoring the rule that the whole is made up of the sum of its parts. Furthermore, industries loved one month are hated the next. And a stock tauted one week is sold the next.

An experienced technician (or mature human being) has no problem with any of these criticisms or failings; in fact, he welcomes them with a silent chuckle. He knows there is nothing that spoils a good thing as universal recognition and wide-spread acceptance, or crowd psychology. And that goes for a tool, a theory or a method. Or, as Jim Fraser wrote recently:

"Today, wherever we turn there is a chartist or technician to save us. Cannot this overly systematize us and reduce our capacity to adjust to unexpected events? It is not the charts we have to fear, only the machine-like chartists; and not new stock market techniques, but the treatment of human investors as mechanical elements; not new knowledge, but the divorce of knowledge from investor psychology."

But non-technical types have had similar problems. The mangled corpses of dead fundamental theories and methods of analysis are sufficient and brutal testimonials along the proverbial winding road of history. Complete re- jection followed a collapse of methods. Times change. Methods change. Styles change. Things are born. Things grow. Things die. Multiples may be low for years. Then multiples break out to new highs. Standards are raised to meet reality. Multiples contract and break to new lows. Stan- dards are lowered to reflect the change. And so it goes. It is all part of the process. As Carl Sagan says in "Broca's Brain" - The human race can only get to where it is going by change and innovation. If we don't want to derail the express train of biological evolution we must continue to innovate, recognizing and causing changes.

The technician's problem, however, is no less difficult. But he (or she) deals in essentials that can never change in a free market system: price- volume. What is done with it depends on one's own artistic industry and patient genius. Moreover, proper development can be a lifetime job.

Sometimes a comedian can offer penetrating insights. In his own cryptic and inimitable way, Will Rogers said: "If a stock don't go up, don't buy it." It is not a forecast. It is not a bottom-fish. It is not a tip or a theory. Implicit in the statement is a serious but simple technical truth. . . a base has been made, a breakout has occurred, a trend has developed - properly confirmed. "If it don't go up, don't buy it." Not too early, not too late.

Will Rogers, popular in the thirties, understood that nothing moves in a sustained sense without proper accumulation, and nothing is properly accumulated without proper "pooling". In his day, pooling was intentional; nowadays it is unintentional, but necessary and effective. His quip is brilliant in its truth and simplicity.

Will Rogers should be the patron saint of technicians everywhere . . . . and Saint Christopher for all others.

William DiIanni, Editor April, 1980

DOES THE TAIL WAG THE DOG? - REVISITED

D. Bruce McMahan Bear, Steams & Company

and F. Martin Koenig

Chase Investors Management Corporation

Since listed options trading began on the Chicago Board Options Exchange in the spring of 1973, a great deal of effort has been expended, developing models that key off price movements in the underlying security for predict- ing option fair values. The authors have attempted to look at things the other way around. Given option price behavior, can anything be said about price expectations in the underlying security or for the market overall?

The purpose of this paper is to expand on certain relationships and to serve as an update to a previous article published in May 1979 in this Journal, entitled "Does The Tail Wag The Dog?

A number of years ago a few generalizations emerged from practitioners attempting to explain option premium behavior corresponding to different market levels and changes in market direction (as the reader will see, market level and market direction relationships ABE DIFFERENT!)

Market Level Generalizations

During the 1974, 1975, 1976 period, relationships between market levels and option premiums were often summed up as follows:

l Market High/Premiums Low (Figure 1)

0 Market Low/Premiums High (Figure 2)

These relationships appeared to persist for months on end, if not for periods existing for up to as much as a year.

More specifically the market was presumed "relatively" high or low when compared to the recent past, and that option premiums were "relatively" low or high when compared to the recent past. These relationships are presented to help the reader gain perspective, and nothing more. As the reader may suspect, there is more here than meets the eye!

9

Market Level vs Premium Level 6 Month Option Premiums* lmrcen1 SIP 500

If4 a 39 4q 1q 1814

*normalized at-lhwnoney Premiums

~~ 3q

14 12s

3q 4q

FKWE 1

Market Level vs Premium Level 6 Month Option Premiums*

18-

Option Index

67 3 4

* normalized at-lb-money Premiums

SIP 500

-120

-80

-60

FIGURE 2

10

Two Dimensional Model of Market Direction Generalizations --

Examining the 1974, 1975, 1976 period again, certain refinements can be made to an elementary two dimensional model of simple option permium behavior compared to the market overall.

Relationships involving short term premium behavior and market movements are not quite as obvious as for market levels. In fact, initial impres- sions may appear contradictory to market level observations set forth earlier. In any event, the next series of charts (Figures 3, 4, 5) attempt to clarify these relationships for "Up", "Down", and "Flat" markets.

The major distinction between market level and market direction generalizations is that the latter can be used as a confirming indicator of market direction and vice versa. The former concerns market level relationships as compared to the recent past. Market direction generalizations should not be viewed as having significant predictive value, except in the very short term - they are confirming indicators. As a result, they may be useful for timing purposes, BUT NOT BY THEMSELVES! Their major value is as coincident (confirming) indicators, NOT as PREDICTORS of future market prices.

The charts that follow illustrate a few decision aids used by the authors in determining potential changes in the direction of premiums. These behavior patterns are a useful confirming indicator of market direction as well. To date, empirical evidence supports this contention. To summarize:

l When the market rises, premiums rise with a few weeks lag, but usually after a short lived decline. There are often three stages to this behavior: 1. DIVERGENCE 2. CONFIRMATION and 3. SEMI-DIVERGENCE. (see figure 3 for detail)

l The opposite is true when the market declines. Premiums rise initially, and then enter a steady declining phase. This often occurs in two stages: 1. DIVERGENCE, followed by 2. CONFIR- MATION. (see figure 4 for detail)

l When the market is stable, premiums decline. There is usually one stage: CONFIRMATION through SEMI-DEVERGENCE. This latter behavior is often an extension of the third phase following a rising market. (see figure 5 for detail)

11

Behavior of Option Premiums in a Rising Market 0 Month Option Premiuma*

Behavior of Option Premiums in a Down Market 6 Month Option Premiums*

ant

w

\

1

S&P so0 120

100

BO

80

12

Behavior of Option Premiums in a Stable Market 6 Month Option Prom&ma*

1975 1976

What is Relevant? --

It doesn't really matter whether premiums are low, or whether premiums are high! What matters when attempting to gauge what one should do with one's money, is whether or not the probabilities are in favor of a long, short or hedge position! As option practitioners, the authors generally prefer to hedge, but not always. Hedges do not have to be neutral either. They can be skewed to a bullish or bearish posture as well. When adjusting positions, we rarely recommend moving 100% in or 100% out of the market, but prefer to scale , making meaningful moves at the margin. Common sense, intuition, and a few key indicators generally tell us when to hedge and when to unwind a position.

When analyzing financial markets, academic and investment professionals have tended to build regression models that rely heavily on repetitive circumstances to trigger certain action signals. The authors also view repetitive circumstances as essential to market forecasting. However, there always has and there always will be a certain amount of "art" required in making reliable forecasts of future market behavior.

Accordingly, our methods are not strictly mechanical, we do not profess to have found an end-all panacea; and lastly, analysis of key variables frequently requires subjective determinations on the part of the user. Stock market forecasting is no simple matter. It cannot be reduced to a simplistic model using a handful of variables.

Notwithstanding the foregoing, the authors have developed a series of indicators, which have proven useful in optimizing the risk/return trade- offs inherent in certain intuitive aptitude. Without this aptitude, the model will fail, but can still be useful.

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w/Sell . . . . . Can The Options Market Tell You When? -- ---

Looking at Figures 6 - 11: "OPTION PREMIUM CYCLE INDEX FOR ALL LISTED OPTIONS", even the most casual observer is sure to notice that when a bulge occurs in the premium pool (plotted across the top of the page - to be defined later) the equity market usually flattens out or turns down in the seven to ten weeks following the bulge (exception late 1979 - early 1980). In 1976 (figure 61, bulges occurred in January, February, June/ July, September, and December. These were high points for the market. This phenomena occurred again in January/June/July, and November of 1977 (figure 71, and again in April/May/June, and August/September of 1978 (figure 8). More recently, (figures 9, 10, 111, a bulge occurred in January/March/August/September/October/November and December of 1979. In 1980 this condition existed throughout January/February, and the first week in March. Conversely, buying opportunities have consistently occurred when the premium pool is at very low levels.

So much for the premium pool charted at the top of figures 6 - 11. Before going much further, however, a few terms need defining:

Option Premium Pool - the daily aggregate total funds (in millions of dollars) flowing through the option market premium structure. This time series is plotted using the upper left hand scale.

S&P 500 - -- this is plotted directly below the option premium pool and is the second line from the top using the upper right hand scale.

Current Index Value - -- the average of all normalized at the money call option premiums, adjusted to a fourteen week expiration. This is plotted using a solid line between the highest and lowest value.

15 Day Moving Average - of the current index value (dotted line between -- highest and lowest value).

Highest Value - this is the third line from the top (about the middle of the page), and is calculated by taking the highest value for each stock's current index value each day over the previous nine months, aggregating the data for all stocks, and exponentially smoothing the series to give greater weight to recent information.

Lowest Value - this is the bottom line and is calculated using the lowest value for each stock's current index value in a manner similar to the highest value, giving greater weight to most recent data.

Premium Levels as a Forecaster --

As the reader may suspect, option premium levels when used alone or in conjunction with overvalued/undervalued models, are not terribly reliable in forecasting future price movements of the underlying security or the market generally. However, when analyzed in conjunction with the option

14

premium pool (a dollar weighted indicator) and what is happening in the overall market, the results have been quite good. The degree to which these three variables accelerate and decelerate together, or whether divergence is observed, is key in determining whether one should buy, sell or hedge.

Major sells generally occur under the following conditions: (1) a high or bulging premium pool, (2) a market that has recently risen, or is still rising, (3) the current index value is relatively high when compared to the recent past and is well up in the premium trading range between the highest and lowest value. Major buys generally occur during periods when the premium pool is very low and premium levels are also low, acting to confirm a market which has been drifting lower in the recent past.

Major buys and major sells are marked on figures 6 - 11 with an M either above or below the arrow. In 1976 there were major sells indicated in February and December. In 1977 a major sell occurred once in November. In 1978 one occurred in January with three occurring in the May/June period, followed by a number of sell signals throughout August and September. One also occurred in November when premiums were at a recovery high of 8% for fourteen weeks, at the money options. This was the highest premiums had been since February of 1976. There was another signal in late December. No major sells were registered in the first half of 1979, but a number occurred in the September/October period, just before a sharp decline in the market. In retrospect, the most recent series of major sell signals were a bit premature, registered in late November through December 1979, continuing in January and February of 1980. However, a covered call writer that had left room to roll up at a positive cash flow, using scaling techniques, as the authors consistently advise, would have faired quite well when the market decline of late February 1980, finally got under way. This is particularly true, had heavy writing of oil related issues been avoided or minimized. Even the oils, however, finally cor- rected in early March 1980.

Looking again at figures 6 - 11, major buys were recorded in January, April, May, August, September, October and November of 1976. In 1977, a number of major buys were recorded in February/March/April, and again in late October. In 1978, there were four major buys in February, March, July and December. In the first quarter of 1979, there were three major

buys, one in late January about a week before an overbought condition and a minor sell, the second in February and the third in March. There were a number of major buys in the April/May/June/July 1979 period just before the rather sharp August/September rally. No major buys have occurred since July of 1979. Time will tell, but as of early March 1980, patience has been rewarded.

Other buy/sell signals are merely indicated with an arrow, and while not termed major buy or sell, they are still quite meaningful within the overall context of short term trading decisions. The batting average has been high and reasonably consistent. The buy/sell signals indicated in figures 6 - 11 represent the concensus of a collaborated effort between broker and

15

client. The signals do not necessarily represent all the broker inter- preted signals either. What you see is a concensus of key buy/sell decisions arrived at independently, but using the same information. Not surprisingly, there were only a few instances where broker and client dis- agreed.

Comment on Option Premium Cycle Behavior -

The foregoing tools do not call for all encompassing moves into or out of the market entirely, except under unusual circumstances accompanied by a high degree of conviction regarding future market behavior. They are meant to signal adjustment to hedged positions, triggering meaningful moves at the margin.

Since the foregoing apply for individual stocks as well as industry group- ings (although data are not presented), opportunities may present themselves from time to time irrespective of the posture indicated for the overall market. For this reason, we advise that a nmber of positions in a typical portfolio should be hedged (or unhedged), under a variety of market conditions. This may be in the face of less than optimal hedging conditions overall.

As with all generalizations, the tools presented should be used intelli- gently. Aids such as these should NOT be followed mechanistically.

Since the primary benefit of option hedging in the short run is risk re- duction, and the long term benefit is increased return through avoidance of risk, investors should be willing to accept the consequence of short term opportunity losses.

On this premise, the authors recommend a policy of relatively continuous option hedging varying exposure at appropriate market junctures, moder- ating volatility and risk in the process. THE WAY TO MAKE MONEY IS TO KEEP FROM LOSING IT!

Even if returns are not increased, the volatility of a skillfully implemented option hedging program should be less than that of an unoptioned portfolio. For this and other reasons, we think covered call writing and other hedging techniques make a lot of sense.

Summary and Conclusion

The foregoing relationships have recurred with surprising regularity. As a general rule, however, the two markets should confirm one another before a particular generalization can be applied with a reasonable probability of success.

One should not construe from the above that options should be written or other hedging techniques should be employed only on the appearance of possible peaks in the market and premium cycle. We are acutely aware of our

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limitations in making reliable short term prognostications. The wasting asset benefit of writing covered calls and attributes of other hedging techniques should not be forgotten.

Consequently, a more appropriate set of strategies should rarely call for a move in or out of the options market entirely. Meaningful moves should be made, but not all at once, and not to the fullest extent possible, un- less one possesses considerably above average conviction and skill regarding the probabilities of future market and premium behavior.

When using option premium information, one must take into account variations in momentum, as well as confirmation/divergence of the premium pool, the market itself, and the current index value. There are essentially three variables plotted on figures 6 - 11 with 6 time series derived from these variables. The interrelationship among these six time series is complex. It is the understanding of this total interrelationship however, that is key to successful forecasting.

Moderation is the watch word as with most technical indicators, The risk of whipsaw is ever present. Scale tactics, making meaningful moves at the margin, will generally be rewarded. With covered call writing and variable hedging, the selling of a wasting asset has generally served to optimize the trade-offs, between risk and reward. This does not mean, however, that option buying strategies cannot produce a similar pattern of risk/reward optimization. The purchase of puts to protect long positions can serve as an excellent hedge. Similarly, the maintenance of a large reserve position combined with the purchase of calls has proved rewarding, as risk is limited to the premium paid , while rewards are open-ended. More sophisticated hedges, including combination or straddle hedging (short one put/call combination, while long another - boxcars and box-

spreads) can produce a high probability of return while operating at an acceptable level of risk.

In sum, if you have a reasonably good handle on where the market is head- ing, appropriately skewed hedges can be set up to minimize the risk of whipsaw, hopefully producing a risk/return profile that is consistent with investor objectives.

17

OPTION PREMIUM CYCLE INDEX FOR ALL LISTED OPTIONS

l4 WEEK OPTION PREYIUUS*

ECodYllllon*** SSP 500

OptIon Premium Cycle Index for all Listed Options 14 Week Option Premiums* y&OI Yllllons l *

sap 500

120

1977

18

r

Option Premium Cycle Index for all Listed Options 14 Week Option Premiums* $ Pod wl~src ..,.! -p.,50LA-A --G, S&P 500

ml10 L

'0

----_- _ - - . FIGURE 0

19

Opiiorr Premium Cycle lndeir for all Listed Options 14 Week Option Premiums* yNl4 Yilhonr..

O.., B

c normallzsd al-Ihe-money Premiums

r.- ~--- --.----.-.

FIGURE 10

3-Option Premium Cycle Index for &&isted Qfions’ !m’ 7114 Week Option Premiums* IAd 1’

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BROAD BOTTOM CONFIGURATIONS And Their Application to Investment Strategy

William S. Doane Fidelity Management & Research

Low Risk vs. High Risk The Investor vs. The Speculator

The Conservative Approach vs. The Aggressive Approach Broad Bottom Configurations vs. Relative Strength/Momentum

Introduction

Back in the early 1960s this writer interviewed George Chestnutt of American Investors. "Bill," he said, "how do you pick next year's winners?" "Well," I explained, "I'd look for a breakout of a big base pattern and then I would buy the stock as it settled back on top of that broad bottom." "Fine," he said, "you'll probably do a bit better than average. Top performance will come, however, by buying last year's winners." I had to give that some thought--and I have pondered that statement ever since.

As we progressed into the mid-to-late 196Os, I observed the aggressive par- ticipants of that era-- the relative strength/momentum players--and I even began to imitate them. It was easy. All one had to do was follow a select list of volatile market leaders and buy, or recommend to buy, every reaction, The trick was in knowing when to stop, And even if one did not know when to stop, he would be wrong only once, and that would be on the reaction that completed the top and reversed the major trend.

The go-go environment of the 1960s seemed to nurture such an approach. Those issues that appeared to be high, went higher, dramatically higher. The early practitioners (later to be called gunslingers) became idols and were wor- shipped as possessing some uncanny insight.

Imitators increase in number as published works by Levy(') and Adam Smith(2) gave credence and acclaim to such aggressive techniques. In fact, the simu- lation models developed by Robert A. Levy (an academic economist and statis- tician) proved unequivocally that "the strong stocks of the recent past are better investment vehicles than the weak stocks of the recent past."

About this time, however, some pot holes began to appear. The market was no

21

longer bailing out mistakes, losses were being incurred and locked-in positions were being maintained--in "bag holder" fashion.

As fads and fashions change within industries and sectors, so do changes take place within investment approaches and techniques. The market seems to have a perverse tendency to send out a smoke screen once too many get the scent of its intentions. This results in erratic performance. If the general market downdrafts of 1962, 1966, 1970, 1974 fail to entrap the aggressive player of “last year’s winners,” the periodic shift of proper investment strategy will. Institutional results tend to verify this as being true. Quite often the top performing fund of one cycle will fall to the bottom quartile during the next cycle. In this respect, the performance race can be compared to the proverbial race between the Tortoise and the Hare.

Given a lengthy period of measurement, the theoretical results of conservatively managed Windsor Fund and Puri- tan Fund could con- ceivably about match that of aggressively managed Enterprise and New Horizons Funds. It is evident from the schematic that if, somehow, one could avoid the losses, or moderate the periods of underperformance, consistently un- paralled results would be attained. Unfortunately, historical evidence has not supported this as being possible no matter how plausible it may appear. High risk is inherent in any opportunity for high gain. There are exceptions, of course, but few know when to stop; few are able to adequately alternate from an aggressive stance to a conservative stance. The ever present human emotions of hope, fear, greed and pride of opinion mitigate

against consistent and continued success.

To make this switch from aggressive to conservative, one must have historical knowledge of excesses on the one hand and troughs on the other. This may mean a substantial change of strategy in accordance with the 4-year cycle . ..a year or two in an aggressive framework followed by a year or two in a conservative mode. Institutions may deem it advisable to look even further out and couple the cyclical with the secular outlook. Dick Stoken(3) in his excellent book on cycles, makes easy reading out of a complicated subject. In other words, one must set up a workable plan and stick to it devoid of emotion. Action should only be taken when hard evidence suggests that a change of consequence is mandated.

The Hare has proven that the end results are well worthwhile--less glamorous perhaps--but certainly less worrisome and aggravating to the manager as well as owner of the assets,

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Broad Bottom Patterns -- An Explanation -

Before one can erect a superstructure, or a skyscraper, a strong foundation must be constructed. The higher the building, the more solid the base must be. It is the same in the stock market, or any other freely traded, marketable instrument--a base is usually formed. Bases are merely periods of reaccumulation where weak and discouraged holders sell and newer, more informed buyers accumulate. Shapes and sizes vary, Those specifically discussed in this paper are long-term bases, often depressed from higher levels, and normally taking 3, 4, and 5 years to complete. Numerous examples appear in the pages that follow.

As opposed to the speculator not knowing when to stop buying and sell, the investor in broad bottom base patterns often has the problem of knowing when to start to buy. Whereas the speculator getting in late in a volatile situation leaves himself wide open to substantial loss, an ill-timed purchase of a depressed issue normally results in only a minimal loss.

This question of when to accumulate has been thoroughly researched and recently Bob Mann( t

ublished in an excellent book on this subject by Ray Hanson and ). They have found that the duration, or length, of the average

base structure is approximately four years (Eleven Quarter Rule). This is measuring from the extreme low, whether it be the initial panic low or subsequent secondary low that completes the bear phase.

It should not be assumed that this approach is the easy road to success. Although it is probably fair to say that 80% of the stocks that enjoy big moves during market upswings possess the technical prerequisites to do so, for every winner, five or six others (with the same characteristics) remained dormant. In this regard, George Chestnutt is right. One will do well, but only "a bit better than average."

Of course, the ideal strategy to employ is a combination of conservative and aggressive techniques. In the words of Ted Warren(S), an old-timer with a good number of years' experience with Broad Bottoms, "buy like an investor should and sell like a speculator would hope to."

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Broad Bottoms of the 1920s

As stated elsewhere, there are any number of similarities between the mid- 70s/early 80s and the 1920s--even economic, political and social. Unfortu- nately there are not many charts of individual companies available for this period. If there were, undoubtedly any number of them would resemble the one below.

Note the large percentage decline General Motors experienced during the Bear Market of 1920-21. By late 1924

a> it was depressed in price, out-of-favor and associated with a general feeling of disinterest,

b) it had technically completed three years of constructive development. It represented a bargain basement price.

Late 1924learly 1925 represented an ideal "entry" level for the conservative investor, As the "After" chart shows, momentum began to accelerate shortly thereafter as the uptrend got underway. Those who were in early had nothing to worry about. Even the "breakouts" of the three continuation patterns produced good results. But be careful of the pit- falls of the aggressive player. Such perceived continuation patterns can, at any time, develop into distributional patterns. This occurred in 1928-29 as the top floor was reached. Those who did not "get off," rode the elevator down.

BEFORE

I GENERAL MOTOR

30 , “U+g II I I

I / , I I

, FOR 1 REVERSE SPLIT

n I a I

1927 1928 1929

AFTER

base

I GENERAL h AOTORS

92 I I I I I ! ! I 1 7

I

88

84

80

76

72

68

64

60

56

52

SOURCE: ANATOMY OF A CRASH

J.R. LEVIEN

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Broad Bottoms of the 1940s ---

A book could be filled of examples from the 1940 period. Those shown below are merely 2 from the "A" part of the alphabet. The "foundations" were laid in the 40s for the advance which lasted, on a rotational basis, into the late 60s.

The patterns present since 1974 can only be compared to those of the 40s and even the 20s. Many of the smaller capitalized, secondary-type stocks (Canadian Oils) have already been exploited. We believe the potential now exists for the larger capitalized, primary quality-type issues. For example, Xerox today is not unlike the charts below.

BEFORE AFTER

25

SOURCE: M.C. HORSEY & CO.

Broad Bottoms -- Gold in the Early 1970s ---

Although not a depressed, broad bottom in the strict sense and as previously discussed, the chart of the London price of Gold Bullion is a textbook case of the forces of supply and demand. Note the drying up of activity as indicated by the narrowing of the weekly ranges at the extreme lows in 1970. Note also the two attempts to exceed the $44 resistance level followed by the successful and impressive breakout in January 1972.

As we know, the "After" portion of the example only shows a portion of the subsequent move, Gold reached $200 an ounce in December, 1974, declined to $100 an ounce by September, 1976, and then proceeded to confound both Bulls and Bears alike as it skyrocketed to an unbelievable $850 an ounce in January, 1980.

They say there's no fever like gold fever. How high is high? How low is low? No one ever really knows. Markets go to extremes--both on the upside and on the downside. They always seem to go further than we are initially able to envision. If one used the same scale as used on the charts below, one would need every page of this article to plot the trend! At times, it is foolish to try to predict a top until a top begins to develop. Tops can be distributional or psychological. In this regard, watching the media and studying crowd psychology of the "tulip era" would have been a great help.

AFTER

BEFORE

hz PRICE OF GOLD

52 - 50 - ‘8 - ‘6 - “ .-------T~~~-- __-- r----------

l/O2 l/O2

x1- x1- 68 - 68 - 66- 66- 6‘ - 6‘ - 62 - 62 - 60- 60- 18 - 18 - 56- 56- Y- Y- 51 - 51 - 50 - 50 - 18 - 18 - ‘6 - ‘6 -

PRICE OF GOLD PRICE OF GOLD S/O2 S/O2

- 70 - 70 - 68 - 68 -66 -66 -9 -9 - 62 - 62 - 60 - 60

I I -58 -58 - 55 - 55 -Y -Y - 52 - 52 - 5c - 5c

y”‘. - ‘8 - ‘8 - ‘6

61 -------------------------------- 61 ___-_-__-_-_---_- br?“? br?“? ‘- “

JbL’ ,h’*. JbL’ ,h’*. b b - ‘2 - ‘2

c*l# c*l# ‘0 1” fp” IP ‘I ‘I

-$d------ ::

i - ‘0

38 ‘I

- 38

36 - il,..pJ ,,#., IL, ;l’.-*Lf’. y - : 1‘ - - 3‘

Il,~l,,l,,l,,l,,r, 111111 ,,l~,l,,r,*~,l,,r,, l,,r,,l,,l,,l,,l,,I,,l,,lI ,,l,,l,,l,, ,,I,,I

1968 1968 1 1969 1969 1970 70 I 1971 1971 I 1972 1972

SOURCE: FM&R

25

Broad Bottoms -- Commodities

Beginning in 1972, one by one, commodities began to exceed upside barriers that had confined them for years: Barley, Cocoa, Corn, Cotton, Flaxseed, Oats, Rye, Soybeans and Wheat. They possessed the technical capability to put on quite a show--and they did, Late-comers could have joined in (in 1973 and '74) and done quite well. But at what point do you stop: Light- ning struck many in 1975 and '76 before a second upward move got underway.

Researching the price of Copper would reveal a huge base in early 1964, another in early 1973 and still another by January, 1979. All three were followed by substantial advances.

Sugar has been a spectacular performer twice--in recent years. In 1972 it emerged from a 7-year base and moved from $.05 a pound to over $.65. By mid-79 it once again indicated extremely limited risk at the $.08 level and subsequently moved significantly higher.

BEFORE

SOURCE: COMMODITY RES. BUREAU

AFTER

27

Broad Bottoms -- The Japanese Market in 1968 --

Individuals being handed a long-term (monthly-basis) chart book of Japanese stocks in 1968 would probably conclude

a> pretty dull and uninteresting, or b) wow, the foundations are in place for big gains--if only the

move could get started.

At that time, the patterns there were classic--huge, broad bases of accumulation. And throughout the decade of the '7Os, one by one, these patterns were resolved on the upside as the Tokyo Stock Exchange Average led the world and advanced from 1250 to 6500, over 400%.

History repeats...with a difference and in different places. There is always a profit opportunity existing somewhere, some place, if one is able to recognize it. Australian Metals and Oils are additional examples. Are the larger capitalized New York issues next?

BEFORE

SOURCE: TOSHI RADAR CO.

28

Conclusion

As you have probably surmised by this time, we are believers in the long base pattern as the foundation for large, long-term price trend movements. It is a methodology that we have studied and implemented for many, many years.

There is logic to the pattern, It reflects the movement of stock out of weak hands into strong hands. It is the result of the natural process of correcting extremes-- the transitional period between overvaluation and undervaluation. Although some experience is needed in distinguishing between the potential winners (E-Systems) and laggards (LTV) and in fine tuning proper entry/exit points, the rewards in exploitation of the Broad Bottom Configuration are, more times than not, well worth the effort,

Footnotes and Sources

Books

(1) Levy, Ph.D., Robert A. The Relative Strength Concept of Common Stock Price Forecasting. --

-

Larchmont, New York: Investors Intelligence, 1968.

(2) Smith, Adam. The Money Game. New York: Random HouT1967.

(3) StoEnih;;ck A. Cycles: What They Are, What They Mean, How to Profit .

New York: McGraw-Hill, 1978.

(4) Hanson, Raymond, Jr. and Mann, Robert K. Non-Random Profits, Lincoln, Rhode Island: Freedom Press, r978.

(5) Warren, Ted. How to Make the Stock Market Make Money for You. p--v- Los Angeles, California:

-- Sherbourne Press, Inc., 1966.

Market Letters

Lee, Burton. The Long Base Master Letter. 1117 St. Caxrine St. W. (Suite loo), Montreal, Canada H3B lH9

Chart Services

M.C. Horsey, Inc. The Stock Picture. Salisbury, Maryla 21801

Toshi Radar Co., Ltd. Tokyo, Japan

Commodity Research Bureau, Inc. One Liberty Plaza, New York, N.Y. 10006

29

intentionally blank

30

RELATIVE PRICE ANALYSIS - WITH A TWIST

G. Edward Noonan, President Contravisory Incorporated

This article on relative price trend analysis highlights one contrary approach proven to be useful - identifying relative price trend changes whose direction is opposite to that of the general market. Negative relative price signals, occurring in an advancing market, have frequently provided better results than positive indications. Conversely, positive signals in a declining market have frequently provided better results than negative indications.

I Background -

Credit should be given to Mr. Hays C. Ray, creator of Ray*Signals, for his extensive and, in fact, ground-breaking efforts in the art of relative price trend analysis. His pioneering research efforts originated in the 1930s. The relative price (RP) methods developed by H. C. Ray, and per- petuated by my firm, Contravisory, emphasize the interpretation of changes (reversals) in the continuity of RP trends. The interpretation z based -- -- largely upon objective rules applied to patterns of price behavior.

Chart I of Dow Chemical provides some background on our RP trend analysis. Three price trends are used: 1) ABSOLUTE, 2) RELATIVE, and 3) RELATIVE MOMENTUM. They are positioned in that order on the chart. Monthly data is employed and the S&P 500 Index is the base. A "reversal" signal of trend change is indicated by an up, or down, arrow adjacent to the RP trend line. Such a "reversal" signal required a trend change interpretation for each of the three price trends shown. Referring to the DOW chart, a "downward reversal" (unfavorable) signal was given in July 1976. At that point in time we were interpreting that the stock would experience RP weakness for at least one year from the signal point. A second signal is indicated for September 1979. This positive signal remains in place. The average trend cycle from "upward" to "downward" is 18 months. We encourage our clients to concentrate, but not limit, research and portfolio activity near the point of "reversal". We consider that such a signal represents a "decision point" for the stock, or group.

31

Chart II on the Aerospace group applies the same methods. Our last interpretation of trend change occurred on March 1975 - an "upward", or positive signal.

II Contra-Flow Results -

Based upon more than forty years of Ray*Signals' efforts and eight years of our experience, we have found that interpretations of RP trend reversals opposite to the market flow have often been particularly effective. For this article we have chosen two periods - the 1973-74 declining phase and the 1976 advancing phase. They have been selected because of their prox- imity to 1980, the substantial number of trend "reversals", and the period following was a "reversal" year for the market. We have also limited the total population of stocks under review to our Institutional 100 - a list of the major non-financial companies comprising approximately 75% of the S&P 500 Index. The measurement of the price performance is from the signal point to the end of the subsequent reversal year for the general stock market. Year-end 1975 is used for the first period and year-end 1977, for the second.

1973-74 Bear Phase

Table1 summarizes the results of our study. Looking first at the 1973-74 bear market phase, we signalled 19 "upward" reversals. Their RP performance to the end of 1975 averaged 29% or better than the S&P 500. The "downward" reversals (49 occurring in this bear market) declined on average 1% more than the Index. In smary, with the market slow down, the "upward" signals performed better in the subsequent year than the "downward" signals.

Chart II of Union Carbide is an example of an "upward" reversal during the 1973-74 period. The positive signal was given in May 1974 in the face of the devastating bear phase. The very strong RP trend during the entire 1974 period is an impressive indication of the "accumulation" occurring in the stock, subsequently reflected in the absolute price advance in the 1975 year.

Chart III of Schering-Plough is noteworthy because of the impressive RP deterioration (distribution) during 1975-76 - an advancing phase. During this time the absolute price held mostly in the SO-60 range. In the following year 1977 the earlier RP deterioration was confirmed by a collapse in the absolute price.

1976 Bull Phase

Looking now at the 1976 period of an advancing S&P 500, Table I again summarizes the results. The 23 "downward" reversals experienced an average RP performance 8% superior to the Index. The 12 "upward" signals (occurring in this advancing market) performed only 5% better than the Index.

32

Chart I of Dow Chemical illustrates a "downward" signal opposite to the 1976 advancing market. The RELATIVE MOMENTUM in 1976 reflected the sharp deceleration of the RP trend for DOW. Chart IV of Union Carbide also carries a "downward" signal in 1976. An acceleration of absolute price decline followed in 1977.

A Look at 1979 - 1980

It may be of interest to review our list of contra-flow signals for 1979. With the S&P 500 Index ahead by some 12% during this year, we have inter- preteted a "downward" signal in six stocks within the Institutional 100 population. Table II provides a summary of the signals and the results, using March 31, 1980 prices for the comparisons. The absolute price (API had declined 8%, while the RP change has averaged 10% more than the Index.

IIIConclusions -

The evidence presented in this study (and confirmed by many years of similar results genexated by H. C. Pay) provides support for an investment approach which uses long-term relative price trend analysis, with an emphasis on signals contrary to the market flow. Buy and sell decisions contrary to the market direction proved to be particularly beneficial when a market trend reversal occurred. Signals with the flow should not be disregarded, but should be treated with lesser weight, particularly as the market trend advances. This approach has been effective in identifying important long-term Rp changes within common stocks and groups - whether induced by fundamental or psychological forces.

April, 1980

33

Chart I DOW- CHEMICAL

50

40

30

20

40

32

24

60

40

20

00

a0

34

a0 --

150

100

75

50

40

--

160

140

120

100

a0

35

I

I

1974 1976 1076 1077 1979 1660

80

70

60

50

40

30

80

60

40

32

2c

.20

.oo

80

36

Chart IV UNION CARBIDE

70

60

50

40

30

60

40

32

140

120

100

80

1014 1976 1078 1077 1078 1879

-&

37

Table I

TREND REVERbAL SIGNALS

*"eraqe Perforu"cr*

upward Signals

(1973-74)

Relative Price

Absolute Relative

Pr1CB Price

Dowward Signals

(1976!

30%

upward Signals

(1976)

20%

10%

0% - _-__ m g ! q _

Absolute Price

Relative Price

Absolute Price

Relative Price

Table II

Institutional 100 Downward P.eversal Signals

1979

Signal Price March 1980 Date API r-s1 AP2 RP2 - - - - colnpany AP2/APl RP*/RP1

Avon Products 2/79 49 50 34 33

General Foods 6/79 29 29 26 25

IBM U/79 63 62 56 55

McDonald's l/79 46 48 41 40

Philip Morris 6/79 31 31 34 33

Sperry Corp. 11/79 43 42 46 45

69% 67%

90% 86%

89% 89%

89%

110%

107%

83%

106%

107%

92% 90% Average:

38

POINT AND FIGURE CHARTING

Alan R. Shaw, First V.P. Smith Barney, Harris Upham & Co.

The fifth annual Market Technicians Association's seminar, held on CapeCod, May 15-18, 1980, was an anniversary in itself. But as the attendees soon learned, even greater celebration was at hand: In 1980-81, Technical Anal- ysis as an investment art applied in the United States will be 100 years old. Market technicians were practicing their skills long before corporate fundamental statistics were readily available for public scrutiny. This absence of "other" information provided the logic for market data interpretation in the first place. Analyze price action, for it will tell of coming events. To wit, the Market Technicians Association's creed: "In Price There Is Knowledge."

"Point and Figure in the 80s" was the title of one presentation at the recent MTA Seminar. The presentation actually covered more ground than the title implied; the evolution and P&F application past and present were discussed. The following article highlights some of the points included in the conference presentation.

The Earliest Proponents of P&F --

Reference works are not precise, but 1880-1881 is generally cited as the earliest period of the application of "technical" disciplines to follow and assess supply/demand forces in the U.S. stock market. The true beginnings of technical analysis seem to go back to the 17th century when, according to one student, the Japanese employed certain charting methods to plot the price of their most important commodity, rice.

Most market students incorrectly believe that of all the charting techniques employed today, bar charting is the oldest. The misconception may lie in the fact that the technique is the most widely charting method of technical analysis and therefore must be the oldest. But research uncovers the first reference to the bar chart sometime between 1895 and 1900. To be more precise, daily "high-low-close" stock quotations were first carried in the Wall Street Journal in 1896.

39

The first charting technique employed in the U.S. was the direct plotting of price movement off the ticker tape (or market book) in a sequential process. Reference to this method and its construction technique allows us to safely assume that "point and figure" charting was the first of the tools at the market technician's disposal.

In 1898, an anonymous writer, who called himself "Hoyle" published a book called The Game in Wall Street, considered to be the first work that made ---- extensive reference to the sequential method of plotting stock price movement. Charles Dow, the father of technical analysis in this country, was thought to have used point and figure charts extensively as one of this approaches to detect emerging stock trends. His interest in the approach is considered to have encompassed the last 10 years of his life, between 1891 and 1901. An editorial written by Dow in his newspaper, The Wall -- Street Journal, on July 20, 1901 bears out his knowledge (and we assume his acknowledqement of the usefulness) of the technique. Entitled "Methods of Reading the Market" and described as "the book method", Dow offered the following observations:

There is what is called the book method. Prices are set down, giving each change of one point as it occurs, forming thereby lines having a general horizontal direction but running into dioagonals as the market moves up and down. There come times when a stock with a good degree of activity will stay within a narrow range of prices, say two points, until there is formed quite a long horizontal line of these figures. The formation of such a line sometimes suggests that stock has been accumulated or distributed and this leads other people to buy or sell in the same time. Records of this kind for the last fifteen years seem to support the theory that the manipulation necessary to acquire stocks is oftentimes detected in this way.

The reference to "the last fifteen years" seems to peg the start of point and figure charting near 1886.

While Dow used the term "book method", Joseph M. Klein in a work published in 1904, described the charting apporach as the "Trend Register" method. Klein's course of instruction, entitled "Chart Method Trading System" is thought to be the most comprehensive early work on the point and figure charting technique. He made reference to the trend register method as being in use for about 23 years, or back to 1881.

Market technicians are no doubt familiar with the name R. D. Wycoff - it is believed that a course of instruction is still available under the name. Wycoff published a number of books on the stock market analysis, two of which were Stock Market Science and Technique and Tape Reading and Active Trading released in 1932 and 1933 respectively. Victor devilliers, then an associate of Wyckoff's, penned a small missal in 1933 simply entitled, The Point & Figure Method; later in the year, he teamed up with Owen --- Taylor to produce a more advanced work. It is devilliers who is credited with popularizing the handle, "Point and Figure". As he explained it, every time the stock moves up or down a point, your put in a figure.

40

So give or take a few years, P&F's root looks like this:

1881 - 1904 - Book Method 1904 - 1920s - Trend Register Method 1920s - 193Os- Figure Charts 1930s - TODAY- Point & Figure Charts

The Later Years ---

Later works on the Point and Figure method would includeAlexander Wheelan's soft cover "course" of instruction, "Study Helps in Point and Figure Tech- nique", first published in 1954 by the investment counseling firm of Morgan, Rogers & Roberts. Jim Morgan, now a senior executive with First Pennsyl- vania in Philadelphia, provides a good deal of insight regarding his old firm as well as the recent history of point and figure.

According to Jim, after Owen Taylor and Victor devilliers parted company, Alex Wheelan joined up with Taylor to run a small amount of money. Taylor went into the service and asked Wheelan to take over the operation. Wheelan, however, didn't want the administrative responsibilities, so he sought out a buyer to turned out to be Jim Morgan's father. The firm of Morgan, Rogers & Roberts did not possess an extensive research operation. So the expertise of Wheelan was an advantageous fit. Because maintenance of an extensive file of stock and commodity charts was an expensive proposition, the firm in 1942 set up a subsidary called Stock Market Publications. They offered a price change service for both stock and commodity P&F devotees along with tools of the trade such as P&F graph paper, and back charts to provide a basis for continuing analysis. There weren't many subscribers to the service in the early years, but dedicated point and figure practitioners such as Tabell, Ward and Schulz were on the subscriber list in the late 1940s. The MR&R service really prospered in the 1950s when many institutions began to subscribe and reached its zenith in 1965 when more than 1500 clients were keeping their own P&F charts based on the price change service.

To further the interest in point and figure charting, Jim Morgan's father convinced Alex Wheelan to write a series of articles on the technique which was sold to clients one chapter a week. First published in loose leaf form, the articles were eventually put into a paperback format and sold as a single entity with the first printing available in 1954. The undersigned as well as hundreds of other P&F users received their first introduction to the approach via Wheelan's discourse.

In the late 1960s-early 197Os, changing stock market conditions caused a great attrition in P&F chartists forMR&R. (The number of subscribers to other market services also dropped sharply.) As a result of these trends and other inherent factors, Morgan, Rogers & Roberts went out of business in late 1978. Muller Data (a division of Muller & Co.) took over the price change service. Muller continues to be the current vendor of the service, sending out daily and weekly computer sheets of the sequential

41

intra-day reversals in price necessary to maintain graphs. Muller's subscribers now number but a handful of devotees to this oldest form of charting. Smith Barney, Harris Upham, in fact, has found it necessary to go into the point and figure graph paper business because of the lack of suppliers of one-point reversal grid paper.

The Growing Use of Three-Point Reversals --

Abe Cohen, an MTA member, became involved with stock market analysis in 1948. His service, CHARTCRAFT, has always used one-unit, three-point reversal presentations. Original point and figure application consisted of one-point reversalunits. In order to keep accurate graphs, however, a price change service was necessary. Three-point reversal charts were also used by the early analysts, but these presentations were usually to supplement the one-point varieties. The three-point (and five-point) reversal charts are used to discern the longer-term trend configurations, while the one- point charts more clearly express the shorter-term formations.

As Abe Cohen admits, when he began CHARTCRAFT, he was using the newspapers to plot his graphs. Thus the three-point reversal graph was the "logical thing to do". Admittedly, the average stock will not experience a number of three-point reversals (if any), up and down, in one day. Thus the newspaper would suffice for this graph. But many one-point reversals are possible in a single day of trading, necessitating the use of the Muller service if accurate charts are to be maintained. As will be covered later, one of the main assets of the point and figure method is the ability to make major trend price objective calculations using what is known as the point and figure "count". An accurately plotted graph is an absolute necessity if this discipline is to have any merit. The "count" for three and five-point reversal charts differs from the one-point technique, while the CHARTCRAFT method has a measuring principle all its own.

A Dying Art? -

In 1961, Cohen's CHARTCRAFT subscriber roll numbered approximately 5,000. He blames attrition since then on the lack of competition. Good point! Particularly in the last two decades, all technical services have suffered from a loss of the private investor and the general lack of understanding of technical methods by the professional portfolio manager although the latter has become more engrossed with "market timing" (once again) as other disciplines seemed to have failed. Cohen's service was boosted not only by his own book The Chartcraft Method of Point and Figure Trading, but also by another paperback written by Earl Blumenthal entitled, Chart for Profit - Point and Figure Trading. First published in 1961, this presentation was inspired by Cohen's ideas and attempted to offer a wider distribution of the concepts. Using the three-point approach, X's in the "up" columns and O's in the "down" columns was popularized. Blumenthal conducted courses across the country on the subject.

42

The MTA's own award-winning John Schulz published a book on point and figure in 1962. John's contribution, The Intelligent Chartist gets into actual graph interpretation more extensively with emphasis given to the "Count" technique. Original point and figure methodology provides the background for the intelligent chartist who has had some experience in the art and who wishes to become more deeply understanding of his craft.

James Dines cannot be overlooked, either. Although today he is considered more or less a prophet on gold, Jim's initial commercial offering was a point and figure motivated advisory service. The Dines Letter continues to emphasize the point and figure approach. Dines also began a very successful charting service in the early 1960s called PAFLIBE (Point @d Figure LIBrary) which was to be found in numerous brokerage offices and institutions. CROSSCHART then came along as the three-point reversal supplement to the one-point reversal PAFLIBE. These services live on today known as MARKETCHARTS. This publication along with CHARTCRAFT are the only available means of tracking stock price behavior via the P&F method other than keeping your own charts.

Point and Figure analysis has not been confined to the United States. Chart Analysis Ltd. of London offers an in-depth point and figure library of worldwide markets and,the leading stocks on the numerous exchanges. This operation, launched late in the 196Os, has enjoyed success with United Kingdom investors as well as international portfolio managers. David Fuller (formally associated with the undersigned) was a founding partner of Chart Analysis Ltd. and a participant at the MTA Seminar.

The Second Hundred Years

As we enter the 198Os, point and figure charting lives on, albeit on a meager allowance. The smaller audience could be to the benefit of the current practitioners. The data is there, so is the graph paper, and the services are still in business. Thus, the opportunities for involvement are at the market analyst's disposal. There may be some prejudices toward the art expressed by the more quantitative empirical market analyst. But it is this writer's belief that all forms of security analysis are educated guesswork. Stock market analysis should never be considered a science. Events of recent years can certainly vouch for the complexities oftechnical analysis or "market timing". Some have said we have been traveling recently in uncharted waters. In fact, the market of recent years has been a chartist's dream. Preconceived notions are one thing, reading the market is another. Point and figure analysis is but one input to the total picture, and it can be a very profitable weapon in the never-ending quest to "be right". And something has to be right about a system that is about to celebrate its 100th birthday.

It is assumed that the reader possesses the knowledge of point and figure construction - a topic lengthy enough for a seperate article. In the following pages is a brief treatment of what the author believes are the most important assets of the method.

43

Point and Figure Analysis --

In a number of ways, point and figure chart analysis differs markedly from bar chart analysis: A point and figure chart only indicates pricemovement of a certain magnitude, and only when such a move occurs it is plotted, there is no element of thie or volume included on the graph. A one-point reversal chart of Superior Oil on a full sheet of point and figure chart paper could represent only five months of price activity, while for an issue like American Telephone & Telegraph, the same space could represent almost 10 years. The volatility and the price level of the stock will have a great bearing on the number of price reversals that are most apt to occur within a given time period. The popularity of a stock also plays a role in determining these factors.

Perhaps the two most important functions of point and figure charting is that the experienced practitioner is afforded the opportunity to analyze from time to time - on a more discernable basis than a bar chart - whether or not a stock is (1) going through a distribution or accumulation phase while in fact the basis price trend is neutral. And, (2) by utilizing the point and figure "count" theory, a determination can oftentimes be made as to the extent of a price movement in either an upward or downwarddirection. Unfortunately, one cannot always project a time parameter for an impending move. In recent years this has been especially so with the great institu- tionalization of the market place that has occurred.

Like bar charts, point and figure charting affords the opportunity to analyze stock price trends, as well as support and resistance levels. In addition, there are certain technical price configurations such as the head and shoulders reversal, a V pattern, or a double or triple top that can be observed on a point and figure graph similar to the opportunities afforded by a bar chart. But as the bar chart has a number of its own peculiar formations such as the triangles, wedge, pennant, flag and gap, so does the point and figure graph display its own peculiar patterns. Figure 1 illustrates some of these pattern formations by name.

When a stock is moving upward or downward, one need not be a technician to determine that the stock is being accumulated or distributed, respectively. On the other hand, when a stock is in fact going through a neutral phase, with neither an upward or downward bias evident, it would be most helpful to arrive at some determination as to the direction of the next move. In many cases, point and figure charting lends itself to this type ofanalysis.

Figure 2 illustrates a typical consolidation phase as it might appear on a point and figure graph. You will note in our example that there are nine columns of the down variety and four column of the up variety. Stated another way, this neutral configuration of price consolidation illustrates there are nine failures for the stock to go lower against only four failures on upside attempts. A failure to move lower does indeed indicate that demand at least equaled, if not exceeded, supply at that point, while a failure to move higher is indicative of supply at least equaling if not exceeding demand. Thus, in our illustration, demand appears to be a more prominent characteristic. Therefore evidence of accumulation rather than

44

BOTTOMS

, I I I I 5 I

I I I I I I I

TOPS

45

distribution is present. Explained another way, within a point and figure price consolidation pattern, price reversals that occur in the lower portion of the congestion phase are looked upon as representing accumulation activity while price reversals in the upper portion are usually represen-

of detecting accumulation proves upward our of the congestion

tative of distribution. If this analysis correct, the stock should eventually move phase instead of downward.

Of course, the technician will probably have much more price data to work with than we illustrated in Figure 2. As an example, Figure 3 reveals that the stock was in a significant downward move prior to entering into the consolidation segment illustrated in Figure2. Oftentimes the previous pattern of the stock can further enhance the analysis of a congestion phase. In other words, the mere inability of the stockto move lower following a prolonged downtrend implies basic accululation, while the inability to continue higher after a significant uptrend would indicate distribution. Figure 4 illustrates the type of point and figure configuration that could very well follow a stock's upward trend.

In this regard, you will note the number of excessive failures in the up portion of the congestion pattern versus the reversals in the lower portion. This consolidation phase is in all likelihood a top reversal pattern. The resulting move from such a configuration would usually be downward.

Within the confines of a major uptrend, consolidation phases will, of course, occur. Figure 5 is a typical consolidation pattern in a upward trend. The trading range between 51 and 58 is considered to be the entire consolidation zone. But, note if you will, that the distinct phases of distribution and accumulation are quite evident in this pattern. At the 58 level, the stock refuses to move higher, thus giving evidence of encountering either resistance or supply. This is the distribution segment of the consolidation zone and should be followed by some

FIGURE 2

-

FIGURE 3

45 -

40-

35 -

30 L

FIGURE 4

70.

65 -

60.

55 -

46

type of a setback or profit-taking phase. This correction occurs as indicated by the decline to 51. But note how the issue ceases to decline any further at the 51-53 level. Evidence of demand equaling, if not exceeding supply; is again at hand as the stock refuses to move lower. --- A new upside move commences resulting in a breakout, and the consolidation pattern has been completed. Such a.consolidation zone in a downtrend would appear something like Figure 6. In this case, accumulation activity precedes distribution of the shares - just the opposite of the foregoing example.

It stands to reason that the more

FIGURE 6 supply that is eliminated from the marketplace (accumulation), thegreater

8s 85-m

the impact should be on the following

a()- 4 move (upward). Therein lies the logic

ii6 or rationale behind the so-called point and figure objective theory

75-

i1: (sometimes called the count). Once a

70- P x x I xx

X~P~F'"" consolidation pattern has been deter-

II i f

mined to be either distribution or

65 - ji accumulation, the mere extent of that E *"x"

lateral consolidation usually will have

60 - 9 a bearing upon the extent of the ulti-

I mate move. The bigger the base, the bigger the upward move; the larger the top, the greater the downside adjustment.

FIGURE 7

According to one approach, a point and figure count is accomplished by merely counting the number of boxes withinthe the consolidation phase, placing emphasis on the price level with the greater fill-ins. In Figure 7 this would be a count across the 36 price line; the example shows the greater number ofx's falling on this level. In addition, the 36 line also indicates the initi- ation point of the new upward trend phase (arrow). In our illustration, a count of 21 points results, which added to the price level of 36 offers an upside price targes of approximately 57.

47

Application of the point and figure count should, of course, be done with great caution ond only after much experience. A stock's volatility or popularity in the market place can either enhance or degrade objective validity. For instance, a glamour stock in vogue at the time may tend to exceed projected price targets as market enthusiasm leads to greater extremes. On the other hand, to utilize the count theory for a utility stock would be more than foolhardy, as objectives of even greater than logical magnitude would not doubt result from apparent consolidation phases. It should be pointed out that the point and figure objective theory is simply another tool. Obviously, the type of market background will play a great role in the validity in the projected targets. A bull market will enhance upward objectives, and a bear market will usually be marked by a number of downside calculations. The count approach can also be used on the other reversal charts. On a three-point reversal chart, as an example, the number of lateral boxes in a consolidation phase would be multiplied by three to achieve an upside or downside objective potential. We caution, however, that objectives calculated from the three-point reversal chart should not be used as a primary input, but more or less as a confirmation to the one-point calculation. Figures 8 and 9 afford good examples of the count technique as it could have been applied to Bausch & Lomb, a glamour favorite of past years.

fIr,UFE 6

Bausch &Lomb l.Point Reversal

48

IS TRADITIONAL MARKET TIMING PASSE?

Robert J. Farrell Merrill Lynch Pierce Fenner & Smith Inc.

Market timing is an attempt to forecast the major peaks and troughs in the stock market in order to improve investment profitability. A renewed interest in timing started with the steepest recession in the post WW II period and the worst market decline since the 1930s. In 1973-74 we were buf- feted by a series of events that led to an unusually severe stock market decline and economic contraction. Both were damaging to a majority of investors and businessmen because they were worse than most forecasters anticipated. As a result, investors, businessmen and economists decided to pursue defensive,risk averse policies that would protect them from being caught again. Armed with this caution, the stage was set in the next five years for one of the longest economic expansions in this century, and one of the best five year periods for owning stocks in history (the average annual return for the S&P 500 from 1975 to 1979 was 14.56%). The caution born in 1973-74 caused businessmen to get ready for the next recession on a regular basis by keeping inventories down and often deferring capital spending commitments. And it caused investors to pursue a risk averse strategy with heavy accent on investment alternatives such as bonds and cash equivalents.

It also had an impact on the demand for economic forecasters and market timers. Those who were caught in the 1973-74 maelstrom looked for economic forecasters and market timers to warn them in advance of the next debacle, little realizing that most of the forecasters had been caught themselves and that the very attitude of caution the majority had adopted was the best insurance against a nearby repeat performance. Consequently, there was a new industry spawned consisting of economic consultants, portfolio strategists, market technicians, and books and seminars on how to survive the coming crash or depression. In 1974 Institutional Investor magazine began a new category in its annual All American Analyst Team poll called portfolio strategy. Two years later in 1976 they added a market timing and economic forecasting category all testifying to the growing demand for timers.

The forecasters themselves who went through the 1973-74 trauma tended to err on the side of caution as well. Economic forecasters started predict-

49

ing the next recession as early as 1976 and have continued to do so for three years perhaps on the theory that if you forecast an event long enough, eventually you will be right. It has yet to arrive with any certainty.

The portfolio strategists added a new dimension to economic forecasting. They emphasized that the stock market was directly related to the economy and evolved impressive statistics to show how to time stock market invest- ing based on the stage of the economic cycle that prevailed. This approach has great appeal to reason, but it did not cope with inflation nor the portfolio manager's need to perform, and, unfortunately, has relied too much on the future being a repeat of the past. While many portfolio strategists have been waiting for one more final bear market leg similar to 1974 since early 1978, the major averages (ex. the DJIA) have advanced to new all time highs again proving the recent past is not necessarily a useful guide to the immediate future.

The market timers ran into a different but related problem. Those that integrated monetary and economic indicator analysis with technical analysis had the same problem as the portfolio strategists. They kept looking for an interest rate related bear market decline. There was also the additional problem of a segmented market that resulted in sectors being in bull and bear markets at the same time. Not since the 1940s have generalizations about "the market" been so meaningless as in recent years. Those focusing on the Dow Jones Average may still insist we are in a bear market, yet virtually every other important major average is at or near all time highs. Many also (including the author) saw the two tier market coming together by virtue of a decline of at least cyclical magnitude in the broad second tier of smaller companies. This too has yet to occur.

So, overall, the generalists and forecasters became least effective and useful when the majority decided to pay most attention to them. Lord Macaulay put it well when he said, "It is ungrateful to be constantly dis- contented with a situation that is constantly improving, but there is constant improvement precisely because there is constant discontent." And the generalists and forecasters have helped foster that discontent.

Will the greening of the market timers and forecasters become so complete that paradoxically it will be important to listen to them again? Very probably so. The only question is when and under what conditions. Already many clients seem disenchanted with their advisors. The economic consensus is coming around to "stagflation" which is an economy with high inflation, but no big down or up cycle. In the stock market the name of the game has become "stock picking". Be in the right stocks and there is little need for overall market forecasting. Both the "stagflation" economy and the stock pickers market are manifestations of a new and growing consensus. We are no longer in a homogeneous world, but rather in a complex segmented environment in which some sectors of the economy are in recession while others prosper and some sectors of the market are in major advances while others continue to languish. This has been the state of affairs at least since 1978 and could last a good deal longer. However , we doubt it will prove to be permanent. When the majority finally recognizes a new pattern in the economy or stock market and acts on it, the seeds are being sown

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for it to change.

For one thing, the recognition of where to be (energy, defense and technol- ogy) and where not to be (consumer and interest sensitive) ultimately leads to overdiscounting of the good and bad features of each sector and creates valuation distortions. Look back to the one-decision stock days of the early 1970s for a prime example of this. Although we doubt such a state has been reached yet, it will arrive at that point when all those who want to own the in-favor sectors will have their fill and all those who want out of the poor sectors will have gotten out. The fact that the majority now agrees on where to be at least says we are in an advanced stage of the bull market in the favored sectors.

How quickly a more generally vulnerable market arrives depends on how long it is going to take the majority to rid themselves of their fear of a big decline. For much of the past two years the major worry of most investors has been that sharp declines like the one which occurred in October 1978 will wipe out their profits in very short order. Since November 1978, in fact, the market has advanced in steady fashion with setbacks every few months that were just big enough to keep fear and caution alive. But after each setback the market has gone to new highs in the process, convincing a few more investors that it is wrong to sell and each decline is a chance to buy. When the consensus is that the long term trend is at last up and we decide we should invest rather that trade, the conditions will be ripe for a cyclical top (similar to 1976). But there are some unfinished pieces in the puzzle.

For one thing, the fear of one more decline of significance is still preva- lent because the news has been so negative. There were more ingredients in the news for a significant decline in 1979 than in any year in the past decade. Record interest rates, double digit inflation, another 40% rise in oil prices, runaway commodity prices, the fall of- Iran, questions over the degree of political leadership being exercised, all could have sent the market tumbling in past cycles. But something was obviously different this time and now the majority is discovering what it is. "Stocks are cheap relative to other assets and are a hedge against inflation." Two years ago, with the DJ Average at 740, very few accepted this premise. Now that the market has risen despite all the "bad news", the asset attraction of stocks is gaining acceptance. Moreover, when you look at the so called bad news and the reaction of the market, it is not so bad after all. All the market sectors doing well benefit from our problems of inflation and energy and geopolitical confrontation. In fact, it could turn out that when the good news of a peak in interest rates, a recession, and a fall in the inflation rate occurs, it will be bad news for the important leaders of the market.

The market trains us how to think which usually means it conditions us to fight the last war. We are not only learning it is wrong to sell and to buy declines, we are learning to ignore bad news. The market is trying to teach us complacency so that we will become greater risk takers.

Already this is apparent in the heavy volume in low priced mining and energy shares this year. The fear of missing a good thing is beginning to

51

overcome the fear of losing. We suspect, however, that it still has a way to go before it develops into major excesses.

An interesting possibility is that in addition to learning to live with bad economic and interest rate news we may learn to live with unfavorable technical indicators long enough to cast some doubt about whether they still work. The most worrisome market indicator to most technicians is a situation in which the major averages or the DJ Average in particular rise to new highs while breadth or advance decline statistics remain flat or decline. Many such disparities in the past have preceded some of the worst declines (e.g. 1961-2 and 1972-3). Disparities and non-confirmations abound in the current market due to the multi-tiered sectorized nature of the market. Breadth in fact has not made a new high since September 1978, Utilities have lagged since 1977 and the NYSE Financial Index has lagged since September 1979. Some may read dire consequences into such diver- gences, particularly since the Value Line and NYSE Composite Indexes have made two unconfirmed higher highs since 1978. This may indeed be flashing a valid caution signal, but we suspect it is not presently as ominous as it looks. The poor breadth and lagging Utility and Financial Indexes all may reflect one common problem - record high interest rates. There are a large number of interest sensitive utilities and preferreds that are in- fluencing market breadth today and while this is rationalizing an indicator, we think it may turn out that the next top will come when interest rates and inflation have peaked. So there could be a catchup phase for breadth that partially correct the disparities as interest rates peak and interest rate sensitive stocks rally. Such developments could turn the last of economic and technical strategy bears to the bull camp and then leave the market open to a cyclical decline.

All this perverse logic is presented more to stimulate thinking along possible contrary lines in an unusually complex environment. In other words, when most everything does look good, it will be because the process of market mark-up and exploitation is nearly complete. At that stage, timing rather than stock selection should again become the factor of greater importance.

Overall, there should still be good potential for gain from stocks in 1980. But with prices having risen substantially since 1974 and institutions on the verge of re-establishing heavy commitments in stocks relative to bonds and cash equivalents as they did in 1976, the stage could be set for another temporary cyclical peak later in 1980 and a period of cyclical decline in 1981. Some of the rules may have changed, but people have not. Will the seers againmissthe boat or if they do not, will their justifiably skeptical clients fail to listen?

February 21, 1980

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SOLAR AND ECONOMIC RELATIONSHIPS

Bernard J. Fremerman

In the later part of the nineteenth century, W. S. Jevons, a British economist proposed a theory that a relationship exists between sunspot activity and business cycles.

In 1934 Carlos Garcia-Mata and Felix I. Shaffner of the Department of Eco- nomics at Harvard University prepared a study published in the Quarterly Journal of Economics. Initially, they undertook the study to prove that the Jevons sunspot theory was invalid. Instead, they found that a relation ship did exist, and "that it is hardly possible to believe that the rela- tions revealed are wholly accidental". In this paper I have attempted to bring up to date a portion of their study - namely, to determine if the correlation they found between sunspots and manufacturing production has continued to the present time.

1-

Garcia-Mata and Shaffner used an index of production compiled by W. M. Per- sons. This index is not as universally used today as it was in 1934, and it is likely that it has not been continued. I have therefore chosen to use the Federal Reserve Board Index of industrial production from 1919 through 1975. For the years prior to 1919, I used a series made up of various indices by Edwin Frickey, W. M. Persons, and the National Bureau of Economic Research.

Similarly, where Garcia-Mata and Shaffner used solar data from the Green- wich and Kodaikanal observatories, I have selected Annual Mean Relative Zurich Sunspot Numbers which are more easily available. Also, their current use is more widespread. With these two exceptions, I have tried to follow the procedures used by Garcia-Mata and Shaffner.

I computed the departures of the logarithms from an eleven-year moving average of the FRB index, to isolate an approximate eleven-year cycle, if in fact it exists. Then I smoothed the data with the same seven term weighted moving average formula that the two Harvard economists used. This formula which was developed by F. R. Macaulay of the National Bureau of Economic Research is as follows:

53

d= a + 3b + 5c + 6d + 5e + 3f + g

24

The results are plotted in Figure 1 below. Next, I computed the first differences of yearly sunspot variations and smoothed the data with the same seven term weighted moving average formula developed by McCaulay. This curve is also shown in Figure 1.

I Sunspots (First Differences, smoothed)

2. IO

2.00

I .go

FRB Index of Hanufa;turingbroduction

(Filtered and smoothed)

& I I I I I I I 1 I 1 I I

1860 70 80 90 1900 10 20 30 40 60 . 50 70

Figure I

SOUrC.ZS* -* Federal Reserve Board Index of Manufacturing Production: Federal

Reserve Bulletin; and Zurich Relative Sunspot Numbers: National

Geophysical and Solar-Terrestial Data Center, Boulder, Colorado.

Throughout the entire span of a century, representing about 10 repetitions of the 11.2 year sunspot cycle, there indeed seems to be a close relationship between sunspots and manufacturing production, with one notable exception. For about fifteen years, beginning in 1940, the two series are out of phase. It was about that time that the United States entered a period of unusual production activities related to World War II.

Due to the use of a moving average filter, the curves cannot be extended to the current time. The last five years of data are lost. However, since the 1967 solar peak, we have witnessed a decline in sunspot formations, with a low occurring about July, 1976. We have also experienced a substantial decline in industrial production culminating in the 1973-1975 business recession.

If the pattern continues, there is a good probability that we can expect industrial production to increase over the next several years, as the current solar cycle reaches its maximum, probably in 1981 or 1982. This estimate of future industrial activity is based on this one cycle concept

54

alone, and a great deal of caution should be used in applying it. To my knowledge there is no evidence of any mechanism or causative factors to relate these two phenomena.

Michel Gauquelin, a French scientist, has compiled a provocative compendium of research in various disciplines, which provides evidence of correlations between sunspot activity and phenomena involving human organisms and human behavior. Leukopenia, infarcation of the myocardium, angina pectoris, tuberculosis, eclampsia, accidents due to human causes, suicides, and acute mental disorders all have been found to fluctuate with changes in sunspot activity.

Whether or not these solar changes manifest themselves in the economic behavior of humans is indeed an interesting subject, and quite controversial. Garcia-Mata and Shaffner devoted a good deal of their paper to this possibility.

References

1. Garcia-Mata, Carlos and Felix I. Shaffner. "Solar and Economic Relation- ships, a Preliminary Report". QUARTERLY JOURNAL OF ECONOMICS, Vol. XLIX, November, 1934.

2. Macaulay, F. R. The Smoothing of Time Series. National Bureau of Econom- ic Research, New York, New York. 1931.

3. Collins, Charles J. "Effect of Sunspot Activity on the Stock Market". FINANCIAL ANALYSTS JOURNAL, November-December, 1965.

4. Gauquelin, Michel. The Cosmic Clocks. Henry Regnery Co., 1967.

5. Hunter, Simeon. "Business Activity's Complex Cyclical Pattern: The Three Component Forces, A Composite Curve Derived Therefrom, and a Composite Obtained by Substituting a Sunspot Curve for the 11.14-Year Cycle". THE ANNALIST. June 13, 1940

6. Konig, H. "The Biological Effects of Extremely Low Frequency Electrical Phenomena in the Atmosphere". JOURNAL OF INTERDISCIPLINARY CYCLE RESEARCH, Vol. 2, No. 3, pp. 317-323, August, 1971.

7. Palmer, John D. "The Many Clocks of Man". NATURAL HISTORY, April, 1970

August 30, 1977 revised September 21, 1977

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R, N, ELLIOTT’S MOST FAMOUS CALL

Robert R. Prechter, Jr. Elliott Wave Theorist

The following is excerpted from "A Biography of R. N. Elliott" contained in The Major Works of R. N. Elliott. (1980, New Classics Library, P. 0. Box 262, Chappaqua, New York, 10514.) $34 Reprinted by permission. All rights reserved.

On December 2, 1934, Charles J. Collins, President of Investment Counsel, Inc., of Detroit, received from R. N. Elliott a letter marked "PERSONAL, and CONFIDENTIAL" dated November 28. Therein Elliott explained that he had discovered three novel features of market action, recognition of wave determination, classification of wave degree, and time forecasting, which were "a much needed compliment to the Dow Theory". He even forecasted that the market advance then unfolding would be followed not by a correction, as had been the case with the two previous legs of advance, but by "a major bear collapse". (This is exactly what happened later, as the dramatic market collapse in 1937-38 erased 50% of the market's value in less than twelve months.)

Elliott asked Collins to finance a trip to Detroit so that he could present his theories completely to him, in hopes that Collins would decide to use the technique of the Wave Principle in his stock market letter to their mutual benefit. Elliott even commented that Collins, if he preferred to keep it secret, need not inform his readers that he was using the Wave Principle as a basis for his investment advice.

Collins was intrigued, but not convinced. He filed Elliott's letter and returned a standard response to the effect that he would be happy to moni- tor Elliott's "calls" on the market, by telegram collect or by air mail letter, for one complete market cycle to see if they had any real merit.

If they proved accurate, then he would consider further steps.

Collins had developed this method of putting off the numerous "geniuses" who continually offered him "foolproof" systems for beating the market, on the assumption that any truly worthwhile system would stand out when

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applied in current time. Not surprisingly, the vast majority of these systems proved to be dismal failures. Elliott's principle, however, was another story. It proved to be one of the only three approaches to forecasting brought to Collins' attention during his lifetime which proved to have validity.

Although Collins assured Elliott he need not divulge his method, Elliott began sending Collins a series of letters and charts outlining the basis of what he referred to variously as "wave theory" or the "Five Wave Prin- ciple" over the next three months. Elliott stressed that since his financial status was difficult, he wished to acquaint Collins with the theory and prove its value without waiting two or more years for a complete market cycle.

On February 19, 1935, Elliott mailed Collins seventeen pages of an overly detailed and somewhat unorganized treatise entitled "The Wave Principle". Twelve more pages and five additional charts were sent over the next two months along with Elliott's regular correspondence. The first page of the treatise contains Elliott's statement of the utility of the Wave Principle:

A careful study of certain recurring phenomena within the price structure itself has developed certain facts which, while they are not always vocal, do nevertheless furnish a principle that determines the trend and gives clear warning of reversal.

Since Collins was in Florida that winter as was his custom, it was not until January 4, 1935 that he began responding to Elliott's "flood of letters", as Elliott himself put it, a task which had until then been left to an associate. On January 11, Collins sent a telegram to Elliott asking him to wire him when a particular minor declining wave they were tracking had ended.

A week later the Dow Jones averages were still in a declining phase and as Elliott put it, "the wiseacres around here are very bearish". At that time he forecast that the Rails would break their 1934 low point but the Indus- trials would not, a forecast which must have struck Collins later as un- cannily accurate. His first telegram in response to Collins' request for pinpointing the bottom of the correction was dated January 15, 1935 and read, CORRECTION ENDED LAST HALF HOUR TODAY. The call was perfect, and a rally ensued immediately. On January 22, Elliott recognized the rally as a corrective wave advance and, after the close (two trading hours prior to the top of the rally) wrote to say, "the picture is bearish again". He then forecast that the Dow would slip below 99 to 96 and the Rails would crack 33 as larger waves3, 4 and 5 downward unfold.

Most of the predictions which Elliott made in his barrage of letters (even those which took years to prove) were correct, many to perfection. However, in the approach to the actual bottom, which was made at 96 as Elliott first forecast, he changed his mind several times in an attempt to call the bottom exactly to the hour. Elliott's changes of mind, newly discovered tenets, and occasional wave re-labeling bothered Collins, who wrote

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Elliott a long and courteous letter on February 15 pointing out the weakness in Elliott's methods and enclosing some of his own work on a five-wave theory as applied to large wave movements. He also suggested that in order to remedy his financial situation, Elliott manage some risk capital and begin a letter service to be circulated to a select group while he developed his theories to completion. He also offered to introduce him to Robert Rhea.

Elliott reaffirmed his wish to become associated with Collins, whose letters, he stated, were so well done that there was "no comparison between your letters and those of any other service that I have ever seen". He also responded rather impishly by listing the various imper- fections in Collins' own market letter's investment decisions of the previous two years.

Collins' justifiable skepticism concerning Elliott's methods was completely dispelled with the next occurrence. The Dow Jones Averages had been declining throughout early 1935 and Elliott had been pinpointing hourly turns with a fair degree of accuracy. In the second week of February, the Dow Jones Rail Average, as Elliott had predicted, broke below its 1934 low of 33.19. Advisors were turning negative and memories of the 1929-32 crash were immediately rekindled as bearish pronouncements about the future course of the economy proliferated. The Dow Industrials had fallen about eleven per cent and was approaching the 96 level while the Rails, from their 1933 peak, had fallen almost fifty per cent to the 27 level.

Then on Wednesday, March 13, 1935, just after the close of trading with the Dow closing near the lows for the day, Elliott sent his famous telegram to Collins and flatly stated the following: NOTWITHSTANDING BEARISH (DOW) IMPLICATIONS ALL AVERAGES ARE MAKING FINAL BOTTOM.

Collins read the telegram on the morning of the very next day, Thursday March 14, 1935, the day which marked the final closing low for the Dow Industrial Average. The day previous to the telegram, Tuesday March 12, had marked the final closing low for the Dow Jones Rails.

The precise hourly low for the Industrials occurred at 11:OO on the opening of the following Monday, thirteen trading hours after Elliott's telegram was sent, with the Rails holding above their prior low. The opening selling pushed the Dow just pennies below the closing low on Thursday and a hair's breadth above Elliott's target at the 96 level. The thirteen-month corrective wave was over and the market turned immediately to the upside.

Two months later, Elliott's "call" had been proved so precisely and dramatically correct as the market continued on its upward climb that Collins, "impressed by his dogmatism and accuracy", wrote and proposed that Investment Counsel, Inc. subscribe for payment to Elliott's forecasts and commented, "we are of the opinion that the Wave Principle is by far the best forecasting 'approach' that has come to our attention".

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IS THE FOUR-YEAR MARKET DEAD?

Charles D. Kirkpatrick II Kirkpatrick & Company, Inc.

When, in 1971, we first proposed the theory that the market made a serious low approximately every four years, it was met with little skepticism (after all, presidents were elected every four years), and when the market

subsequently collapsed into 1974, precisely four years after the 1970 low, the theory earned still wider acceptance; thereafter, even non-technicians assumed its continuation and anticipated a similar low somewhere in the fall of 1978. Nothing remains that simple for long, however, and, indeed, the market's failure to produce the anticipated dramatic low has caused much apprehension about the continued existence of the four-year market. Many are presently confused and others are disillusioned. In fact, we now find that in some quarters the entire thesis is being questioned.

Despite what we see as the implicit folly of such thinking, we are not entirely surprised. When taken on its most simplistic level, a thesis as obvious and mechanical as that of a major low occurring every four years is bound to run into trouble at some point. Theoretically, if the market were purely efficient and investors fully knowledgable of a low occurring every four years, the low would be nullified by premature buying and selling in anticipation of its occurrence. We do not believe that the low due in 1978 was totally negated by such anticipation, however. Instead, we believe that a four-year type low did take place but that because it occurred a year early and did so without the fanfare and prior collapse associated with the previous lows of 1962, 1966, 1970, and 1974, it went un- recognized by just about everyone.

In short, we believe that the prior four-year lows had created expectations that were too pat (to which, as we all know, the market does not take kind- ly). Without fully understanding the true nature and history of four-year type markets, those who adhered to the theory sold but never repurchased at the appropriate time. For those who have long been out of the market, we see an increasing danger. As time passes and the market continues to perform well, the pressure for them to get back in mounts. If they do so, it will be at precisely the wrong time, for as we shall see, another four-year type low is rapidly approaching.

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The Four-Year Market (or is it now closer to three?) ---

Prior to 1949, the periodic motion of the stock market was most dominated by a 40 month cycle. This cycle was observed by Dewey and had been hypoth- esized by a few others from earlier data as well. After 1949, for unknown reasons, the 40 month cycle seemed to stretch to a 47-55 month cycle and, indeed, the mean length for four-year markets from low to low for the period 1949-1974 proved to be 51 months. Because the error about this period has been quite small, the belief in its consistency has been quite strong.

The change from a 40 month to a 47-55 month cycle did not affect the structure of the cycle itself, however. Regardless of its length, each has a tendency to be dominated by some segment of the market such as conservative or speculative, industrial or consumer, large company or small growth, etc. (Rarely have all segments done well.) In turn, this leadership has rarely extended beyond each cycle of the market. A conservative market will almost never be followed by another market dominated by those same stocks. In fact, the leadership change usually begins during the declining segment of the previous market. We raise this point for two reasons: (1) to warn investors that when the market ends, its leaders will not, in all likelihood, be the leaders in the next and (2) to demonstrate that if one is watching any particular average, especially one not favored by investors at the time such as the Dow Jones at present, it is possible to miss the four-year low because of the general lack of interest in those stocks. Even when watching a more active group of stocks, however, it is erroneous to assume that a four-year type low must necessarily be preceded by a significant and well-defined decline. The 1932-1937 market, which was two 40 month markets, shows just a minor low in March, 1935 because the underlying trend was so strongly upward at the time. Therefore, four-year type lows can be only a major deviation from some underlying trend, and only in instances where the underlying trend is sideways or downward will the deviation also be downward and the low beprecededby a large decline. In instances where the underlying trend is upward, the deviation may be a sideways move, one which is not easily noticed and which does not produce any extremes in negative sentiment.

Contrary to what is popularly assumed then, we find (1) that four-year type lows need not occur at exact four year intervals (for many years prior, their interval was 40 months or close to three years), (2) that the low sometimes may be difficult to establish when the underlying trend of the market is upward, and (3) that the leadership in any particular four- year market will not likely be the leadership in the next, and, in fact, may undergo a severe decline irrespective of what the rest of the market is doing.

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Intermediate Markets

We have observed that within each major market three distinct intermediate moves always occur. That many four-year low theorists have yet to recognize this can be attributed principally to their preconceived notion that intermediate legs, in the Elliott sense, must make successive highs or at least a percentage move equivalent to the others. Such assumptions are both confusing and untrue, however. For example, in the 1966-1970 market, the third leg (almost always the most controversial) amounted to only 61 points in the Dow Jones and was hardly distinguishable from other rallies of lesser significance. At the time, many missed the significance of this move, again because of their preoccupation with a particular index, especially one representing stocks out of favor, When the rise of the third leg took place in 1969, the favorites were the new issues and those highly speculative "nifty-fifty" type stocks. While the Dow Jones rallied only 61 points or 7.6%, the American Exchange rallied 17.5%, and the NASDAQ Index made a new all time high.

Intermediate markets have been marked by lows accompanied by a greater degree of pessimism than existed at other lows during the major market. They have often been preceded by a price decline but in times of a strong underlying uptrend occasionally have been preceded by sideways or flat price motion. Intermediate lows have also been characterized by a decided loss of momentum so that on a 25 week basis, at least, a moving average of either breadth or price change has declined through zero.

The intervals between intermediate lows have tended to be regular but have not been without significant error. In 47-55 month markets, they have tended to be 15-18 months apart (as would be expected), but have sometimes been surprising in their brevity (10 months in 1969-1970). Although their intervals have not been sufficiently regular to be useful for predictive purposes, their standard calculated limits have sometimes been useful to point out a potential error. For instance, in the present market, if March, 1978 (Dow at 740) is taken as the second intermediate low (as some argue) , as of February we are now 23 months from that low without having experienced the third and final low. That interval becomes even longer and more unlikely when the recent behavior of the market is taken into account. Rather than having topped and declined or even having shown signs that such a decline was imminent, the market is making new highs. Its present strength is sufficient to minimize the chances. of a major low occurring within the next couple of months. Since a 24 month interval between lows is beyond 2.3 standard deviations from the normal, the odds of March, 1978 being only a second intermediate low are 99.9% against.

Before 1949, the 40 month markets exhibited the same characteristics as the longer markets which followed, and their intermediate markets, likewise, were marked by the same features. Three intermediate legs always occurred which at their lows displayed larger than normal pessimism and a decline in 25 week momentum. The only difference in basic character was that their intervals were shorter (10 to 15 months) as would be expected with the shorter interval of the overall 40 month market. After 1949, and until 1974, no other change in market behavior took place during the period of four-year markets.

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Present Interpretation

Our problem has been to analyse the market in terms of the major (four- year) market thesis and the three intermediate legs which have always occurred within. We do not believe that 200 years of market history should be disregarded as lightly as some would seem to wish. At the same time, we do not wish to be dogmatic about this theory and have tried to remain flexible so that we do not fall prey to oversimplification.

Our analysis centers on the location of intermediate lows and whether those designations reveal anything about the major market. Intermediate lows, as defined by definite changes in momentum and sentiment, have always occurred twice between each major four-year low. We think there is little dispute that such a major market low took place in 1974. Some dis- agreement exists on whether October or December should be taken as the actual low: we prefer to take October as the low and refer to the second as the test. Having determined the location of the last major market low, we then mark off the succeeding intermediate lows:

# Low Date Interval

1 10/75 13 months 2 11/76 13 months 3 ll-77-3/78 12 months 1 11/78 12 months 2 11/79 12 months

Among these designations, the only tentative low is the one in November, 1976. This low was 13 months from the prior, but if eliminated makes the interval 25 or even 29 months to the March, 1978 low. Because these intervals are more than unlikely (99% against), we assume the November, 1976 low to be the second intermediate low.

Counting lows then, we find the third (and thus the four-year type low) to be the November 1977 - March 1978 low. We assume this to be the major low equivalent in stature, if not dramatism, to the previous major lows of 1974, 1970, 1966, etc. We also note that in the Dow Jones at least, a significant decline transpired prior to this low (1000 to 740) and that later intermediate lows failed to go lower despite all the negative economic and monetary background. The fact that sentiment did not reach extraordinary levels can be attributed to four factors:

l Widespread anticipation of the low dulled the pessimism by spreading it over a longer period of time.

l A generally negative attitude towards stocks already existed among individuals and professionals.

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l The low amounted to only a sideways movement in a large sector of the market because the underlying trend had been so strongly upward in averages other than the Dow Jones. As we have said, sideways movements do not generate the pessimism of declines.

l Sentiment indicators have changed in habit with the advent of the options markets and are no longer as reliable an indication of sentiment.

We find nothing extraordinary about referring to the November 1977 -March 1978 period as the major four-year type low. An interval of 37-41 months from the October, 1974 low is not unusual and was the more common interval prior to 1949. The intervals between the intermediate lows have been surprisingly consistent, the only difference being that they have been shorter than those observed since 1949. The lows have demonstrated the same criteria as all other intermediate lows going back to the turn of the century, the only possible exception being the decreased interval. As we have seen, even that is not entirely unusual.

A question has arisen as to where the low in 1977-1978 specifically occurred. The determination depends on which average is taken and where the maximum deviation from the underlying trend occurs. As we did in 1974, we take the earliest of the lows, the November 1977 low, as the major low because it encompasses the maximum deviation in most averages, was not broken by the AMEX average, and was only slightly broken by the breadth in the spring of 1978. The weakness in the test of the Dow Jones during that spring signalled the future relative weakness of the Dow, a weakness which has prevailed throughout this market.

Where Are We? ---

From the table of intermediate lows since 1974, we see

l That the intervals of intermediate ‘lows have shortened to 12-13 months indicating that the market may very well be reverting back to its former 40 month cycle.

l Two intermediate lows have transpired since the major low of November, 1977. We are now, therefore, in the third and -- final leg of the major market beginning ii? 1977 and are rapidlyapproaching the end of another market.

l The leadership has been more in the Amex type issue than the Dow Jones. Since the leading stocks in one market rarely catch fire in the subsequent, we should see a switch out of the Amex type stocks at the next major low.

65

We had thought at first that there might be a possibility of a larger than normal third leg move, even in the DOW, based on the general negativism and nervousness of those with large cash holdings. A precedent for this type of move is the enormous broad-based upward blow-off type move which occurred in 1961. Such occurrences are extremely rare, however, and evidence at present disputes the possibility of such an upward move. The presence of a breadth divergence between both daily and weekly advances minus declines versus the S&P 500, NYSE Composite and others, the high specialist short sales versus low public short sales, the generally overbought nature of the market, the shrinking and specialization of leadership, and the speculation in precious metal type issues all indicate a lack of a base broad enough for continuing the upward portion of this leg much farther. The pessimism much discussed by bullish advisors will not now provide impetus for a sustained bull market. Instead, we feel that except for those few stocks which performed well over the past few years, the general negativism and cash holdings willact as a buffer to the large declinewhich customarily follows the upward portion of this last leg. The Dow, we anticipate, will not decline as sharply as has been its history in such times, althoughcommoditybased stocks - the oils, the metals, the golds and their related industries - will probably get bashed. Normally, the strongest stocks in a four-year market remain strong the longest but take the biggest losses in the end. This market should be no different.

The Outlook

We see no reason to abandon our long-standing thesis of deflation and consequent roaring bull market in a few years. In order to achieve such a situation, however, the stock market must switch its emphasis from those issues concerned with inflation, namely those which have performed superb- ly over the past few years, to the basic industries which are users of commodities and benefactors of deflation, at least temporarily. Switches in leadership do not occur in mid-stream; they occur at four-year (40-month) lows after the leaders of the previous market have been cor- rected and before the new leaders can emerge. To achieve the switch from inflation type stocks, therefore, requires a low of this magnitude with a decline of some severity preceding it.

The market has progressed through two of its three intermediate phases and is close to the top of its third. Initially, the strong stocks will remain strong, although more difficult to select, but their profitability will be only relative to the decline of the laggard stocks, those which are and have been the weakest during the current 40 month market. Later, the stronger stocks, after completing tops, will suffer severe percentage declines.

In line with the transition to deflation, we would also expect that precious metals as well as oil, house prices, and other of the hottest commodities will decline. Gold will not, therefore, be contracyclical as has been the recurrent myth in the recent market. The recent few years of rising market (the Dow Jones being an exception) has been accompanied by

66

rising gold and precious metals prices. No reason exists for them not to accompany each other in the opposite direction.

Interest rates,on the other hand, show no signs of declining immediately and they should not if the stock market is on the edge of a 40 month decline. History demonstrates that interest rates tend to peak at least three months prior to the major low in the stock market. By using reverse logic and assuming that the market low will occur 10 to 12 months from the last intermediate low, we can estimate that interest rates will peak at some point no later than June. Considering the scheduled Democratic primaries for the summer and the predilection for declining interest rates by presidential election time, the above estimates for an interest rate peak certainly would not be surprising.

We expect a market top, therefore, within a month or so and then a decline in the laggard stocks. This decline usually occurs prior to the peak in interest rates. Because of the lack of enthusiasm for the Dow Jones In- dustrial during the entire bull phase, we would anticipate its total decline to the major low to be greater than the decline of 100 to 120 points experienced during the intermediate corrections in the fall of 1978 and 1979, but not much more. If we err, however, it will be in not antici- pating a larger decline. We advise that investment money be prepared, therefore, for a decline of larger magnitude and be put in a more flexible position in order to take advantage of the low wherever it occurs. The other areas of the market, those which have performed well over the bull phase, will trade in a zone for awhile until tops have been completed. Their eventual decline will be quite disastrous and will have necessitated their complete sale at the appropriate time.

February 1, 1980

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68

CATASTROPHE THEORY: A PRACTICAL APPLICATION

Henry 0. Pruden Ph.D.*

A Cusp Catastrophe Model of a Stock Exchan e was presented in Issue 6 of the Market Technicians Association Journal s . That article asserted that the Cusp Catastrophe Modes was perhaps the framework for explaining the behavior of a securities exchange. The model was based on a mathematical logic for explaining things that change suddenly, by fits and starts. It was viewed as a reliable method for analyzing equilibrium and its break- down; it could explain discontinuous events such as selling panics and buying stampedes. The model brought into clear and systematic relief the linkage between opposing bullish and bearish forces at one level and a corresponding market index at a parallel, higher level (see Exhibit 1).

This article seeks to take Catastrophe Theory a step beyond theoretical plausibility, toward practical application.

There are three parts to this practical demonstration of Catastrophe Theory. First, the three-dimensional Cusp Model is reduced and simplified into a more useable two-dimensional form. Second, various indicators are selected to represent each of the several parameters of the simplified Catastrophe Model. Third, two recent intermediate bottoms and two recent intermediate tops are presented as practical case evidence.

From Three Dimensions To Two -- --

Refer to Exhibit 1. Imagine that the Cusp Model is a three-dimensional layer cake with an air pocket in the middle cusp area (inaccessible zone), between the top sheet and the bottom sheet of the equilibrium surface. Now let us slice off a cross-section of this cake, cutting from top to bottom near the foreground. A side view of the resulting slice of Cusp Catastro- phe cake would appear like Exhibit 2.

*Dr. Pruden is a private investor, a Lecturer at Golden Gate University and a member of the Board of Directors of the Technical Securities Analysts Association of San Francisco.

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Exhibit I

A CUSP CATATROPHE MODEL OP A STOCK EXCHANGE

Exhibit 2

SIDE VIEW OF A CUSP CATASTROPHE MODEL OF THE STOCK MARKET

Exhibit 3

ADDING THE TIME DIMENSION COhVERTS A CLOSED CIRCLE INTO A FOUR-PHASE

MARKET CYCLE

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The closed-loop (broken line in Exhibit 2) traces out a full-cycle of market behavior: base building on the bottom sheet, mark-up during the stampede catastrophe-jump, distribution during the top-sheet formation, and markdown with the panic catastrophe-jump. In other words and pictures, Exhibit 2 is analogous to the four phase or full circle of behavior depicted by W. G. Bretz3. Compare Exhibits 2 and 3. Visualize the closed circle (broken line) of behavior flowing over the Cusp Catastrophe (Exhibit 2) stretched out over time like the right-handed pcrtion of Exhibit 3.

In conclusion, the market cycle of accumulation, mark-up, distribution and markdown retains all the salient properties of a Cusp Catastrophe. It sim- plifies the price index on the equilibrium surface from three dimensions into two. It can also be expressed as an S-shaped curve of price (Exhibit 4a).

But what of the parallel sentiment or control variables, fear and greed which lie directly below the price index in the Cusp Catastrophe Model?

Fear and greed may likewise be simplified into a two-dimensional model. Two separate but opposing variables like fear and greed (supply and demand) can be made into a single, more complex variable by creating a ratio between them. Technicians do this every day with sentiment variables, such as when they compare odd-lot short sales to total odd-lot sales, or non-member's short-sales over specialists' short-sales. There are innumerable combina- tions which are able to be expressed in ratio form.

An easily glossed-over fact is that most of these sentiment indicators of fear and greed are ratios of volume. These volume ratios represent the degree of participation by various qualitatively different categories of market players (e.g., members, mutual funds, round-lot public, odd-lot public and so on).

These important and reliable ratios of market sentiment also contain an implicit time element. Insiders (innovators), are presumed to have bought or sold early while "odd-letters" (laggards) are supposed to purchase too late and sell too late. Broadly speaking, purchases and sales by distinctive investor categories are concentrated at different stages of the market cycle; the relationships among these of adopter categories is a measure of sentiment.

A bell-shaped curve of adopter categories is a reliable scheme for organiz- ing different groups of investors over time (see Exhibit 4b). In addition, the bell-shaped curve shows volume ideally peaking about mid-way through a market up-phase or down-phase (Exhibit 4a). Finally, and most importantly, note the singular correspondence between the bell-shaped curve of volume representing the control surface of the,Cusp Catastrophe and the S-shaped curve of price representing the equilibrium surface of the Cusp Model. "Both of these curves are for the same data, the adoption of an innovation (buying or selling) over time by the members of a social system. But the

bell-shaped curve shows this data in terms of the number of individuals adopting each year (unit of time) , whereas the S-shaped curve shows this data on a cumulative basis."" Please study Exhibit 4 carefully before pro- ceeding.

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The bell-shaped frequency curve and the S-shaped cumulative curve for an adopter distribution.

Exhibit 4a

100%

90%

80%

70%

20%

10%

0

,-

Exhibit 4b

Source: Rogers"

4 H4

#-*

0’ 0

Frice )

/'

/- 0 , \ ./ ,o \

Volume \

4' ,' 4'

4' '\

\ \

.',- '\

I I I I I I I I I *p* I 1 I I I I 1 I I I I, I 1 ,*

Time -

Both of these curves are for the same data, the adoption of an innovation over time by the members of a social system. But the bell-shaped curve shows these data in terms of the number of individuals adopting each year, whereas the S-shaped curve shows these data on a cumulative basis.

Adopter categorization on the basis of innovativeness.

or Sentiment

R - 2sd X- sd X x + sd

The innovativeness dimension, as measured by the time at which an individual adopts an innovation or innovations, is continuous. However, this variable may be partitioned into five adopter categories by laying off standard deviations from the average time of adoption.

72

In conclusion, the S-shaped curve of price and its companion bell-shaped curve of volume and sentiment are the two-dimensioanl analogues of the three-dimensional Cusp Catastrophe Model. Now that we are equipped with the simplification of the Cusp Model, we can turn to familiar technical indicators to represent each key parameter.

Technical Indicators

The parameters of our two-dimensional catastrophe modes are price, time, volume, sentiment and the interrelationships among these variables. For the purpose of this demonstration, let us assume an "intermediate-term" time-cycle of from one to one-and-one-half years trough to trough or peak to peak (Appel'; Cooper4). We will then select a series of indicators which are compatible with this cycle.

A workable series of indicators is presented in Table 1. The qualifier "workable", is intentional. Other technicians might well extend, substi- tute or otherwise improve upon this list. Moreover, there is the ever-present risk of an indicator becoming outmoded through overuse, shifts in investor behavior, or the advent of a dampened cyclic pattern caused by the birth of a strong secular trend. An important way to compensate for indicator failure at any juncture is to rely upon the overall pattern of technical variables.

At market bottoms the analyst should like to find most of the proposed indicators of time, price, volume and their interactions within minimal bounds of acceptability for a bullish reading. Principally, about 12 to 18 months from the last intermediate low, when a similar pattern appeared, a price decline of 10% or more from the last peak, an oversold market as evidenced by the over/under 30-week average, coupled with a positive change in momentum as measured by the 13-week rate-of-change cycle. At this bottom, volume accumulation should be in evidence according to Granville's O.B.V. readings, while the sentiment relationship should show mounting non-member shorting as against specialists' short-selling. In Catastrophe Theory terms, demand is overcoming supply on a bottom sheet which is gradually turning upward.

The configuration of these variables should narrow the analysis down to an area pattern of accumulation that is evidently reaching completion. For example, the formation of an inverse head-and-shoulders. The Catastrophe threshold buying-points could be the right shoulder, the breakout through the neckline and the pullback to the neckline.

At the top of a bull move, the analyst should wish to see most of the proposed indicators flashing bearish signals. Generally speaking, 12 to 18 months from the last intermediate highs, when a similar pattern of indicators was in evidence, a price rise of at least 10% from the last intermediate low, an overbought registration on the over/under 30-week average, plus a negative change in the 13-week momentum cycle. During this topping period, volume distribution should be evidenced by Granville's O.B.V., while the sentiment recordings ought to show diminishing non-member shorts as against specialists' shorts. The overall pattern of these vari-

73

d ki .

F G ui

74

ables should narrow the analysis down to an area where a distribution formation is nearing completion.

In terms of the Cusp Catastrophe Modes, bearish potential is gathering along the top sheet. The rectangular trading range of the market index represents the fold curve of the top sheet. The longer a sell-off is delayed, through artificial bids and the absorption of remaining demand, the further the top sheet stretches out over the inaccessible zone, as the bottom sheet recedes farther and farther away. Meanwhile the corresponding levels of fear and greed are high, with fear gaining the upper hand, thus causing the fold curve to roll over. Suddenly at the threshold there is a radical increase in the intention to sell, as price breaks key support, volume expands, and the bandwagon gains momentum to the downside.

CASES: Two Tops and Two Bottoms

The essence of the case method is a multiple. number of variables (indicators) interrelated into a pattern at a cross-section of time. Its purpose is to explain the workings of a total system at a stage of development. In contrast, a statistical study of one or a few variables (indicators) over time is used to establish or reject their validity and reliability as predicators of certain phenomena, such as the Dow Averages. Whereas the statistical approach aspires to define specific indicator signal levels for future use, the case method, while relying upon indicators, harbors the, assumption that no two case situations are exactly alike. In other words, the case method assumes that at;each market turning point, there will exist a different "mix" of indicator signals.Statistically reliable indicators are essential, but the analyst must interrelate and weigh the evidence afresh at each juncture.

We start our case study series with the February-March 1978 bottom and proceed through the September 1978 top, the November 1978 bottom and finally to the September 1979 top. The data for these analyses appear on Exhibits 5 and 6. As we discuss each of these turning points please keep relating them in your mind to the S-shaped and the bell-shaped curves plus the original Cusp Catastrophe Model. ‘.

(1) February-March 1978 Bottom --

Approximately 15 months had elapsed from the previous intermediate low when we find the market probing for a bottom in February 1978. The overall market was definitely oversold as measured by the over/under 30-week moving average, while the 13-week rate-of-change cycle hinted that the downward momentum was abating. If these indicators are. superimposed upon an inverted S-shaped curve, you can visualize how the price movement was "rounding under" . . . it was on the bottom sheet of the Cusp Model and approaching an upside, breakout threshold. At this juncture, the analyst should seek confirmation for his diagnosis in the underlying, corresponding levels of fear and greed, as measured by on-balance volume and non-member/ specialist short-sales. In February 1978, volume and sentiment were

75

Exhibit 5 Technical Indicators

IO00

.OO

coo

700

I I I I I I I

D ~NSOPYI~TICATED ACTIVITY f j OOO( I I ,

s

o.eo,;‘;;“,cJ’,., . , I , . I L., l . * 0 . .

76

Source: Merrill Analysis Inc.

giving the green light for an advance as they reached saturation levels near the right-tail of the bell-shaped curve: Granville's O.B.V. system was then flashing a buy as was the non-member/specialist short-ratio, which revealed an excessive amount of fear (supply) with the arrival of the laggards.

With these bottom correlates lined-up, the analyst could then turn to an integrative pattern of time/price/volume. As Exhibit 6 indicates, an inverse head-and-shoulders accumulation pattern had been forming in early 1978. Purchases could have been executed on the pullback to the right shoulder and on the threshold at the neckline, just as the bearish mode relinquished its magnetism to an upward, bullish catastrophe-jump in April 1978.

Exhibit 6

-a&--. --.__. :.gl

40-- __._. ‘.’ tl’ 24 m 0 01

Source: Trendline, a division of Standard & Poors.

77

(2) The August-September 1978 Top ___-

Here we discover a set of conditions which are almost opposite to those of February-March 1978. About 20 months had expired from the January 1977 peak. Neanwhile the overall market had reached dangerously overbought levels following a 20% rise, with an excess of stocks above their 3O-week moving averages. The upward momentum was similarly waning as the 13-week rate-of-change cycle started to curl over. These indicators and the Dow Jones Industrials were tracing a configuration reminiscent of the S-shaped cumulative curve, or top sheet of the equilibrium surface. Meanwhile, immediately beneath the price curve we discover confirmatory volume and sentiment signals. A daily volume peak occurred earlier in August, and thereafter O.B.V. and short-selling measures extended further toward the right- tail of the bell-shaped curve. In short, the Dow Jones was building a broadening-top formation. What followed was a catastrophic decline in October.

The 1978 top is a good illustration of the analytical/predictive powers of the Catastrophe Theory. The expansion in speculative activity during August and September delayed the corrective sell-off, thus extending the fold-curve further out (larger top), so thereby setting the stage for a deeper, vertical plummet. Meanwhile, the curving over of the equilibrium surface (top sheet) toward the threshold was evident in the NYSE cumulative advance-decline line, which was rolling over and diverging negatively from the Dow Jones Industrial Average. Hence, while the rectangular trading of August-September 1978 may have appeared neutral (bjmodal), with an upside breakout as equally likely as a downside collapse, a reference to the underlying position of fear and greed would have strongly predicted a downside resolution. Greed was high at this time, but fear (supply) was substantial and overcoming greed (demand) as indicated by the advance-decline line rolling over. The only thing that could have postponed the decline at this stage would have been the addition of more speculators. However, these speculators would have ultimately caused an even more serious crash - the top sheet would have been longer in extending over the bottom sheet while the bottom sheet receded progressively further away.

(3) The 1978 Bottom --

The October 1978 decline was a catastrophe jump downward from 900 to below 800 on the Dow. Thereafter we once again encounter the appearance of a pattern among our technical indicators comparable to February-March 1978. However , for this cycle only 9 months had elapsed. The non-conforming time cycle underscores the importance of using a case-by-case approach relying upon an overall "mix" of indicators. The rate of decline had been so extreme that the market dropped over 100, becameoversold as measured by the number of stocks under their 30-week moving average, while the 13-week rate-of-change cycle became extremely negative and then started to rise. As these price extremes were reached, there were definite signs 02 smart- money accumulation by market insiders indicating that the adoption of the bear phase had reached the laggards in the right-hand extreme of the bell-

78

shaped curve. This was clearly reflected by.the 8-week moving average of non-member/specialists' short-sales. Meanwhile, the Granville O.B.V. system was signalling an OK to buy. Hence, here again we see a pattern of price, time, volume and sentiment which was suggesting that an intermediate bottom was forming. The result was a triple-bottom completed in November and December 1978.

(4) The 1979 Top --

In August-September 1979, we find a mixture of time, price, volume and sentiment analogous to the 1978 intermediate'top. About one year separated these two periods of horizontal trading which followed substantial markups in price. As the trading range wore on, the 13-week rate-of-change cycle exhibited a loss of momentum while the over/under 30-week oscillator was accruing an ever more overbought condition. Granville's O.B.V. system had picked up an important sell signal in September. Concurrently the sentiment indicator revealed heavy distribution by insiders (specialists) which persisted until the October 5th peak day. In sum, these variables were forming somewhat of a broadening top formation in the DJIA.

On the whole, the 1979 top was strikingly similar to the 1978 peak. Like the earlier formation, the 1979 top ultimately gave way to another October catastrophic selling-panic.

SUPiiRY AND CONCLUSIONS

Catastrophe Theory promises technical analysis a.sound theoretical foundation. This article sought to move Catastrophe Theory from promise toward practicality by demonstrating how the Cusp Model can be used in calling some intermediate turning points. First, however, it was necessary to convert the three-dimensional Cusp Model into a more usable two-dimensional form. After all, almost all charts of'the stock exchange are two-dimensional. The result was a two-dimensional analogue of the Cusp Model with an S-shaped cumulative curve of price and a bell-shaped curve of volume representing different categories of adopters over time. The relationships among these adopter categories created some commonly-known sentiment indicators.

Once armed with the two-dimensional analogue of the Cusp Catastrophe Model, it was possible to designate specific technical indicators for each parameter of the model. Among others these were an intermediate cycle of 12 to 18 months, a +lO% movement in price, and over/under 30-week moving-average oscillator for overbought/oversold readings, a 13-week rate-of-change cycle for momentum, Granville's on-balance-volume', and non-member/specialists' short-sales as a sentiment indicator.

These indicators were combined into patterns for particular cross-sections of time. They were used in a case-method approach as distinct from a statistical time-series approach. The assumption was that market junctures

79

must be approached on a case-by-case basis, since the "mix" of indicator signals will be uniquely different in some fashion or another from one juncture to the next.

Four turning points were examined for historical case evidence to demonstrate the Cust Model's practical applicability. In general, it may be asserted that the four intermediate turns of February-March 1978, August- September 1978, November-December 1978 and September-October 1979, were predictable using the two-dimensional analogue of the Cusp Model together with the workable list of technical indicators.

A further step of development would be to demonstrate the Cusp Model's power to make predictions of future market turning-points. It may be that the case examples given here were unrepresentative in that the Dow Jones Industrial Average was essentially in an 800 to 900 trading range throughout most of the period under study. Hence, the "mix" of signals will no doubt change in the future; perhaps soon, perhaps dramatically.

References

1. Appel, Gerald, Winning Stock Selection Systems (New York: Boardroom Books, 1979), pp. 97-115.

2. Bank Credit Analyst (Montreal: Monetary Research Ltd. January, 19801.

3. Bretz, W. G., Juncture Recognition in the Stock Market (New York: Vantage Press, 1972).

4. Cooper, John M., "Market Analysis" in A. W. Cohen, Editor The New Encyclopedia of Stock Market Techniques (Larchmnt, New Yark: Investors Intelligence, 1977-78).

5. Cohen, Abraham, Editor, Investors Intelligence (Larchmont, New York).

6. Edwards, Robert D. and John Magee, Technical Analysis of Stock Trends, (Springfield, Mass., John Magee, 1966).

7. Granville, Joseph E. Editor, The Granville Market Letter, (Holly Hill, Florida: # 661, 684, 697, and 738).

8. Merrill, Arthur A., Editor, Technical Trends, (Chappaqua, New York: Merrill Analysis, Inc., September 22, 1979).

9. Pruden, Henry O., "Catastrophe Theory: A Model for Technical Analysis", Market Technicians Association Journal (November 19791 pp. 27-34.

10. Rogers, Everett M., Communications of Innovations, (Glencoe, Illinois: Free-Press, 1970), p. 177.

11. Trendline's Daily Basis Stock Charts, (April 4, 1980).

80

PROFILES: ALEC ELLI NGER

ENGLAND’S PIONEER TECHNICIAN

David L. Upshaw V.P. Waddell & Reed Incorporated

Editor's Note: Technical analysis is performed by people. The MTA Journal welcomes articles about technicians in addition to articles about our craft. This piece begins what we hope will be a series about members of our profession. Readers are invited and urged to submit articles such as this one.

Alec Ellinger: England's Pioneer Technician

Technical analyst. Classical Greek scholar. Gourmet cook and wine expert. Investment counselor. Author. Fun. Alec Ellinger is all of these, and this article will introduce him to you.

In the United States, investment research is a calling, a craft, and, we hope, a profession. In England, Investment Research is the straightforward name of the firm Alec Ellinger founded in 1945 with a pencil, ruler, and some sheets of semi-log paper. Today, Alec hasthreepartners and a staff of six. His firm engages in financial counseling, the publication of marketletters,and a series of chart books. It also acts as a sales agent for unit trusts (mutual funds). A conference, held every September in Cambridge, draws 80 or so technical devotees from England and many European countries. It is a delight to attend, both professionally and socially.

Alec's father was born in 1867, a year that Alec notes was a turning point in the Kondratieff wave. Alec studied the classics at Oxford, and in 1927 joined his family's business, which was the exportation of cotton cloth and fancy goods to the Far East. In 1930, he went to work for an uncle who was a stockbroker. Banks would pass on questions from their clients to Alec's uncle, and Alec would help to answer them. He discovered articles about charts in the Financial News, and by 1937 he was very interested in technical analysis. It was at this time that he read Gartley, whose work greatly appealed to him.

He began work on railroad traffic statistics , making seasonal corrections to the data. Soon, he was plotting rail stock prices as well as the traffic data, and his career as a chartist was launched. During World War II,

81

Alec served in the Royal Army Serivce Corps (supply and transport). While in the service, he decided that he wanted to be an investment counselor. He also decided to work outside of London, to use charts, and to be independent.

Thus it was that in October 1945, Alec Ellinger began his business in Cambridge with no clients and some sheets of semi-log paper. He chose Cambridge not because of its University, but because he wanted to be near industrial Britain. At the time Alec began in October, he had stock prices dating back to 2 July 1945, or about three months. By December, he and an assistant had completed 200 charts, plotted from July through December.

Alec began writing about the market in broad terms, including comments on industry sectors. He sent these Notes to people he knew, for no charge. In January 1947 he began his Monthly Investment Letter, which he sold by direct mail until 1955. He landed his first client, who had been his tutor at Oxford. Alec still serves three of this man's four children. Alec recalls that one of his better investment decisions early in his career was the purchase of colliery shares after the announcement of their nationalization.

I asked Alec what his early clients thought about his use of technical analysis, which was a radical departure for a counseling firm in the 1940s. Was it a difficult concept to sell in the beginning? "No. Results mat- tered. My methods didn't." This answer was a surprise to me, because I had a notion that British investors were a very conservative lot, resistant to major changes in investment philosophies and methods. Happily this was not the case at all.

Alec's book,' The Art of Investment, --- was published in 1955 and is now in its third edition, published in 1971. In the book he gives a lot of credit to Edwards and Magee, but he has a style and wit all his own. One of my favorite passages illustrates both:

"We must think of the market (or of an individual security) as always looking for the 'right' price; at the same time we must bear firmly in mind that the notion of a 'right' price is illusory. The investor's greatest mistake is to fall into the error of Mr. William Saraoyan's Armenian musician. This gentleman played the cello; he played it at home; he played only one note the whole time, and this troubled his wife. After several years she remonstrated with him and pointed out that other cellists moved their fingers up and down the strings and thus made tha instrument sound different notes. To this he replied magnificently, 'Oh! woman of little sense! Other men are looking for the right note; I have found it.'

There is no right price for the market to find; for the price which seems right today seems wrong tomorrow and the market must move on in its search. Sometimes it moves too slowly and must persue the reverse direction. Sometimes it seems to

82

have found the right price and it then stands still for two days or three; then the right price dodges away from it and it must proceed on its eternal chase."

The advantages of charts are aptly described in another part of the book:

"The great advantage of using charts is that you base your judgements on what you see. Investors do the truth to the best of their ability and you see in charts what investors are doing; their purposes in what they say and write may be far divorced from truth. What they say and what they write is meant to influence their hearers and readers; what they do is meant to profit themselves. So when you are looking for shares to buy, eyes must be open, ears are better kept closed. What songs the sirens sang may have been a difffi- cult question (though he thought not too difficult) in the days of Sir Thomas Browne; had he lived another forty years through the South Sea Bubble he would have known that the sirens were financial journalists."

Finally, a comment on market average charts and charts of individual securities:

"When we look at the behaviour of a really broad market average, we can estimate what a really large number of investors are doing and can trust that the sum of their transactions represents, more or less closely, what is right. When we look at a narrow market average, we can estimate what a much smaller number of investors are doing buy we can have much less trust that they are right. When we look at the course of an individual share, we can estimate what is being done by its particular crowd, but we must reckon that this crowd can be as easily possessed of error as of the truth and must attach a correspondingly smaller weight to the evidence given by the single share."

If and when the MTA opens its annual award nominations to analysts outside the U.S., the name Alec Ellinger will surely merit consideration. He is a pioneer in our field, and one who should be better-known in the United States.

'Ellinger, A. G., The art of Investment, 3 ed., Bowes & Bowes, London 1971 293 pp. Available from Investment Research, 28 Panton Street, Cambridge CB2 ~DH, England. Kg.50

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