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JOURNAL

of
Technical
Analysis
Issue 61

Winter-Spring 2004

SM

Market Technicians Association, Inc.


A Not-For-Profit Professional Organization

Incorporated 1973

JOURNAL of Technical Analysis Winter-Spring 2004 Issue 61

Table of Contents
The postponement of the Dow Award this spring had its repercussion with our Journal of Technical Analysis. We
normally publish the winning paper in this issue. However, it has turned out for the better. Not only are more excellent
papers being submitted for the award, but also this Journal is enlivened with some wonderful practical as well as
theoretical articles for your enjoyment and education.
As technicians, we like to believe that somewhere out there is a theoretical base that can explain what we have long
observed through our own experience and learned from the experience of others about open market behavior. In this
issue Dr. Henry Pruden, long time past editor of the Journal, and two French professors, Dr. Bernard Paranque and Dr.
Walter Baets, continue to investigate the connection between investor behavior and our technical principles utilizing
catastrophe theory and an experiment at Cal-Tech on irrational exuberance.
We also have two excellent articles of more practical nature: one on using a new configuration of an old, wellknown oscillator by Saleh Nasser from Egypt and the other on using the classic relative strength model on selecting
foreign stock markets and sectors for investment by Tim Hayes. Both of these gentlemen are CMTs.

Charles D. Kirkpatrick II, CMT, Editor

Journal Editor & Reviewers

The Organization of the Market Technicians Association, Inc.

Behavioral Finance and Technical Analysis


Interpreting Data From an Experiment on Irrational Exuberance, Part A:
Applying a Cusp Catastrophe Model and Technical Analysis Rules

Henry O. Pruden, Ph.D.; Dr. Bernard Paranque; Dr. Walter Baets

The Deviation Oscillator (DO)

Saleh Nasser, CMT

Momentum Leads Price: A Universal Concept With Global Applications

13

19

Timothy W. Hayes, CMT

notes

JOURNAL of Technical Analysis Winter-Spring 2004

JOURNAL of Technical Analysis Winter-Spring 2004

Journal Editor & Reviewers


Editor
Charles D. Kirkpatrick II, CMT
Kirkpatrick & Company, Inc.
Bayfield, Colorado

Associate Editor
Michael Carr, CMT
Cheyenne, Wyoming

Manuscript Reviewers
Connie Brown, CMT
Aerodynamic Investments Inc.
Pawleys Island, South Carolina

J. Ronald Davis, CMT


Golum Investors, Inc.
Portland, Oregon

Kenneth G. Tower, CMT


CyberTrader, Inc.
Princeton, New Jersey

Matthew Claassen, CMT


The Technical View
Vienna, Virginia

Cynthia Kase, CMT


Kase and Company
Albuquerque, New Mexico

Avner Wolf, Ph.D.


Bernard M. Baruch College of the
City University of New York
New York, New York

Julie Dahlquist, Ph.D.


University of Texas
San Antonio, Texas

Michael J. Moody, CMT


Dorsey, Wright & Associates
Pasadena, California

Production Coordinator

Publisher

Barbara I. Gomperts
Manager, Marketing Services, MTA
Marblehead, Massachusetts

Market Technicians Association, Inc.


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JOURNAL of Technical Analysis is published by the Market Technicians Association, Inc., (MTA) 74 Main Street, 3rd Floor, Woodbridge, NJ 07095. Its purpose
is to promote the investigation and analysis of the price and volume activities of the worlds financial markets. JOURNAL of Technical Analysis is distributed to
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Analysis is copyrighted by the Market Technicians Association and registered with the Library of Congress. All rights are reserved.

JOURNAL of Technical Analysis Winter-Spring 2004

The Organization of the


Market Technicians Association, Inc.
Member and Affiliate Information

Journal Submission Guidelines

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ask for active simple rather than passive sentences, minimal syllables per word,
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JOURNAL of Technical Analysis Winter-Spring 2004

Behavioral Finance and Technical Analysis


Interpreting Data from an Experiment on Irrational Exuberance, Part A:
Applying a Cusp Catastrophe Model and Technical Analysis Rules
Henry O. Pruden, Ph.D.
Visiting Scholar

Dr. Bernard Paranque


Head, Finance and
Information Department

A Cusp Catastrophe Model from the behavioral sciences provides a positive scientific theory as to the why of behavior in a stock market. Technical
market analysis furnishes a nominal theory of rules and principles about how
a trader or investor may profit from the behavior observed in a stock market.
Introduction
While watching the 1997 McNeil-Lehr Newshour Video depicting the California Institute of Technology Experiment on Irrational Exuberance in securities trading, we became intrigued by the apparent strong parallels between the
trading behavior exhibited in the video film and the idealized graphical model
of the Cusp Catastrophe Model presented in Christopher Zeemans 1977 book
Catastrophe Theory Selected Papers, 1972-1997 (See Figure 1). Investigative
attention was focused upon the fold or cusp in the model which captures the
transition from bullish behavior to panic conditions. As outside observers, we
agreed with all of the comments made by Professor Charles Plott (McNeil Lehrer,
1997) of Cal Tech during the experiment, except for one critical exception.
Professor Plott claimed that there was no way that a participant or observer
could have predicted the break in prices and, hence, no way for any of the
players who were in the experiment to have capitalized upon the bubbles burst.
We disagreed with Professor Plotts conclusion. Instead, we hypothesized that
according to Cusp Catastrophe Theory a dissipative gradient occurs in the
behavior pattern of the trades in the experiment just before the catastrophic
plunge in price. Hence, the break in price action could have been anticipated.
Furthermore, we anticipated that close examination of the price behavior within
the zone of the Cusp, or threshold, would reveal behavior patterns that could be
profitably analyzed and interpreted according to the rules and indicators of
technical market analysis.
Figure 1. A Cusp Catastrophe Model of a Stock Exchange

Dr. Walter Baets


Professor of Complexity and
Knowledge Management

Technical market analysis and behavioral finance are similar in their roots.
Both are rooted in the assumption that man acts for behavioral reasons in ways
that, by the standards of classical economics, may seem irrational. Both approach the study of markets to identify patterns of human behavior that uncover opportunities for profits.
Technical market analysis has existed as a practice in real world financial
markets for over a century. It, too, has theoretical roots in psychology and sociology which are often overlooked by the practical men and women of action
who practice investing, trading and analysis. If we envision a theory-application
spectrum, we can see behavioral finance occupying the theoretical pole while
technical market analysis occupies the practical applications end of the spectrum.
Arguably practitioners and students of technical market analysis championed the center stage of behavioral finance long before the arrival of what recently has become known as behavioral finance. In his 1969 book, Stock
Market Behavior: The Technical Approach to Understanding Wall Street, Dr.
Harvey Krow defined technical analysis as synonymous with behavioral finance. In his preface to that book, Dr. Krow identified three competing schools
of thought in finance: fundamental analysis, the random walk, and the behaviorist. Technical analysis fell within the behaviorist or behavioral school, concluded Dr. Krow.
The prominence of behavioral finance grafted to technical analysis was
boosted by October 9, 1993 issue of the Economist magazine. In that article,
the author Matt Ridley observed the linkage between technical analysis and
behavioral finance. Mr. Ridley stated that a combination of computer horsepower and mathematical brainpower had made it possible to find new sources
of profit in the forecasting of financial markets. As the author stated:
What the new mathematicians are mining for is not inefficiencies in the
flow of information but something entirely different. They have found new
meat in the familiar fact that traders are a diverse bunch; by unearthing
some of its previously unrecognized effects...the most popular idea for explaining it has to do with the heterogeneity of traders in particular, the fact
that people reason differently about the information they receive, that they
have different time horizons...and that they have different attitudes to risk...
The efficient-market theory is...right that efficiency will delete time-arbitrage opportunities based on who does not have information, but wrong to
conclude that therefore the market cannot be beaten.
Ridley emphasized, Prices do contain hints of what they will do next. Computers have resuscitated chartism.
As the Ridley article emphasized an appreciation that technical analysis
was evolving through the attempt to predict prices using computers to study
market behavior. For example, moving average timing and break out signals
produced profits by more than by chance.
As Ridley concluded, Chartists who prefer to be called technical analysts
justify their techniques with quite reasonable arguments about the behavior of
investors. They do not claim to predict the behavior of the index so much as the
behavior of the people who trade in the market...a rising price is a band wagon.
And there are models from behavioral science that capture band wagons. Technicians were studying the behavior of people who make markets run.

JOURNAL of Technical Analysis Winter-Spring 2004

Behavioral Finance: Cusp Catastrophe Model


Catastrophe theory is a new mathematical method for describing the
evolution of forms in nature. It was created by Rene Thom who wrote a
revolutionary book Structural Stability and Morphogenesis in 1972,
expanding the philosophy behind the ideas. It is particularly applicable
where gradually changing forces produce sudden effects. We often call
such effects catastrophes, because the lack of intuition about the underlying
continuity of the forces makes the very discontinuity of the effects so
unexpected. The remarkable thing about the results is that, although the
proofs are sophisticated, the elementary catastrophes themselves are both
surprising and relatively easy to understand, and can be profitably used
by scientists who are not expert mathematicians (Zeeman, 1977).
A Catastrophe Theory Model modified for the explanation of the evolution/
revolution of behavior in the securities market can be classified in the realm of
behavioral finance. (See Thaler, 1993; Statman, 1998 and Pruden, 1989). An
early model of the Cusp Catastrophe Model modified to explain speculative
crashes appeared in Zeeman (1976, 1977). Later, Pruden (1979) expanded upon
Zeemans use of the Cusp Model version of Catastrophe Theory to allow for
buying stampedes as well as selling panics. Pruden (1980) also established
connections between the Cusp Catastrophe Model and technical market analysis. Whereas the Catastrophe Theory Model, like other models from the behavioral sciences, provides a positive scientific theory as to the why of behavior
in the stock market, technical market analysis furnishes a nominal theory of
rules and principles about how a trader or investor may profit from the behavior observed in the stock market. Hence, the presupposition is that behavioral
science models that explain the stock market behavior provide solid scientific
foundations upon which to base the principles and practices of technical market
analysis.
The Cusp Catastrophe shown in Figure 1 offers a unique three-dimensional
graphic model for structuring two independent and one dependant variable. It
furnishes a basis for classifying and interrelating price trends and sentiment
variables, thereby enhancing logical clarity and empirical predictability. Implicit in the model is a fourth temporal dimension.
EQUILIBRIUM SURFACE
The Cusp Catastrophe model posits two parallel surfaces. The upper behavior or equilibrium surface is represented by a price index such as the DowJones Industrial Average. This behavior surface is further subdivided into a top
sheet representing bullish behavior and a bottom sheet reflecting the dominance of bearish behavior. Each point on the behavior surface is an equilibrium
juncture between supply and demand, even though incremental and transitory.
Near the center of the behavior surface of the model lies the Cusp
Catastrophes most interesting feature a fold curve or cusp. What this suggests is that there is no equilibrium (horizontal range) available until the top
sheet is reached after a buying stampede or the bottom sheet is reached after a
selling panic. Notice that the abstract model shows the behavior surface curving over to a threshold point, after which comes the panic sell-off. In the Cusp
Catastrophe model this all-important juncture along the top sheet is known as
the dissipative gradient.
CONTROL SURFACE
The market price or the equilibrium behavior surface is the dependent variable. The independent, predictor or control variable, which accounts for the
index or to which the index may be ascribed, lies on the control surface below.
In Figure 2, the independent, predictors are shown as the emotional forces of
fear and greed.
The model featured in Figure 1 presents fear and greed as opposing factors.
The relative power of these two opposing forces is what animates market behavior. The gradual changing relationship between fear and greed gives rise to
sudden discontinuations in price behavior when thresholds are reached and panics or stampedes ensue.

Figure 2. Dissipative Gradient

CUSP MODEL IN OPERATION


Now let us imagine Figure 1 in operation. The flow of the market index
takes place over a smooth surface composed of equilibrium points. Changes in
the control variables, fear and greed, have unique responses on the behavior
surface. The dynamic process of the model causes the index to seek out local
points of stable, albeit temporary, equilibrium.
Starting at a bear market low, where the market index is on the lower attractor
sheet, the level of greed (demand) is suppressed by the level of fear (supply).
Mounting greed (e.g., expectation of higher prices) gradually overcomes fear
until the edge of the sheet is reached, at which point the market breaks out of an
upside reversal pattern via a catastrophe jump to the top sheet as the mood of
the market becomes decidedly bullish. The index then flows along a rising channel on the top sheet until the bullish potential is exhausted. At that point, both
greed and fear are high. Finally, as fear overcomes greed the market index is
pushed to a threshold on the top sheet, then the price index plunges to the bottom sheet via a bearish catastrophe jump.
Catastrophe Theory analyzes equilibrium and its breakdown. As such, it is
ideally suited for understanding the stock market where price movements result from the balances and imbalances between buying power and selling pressure, which in turn are animated by the forces of greed and fear.
Applications of Catastrophe Theory can be qualitative in nature. Catastrophe Theory does not pretend to render pinpoint or unalterable predictions far in
advance. The theory does not negate the art of interpretation.
In Catastrophe Theory the prior history of behavior states of the market is
required to predict the future. This undercuts the assumptions of the random
walk or efficient market hypothesis. Catastrophe Theory underscores the relevance of the historical, chart approach to analyzing the market.
The Cusp model encompasses duality and opposition. There is room for a
greed axis and a fear axis. It brings the opposition between bullish versus bearish sentiments into clear relief.

The Cal Tech Experiment on Irrational Exuberance


INTRODUCTION

When the internet bubble burst there was a massive opportunity to make
serious money through short selling or at least avoiding losing money already
earned. A predictive theory that would have alerted a trader to the potential
collapse would have been extremely valuable.
The Cusp Catastrophe Model could have been that predictive theory. The
Cusp-Catastrophe Model is based upon behavioral science/behavioral finance
to explain types of non-linear, discontinuous behavior. It is especially models
behavior of rapid change, such as a stock market bubble bursting. Catastrophe
theory has revealed that sudden change and behavior extremes are not only
natural and interrelated but, if one were to see the early warning signs, a collapse would be predictable.
The Cusp Catastrophe Model posits that behavior is driven by fear and greed.
In the case of a stock bubble, price climbs along the top layer of the Cusp

JOURNAL of Technical Analysis Winter-Spring 2004

Model. Eventually the speculative excess reflects increasing nervousness and


starts to de-escalate, moving toward the drop-off at the cusp. Within the cusp
itself there exists the small, incremental change downward, the dissipative
gradient, that marks the beginning of the collapse. Afterward behavior then
suddenly drops off the cusp and falls vertically in rapid collapse (See Figure 4).
Market behavior explainable by the Cusp Catastrophe Model was evident
after the U.S. stock market run up in late 1999 and early 2000. The market had
become extremely overpriced and signs of nervousness started to appear. There
was one market session in which the NASDAQ dropped over 500 points only
to make a surprising and outstanding recovery back before the end of the session. The nervousness depicted by this sudden and dramatic price drop was a
sign of the impending collapse. The dot.com bubble having reached the cusp,
it was period for a catastrophic decline.
THE EXPERIMENT
Using the Cusp Catastrophe as a framework, we interpreted the research
data from a Cal-Tech Experiment on Irrational Exuberance that was produced
by WGBH television and shown on PBS (McNeil Lehrer, 1997). The Cal Tech
experiment furnished empirical data to test propositions derivable from the
Cusp Catastrophe Model. The experiment likewise offered an opportunity to
extract and highlight several nominal rules/indicators of technical analysis that
fit with the logic of the Cusp Model. The indicators of technical analysis that fit
with the Cusp Model were then also applied to the data of the experiment in an
effort to anticipate and profit from the catastrophic decline in price that followed the bursting of the speculative bubble created during the experiment.
To further our research efforts, we stopped the video of the Cal Tech Experiment at key junctures in order to photograph the charts that had recorded
the behavior of the traders during the experiment (See Figure 3 and Figure 4).
We blew up the pictures from the video that showed the transition from a bull
market to a bear market. Our interpretation of the expanded photos of behavior
led us to conclude that the Cusp Catastrophe Model coupled with technical
analysis principles and indicators could have explained the experimental data
and exploited the trading action generated by this laboratory experiment on
irrational exuberance. The data indicated that, as anticipated, a dissipative gradient precedes a catastrophic collapse in price.
Professor Charles Plott, California Institute of Technology, conducted his
experiment with well trained, knowledgeable Cal Tech students. The students
had experience with similar experiments but they had not been exposed to the
exact parameters of irrational exuberance experiment. All the students were by
definition very bright, very rational individuals who were oriented toward making the most profit available within the context of the risk they perceived.
Trading was done on a closed network of computers and students were allowed to buy or sell one stock. The better they traded, the more money they
could make up to several hundred dollars. The students who held the stock at
the periodic divided payment junctures were the ones who would win the game.
The stock being traded was a fictitious oil company and to make things simple
it had only one oil well. As oil was pumped from the well, the stockholderstudent was paid dividends at pre-set intervals. When the oil ran out, the company was basically worthless.

Figure 3. The Overall Results of the Experiment

Figure 4 depicts the overall results of the experiment. It shows the average
value of the company as it depletes the oil (line A) and the absolute maximum
value of the company with oil at its maximum potential market value (line B).
Line A should represent the average stock price and line B should be the maximum price over achieved. Stock prices beyond line B were not rational because
everyone in the game knew that the value above line B was beyond any underlying asset value. At set intervals, the dividends were paid. These dividend
payment intervals are shown in Figure 4 by the dashed vertical lines. All participants in the experiment knew this information before the game was played.
The prices established by the buyers and sellers in the experiment did not
drop as would have been expected from the logic of rational economic analysis
of the situation even though all players were rational and had the same information. The traders in the Cal Tech experiment persistently traded at a prices that
were greater than the fundamental value indicated the company was worth. As
the experiment progressed, the traders in the experiment ignored the average
value line and then, surprisingly, crossed the maximum value line. The students
in the experiment paid for the stock in the experiment well beyond what even
the most optimistic investor should have paid. Apparently, chasing dividend distribution dates, they continued to trade was based upon the greater fool theory. It
was rational to buy overvalued stock so long as someone else would buy their
overvalued stock later on, after the dividend had been collected, thus allowing
the trader to continue to profit from dividends with little risk.
Eventually, as the oil well neared depletion, the market began to show signs
of nervousness. This nervousness by players in the experiment was very evident on the videotape since Professor Plott had tied price bids to purchase the
stock to lower sounds on the musical scale. The high notes on the chart reflected sell offers while the low notes were bid orders (See Figure 5). As the
market neared extreme upside valuations, there arose heightened nervousness
evidenced by a striking increase in the intensity of the lower notes. Both sellers
and buyers were shifting their expectations downwards apace with lowering
tones and the sound volume level increased rapidly. Such a change in the sound
of the market, the sentiment, has been often noted by traders on the floor of the
exchange as a harbinger of a reversal of price trend. As the experiment progressed the buy offers that were well below the existing price began to increase, although the price level itself stabilized into a horizontal trend channel.
Ultimately there occurred a sudden, sharp drop the catastrophic jump in the
transaction price in the experiment. The market changed suddenly and swiftly;
sentiment flipped from bullish to bearish as the price plunged to its underlying
economic asset value.
It should be mentioned that this experiment was conducted without exogenous factors. There were no news or media reports, no external noise, and no
one was allowed to voluntarily enter or leave the game. These restrictions may
have contributed to the stability of the price data along a horizontal trend channel rather than prompting price to oscillate upward and downward as time progressed.

JOURNAL of Technical Analysis Winter-Spring 2004

Figure 4. Applying Technical Analysis

sentiment played on key. Additionally, the picturing of the fear and greed variables sentiment as opposing forces in the Cusp Model was brought into dramatic display by two high notes versus the low notes in the Cal Tech experiment. The Cusp Model revealed a new and powerful way for practicing technicians to display and interpret indications of sentiment.
A tight trading range of channel of price behavior, predicted by the Cusp
Model, was created by the student investors in the Cal Tech experiment (Figure
6). That the price behavior adhered so closely to a linear trend channel was
surprising to the author, who expected to see broader and more jagged up and
down swings in price. The linear trend channel of price behavior occurring
during the experiment upheld the technical analysis practice of drawing linear
trend lines of support and resistance. The breaking of a support line drawn
along the horizontal price bottoms of the price channel created during the experiment constituted the crossing of the Cusp and the onset of the catastrophic
downward plunge in price.
FIGURE 5. FEAR VS. GREED JUXTAPOSED

Even though Professor Plott asserted that the sudden and dramatic shift that
was not predictable, looking at the data with the aid of the Cusp Catastrophe
Theory reveals that there was a tip-off before the tumble. This tip-off was to be
expected by the curve of the dissipative gradient at the cusp of the model.

Applying the Cusp-Catastrophe Model


What occurred in the Cal Tech exercise was ipso facto an experiment demonstrating the elements and efficacy of the Cusp-Catastrophe Model. The market moved along an elevated course until it met with a bifurcation point. That
point was the maximum expected value or line B on Figure 3. The group of
students participating, motivated by greed, collectively decided to continue buying despite shrinking oil well resources. This build up of a speculative bubble
can be seen as taking place along the top sheet of prices on the Cusp Catastrophe model. The price moved smoothly along the upper level of the sheet until
the cusp. Then as fear started to play a stronger role while buying intentions
were becoming exhausted (fear was overcoming greed as a collective motive)
the threshold of the cusp was reached. Thereafter, the price plunge in the experiment can be explained as the dropping off from the upper level of the cusp
in a dramatic swoon to lower level as the selling panic, the downward catastrophe jump erupted.
APPLYING TECHNICAL ANALYSIS
The Cusp Catastrophe Model itself and the application of the Cusp Catastrophe Model to the Cal Tech Experiment on Irrational Exuberance spotlighted
the efficacy of six principles of technical analysis and trading that are well
known but often overlooked or under-appreciated by technicians and traders.
These principles of technical market analysis and trading are:
Fear vs. Greed Juxtaposed
Trading Range Channels Along Tops and Bottoms
Descending Price Peaks: Dissipative Gradient
Catastrophic Panics Causing Price Gaps
Mental Discipline Needed to Win the Greater Fool Game
These six principles could play an analytical role alerting a trader, a participant in the Cal Tech Experiment, when to abandon playing the greater fool
theory game. These principles of technical analysis and trading were instrumental in the diagnosis of the dissipative gradient and thus the prognosis of
the decline (See Figure 4).
FEAR VS. GREED JUXTAPOSED
The Cal Tech experiment vividly revealed the classical role of sentiment as
the musical notes depicting bids and offers reflecting sentiment shifted downward before the downward slide in price (Figure 5). The anticipatory role of
8

FIGURE 6. TRADING RANGE

JOURNAL of Technical Analysis Winter-Spring 2004

Descending Price Peaks: Dissipative Gradient


Our expectation of a pattern of descending price peaks within the trend
channel but before the price break was a key reason why we had disagreed with
Professor Plotts assertion that the break in price was unpredictable and unbeatable. As he opined, there was simply no way to get out on the way down.
However, technical analysis with aid of the Cusp Models, dissipative gradient of descending price peaks led us to expect a window of opportunity that
would alert a few astute traders to exit before the crash. The evidence from the
Cal Tech Experiment on Irrational Exuberance confirmed that expectation: the
downward plunge in price at the end of the Cal Tech experiment was predictable (Figure 7).
Descending price peaks were long ago recognized by such technical analysts as Richard D. Wyckoff as a reliable pattern for prognosticating of behavior for lower prices to come. The repeated attempts to rally which failed to
reach previous price levels (i.e., lower price peaks) showed that demand was
reaching exhausting. Greed/bullish sentiment was no longer supporting the elevated price, hence a price drop was about to occur.
Figure 7. Descending Prices Peaks

Figure 8. Catastrophe Panic Causing Price Gaps

tend to overlook and underappreciate the pattern of descending peaks as a tip


off of weakness and harbinger of panic.
Once the panic decline gets underway, the scramble of offers to sell coupled
with the withdrawal of bids to purchase, leads to repeated air pockets or gaps
in price on the way down in price Data from the experiment revealed a gapping
phenomenon more pronounced and prevalent than the time honored break away,
measuring and exhaustion gap trio of technical analysis (Figure 8). The
breakaway gap corresponds to the catastrophe jump across the threshold.
Figure 9. Mental Discipline Needed to Win
the Greater Fool Game

The sixth technical analysis principle enumerated above, mental discipline


needed to win the Greater Fool game has more to do with trading discipline
than with chart reading (Figure 9). When commenting on the rational versus
irrational behavior of the student-investors in the experiment, Professor Plott
observed that each person who was playing the game to win was acting rationally. One is tempted to amend Professor Plotts statements with the words
individually rational but collectively irrational. To win the game, the student
trader had to engage in the risky behavior of buying. Those who did not participate in the game could not earn the all-important dividend reward available to
those who did play. The optimal winning mental discipline would have been to
play the game in order to have a chance to win and continue to play with
confidence until the sentiment-mood started to shift. Then the trader-studentgame participant had to depart from the game as price behavior as evidenced
by the descending price peaks that follow after the early warning signals of
sentiment. With the empowerment given to an active-aggressive trader by underlying behavioral finance theory like the Cusp Catastrophe Model, and the
five technical analysis principles explained above, the participant in the game
could have played the game with confidence until the end of the opportunity
for profit.

Summary and Discussion

The pattern of descending price peaks occurred in the experiment it was


reminiscent of the right-hand side of the classic price-reversal patterns analysis
employed by technical analysts. For example, within the classic head-and-shoulders top formation, the technical-analyst-trader is counseled to enter a short
position on the third rally or pullback to the neckline of price support. Prior
rallies to higher prices would have been to the right shoulder and to the head of
that formation. In sum, the Cusp Catastrophe Model reveals the triple descending peaks pattern as a powerful technical tool. In our judgment, technicians

Catastrophe Theory began with the ideas of Rene Thom in the early 1960s.
Both the mathematics and the applications were present from the beginning,
each stimulating the other, as can be seen in Thoms classic book on Structural
Stability and Morphogenesis. The concept was then popularized by the various
works of Christopher Zeeman, most notably in his 1977 book, Catastrophe
Theory: Selected Papers 1972-77. Then in 1979 Pruden described the logical
linkages between Catastrophe Theory, a dimension within behavioral finance
and technical market analysis. The Cusp Model of Catastrophe Theory presents a behavior path flowing along the top sheet until a threshold, a cusp, is
reached as the underlying emotions shift toward fear overcoming greed, then
suddenly the market price will jump downward. The clues given by the shift
toward dominance by supply over demand during the latter stages of a trading

JOURNAL of Technical Analysis Winter-Spring 2004

range will presage the development of a bearish trend in stock prices. But up
until that transition phase threshold point, the market would remain high and
delay its descent until remaining pockets of demand were exhausted.
Let us fast forward to the stock market shown in the Cal Tech Experiment
and then zoom in on the behavior brought about by bullish emotions vs. bearish
emotions during the latter phases in a trading range market. The moral of the
jump story applies directly. During the trading range the alternating price swings
up and down reflect the struggle between greed and fear, so the analyst - trader
must respect the fact that the market could jump either way...its behavior is bimodal. So to be effective the trader must remain neutral until the testing phase
on the right hand side of a stock market trading range. Before we reach a
conclusion regarding future trend direction, the market should be allowed to
define the line of least resistance and then and only then should a position, long
or short, be entered. The breakdown was anticipated by the descending price
peaks, the dissipative gradient, as shown on the Cusp Catastrophe Model.
Behavior changes gradually before the breakdown. On the top sheet of the
cusp catastrophe model one can see a slight curling over of the behavior path.
Stock market behavior would likely show, for example, a series of descending
peaks in price. Similarly on the bottom sheet of the cusp model one can see a
gradual curling upward of the bottom behavior sheet before the upward jump
(breakout) by a series of ascending bottoms during the ending stages or the
right hand side of a trading range. These descending price peaks and ascending
price bottoms are powerful, but under-appreciated, technical tools.

References

10

Krow, H. (1969), Stock Market Behavior: The Technical Approach to


Understanding Wall Street, Random House
Pruden, Henry O., (1999), Life Cycle Model of Crowd Behavior, Technical
Analysis of Stocks and Commodities.
Pruden, Henry O., (1979), Catastrophe Theory: A Model for Stock Market
Behavior, Market Technicians Association Journal.
Pruden, Henry O., (1980). Catastrophe Theory: A Practical Application,
Market Technicians Association Journal.
Pruden, Henry O. (1995), Behavioral finance: What is it? Market
Technicians Association Newsletter and MTA Journal, September.
Pruden, Henry O., (2003), Catastrophe Theory and Technical Analysis
Applied to a Cal Tech Experiment on Irrational Exuberance, Managerial
Finance Journal.
Ridley, M., Survey: Frontiers of Finance, The Economist, (October 9,
1993).
Rogers, Everett M., and F. Floyd Shoemaker (1971). Communications of
Innovations, Free Press.
Schwager, Jack D., (1996). Schwager On Futures: Technical Analysis, John
Wiley & Sons.
Shiller, Robert J., Stock Prices and Social Dynamics in Thaler, Richard
H. ed, (1993) Advances in Behavioral Finance, Russell Sage Foundation
Statman, Meir., (1998), Behavioral Finance, Contemporary Finance
Digest, Financial Management Association.
Thaler, Richard H., ed. (1993). Advances In Behavioral Finance, Russell
Sage Foundation.
Thom, Rene., (1972), Stabilite Structurelle et Morphogenese, New York:
Benjamin Press
Wyckoff, Richard D. in Charting The Market: The Wyckoff Method, Jack
Hutson, Ed. Technical Analysis of Stocks and Commodities.
Zeeman, E.C., (1977), Catastrophe Theory: Selected Papers, 1972-1977,
Reading, Mass: Addison-Wesley Publishing Company (1977), p. 1.
Zeeman, E.C., (1976), Catastrophe Theory, Scientific American, pp. 6583.
Zeeman, E.C., (1974), On the Unstable Behavior of Stock Exchanges,
Journal of Mathematical Economics, pp. 39-49.

JOURNAL of Technical Analysis Winter-Spring 2004

About the Authors


DR. HENRY O. PRUDEN

Hank Pruden is a professor in the School of Business at Golden Gate


University in San Francisco, California where he has been teaching for 20
years. Hank is more than a theoretician, he has actively traded his own
account for the past 20 years. His personal involvement in the market ensures that what he teaches is practical for the trader, and not just abstract
academic theory.
He is the Executive Director of the Institute of Technical Market Analysis (ITMA). At Golden Gate he developed the accredited courses in technical market analysis in 1976. Since then the curriculum has expanded to
include advanced topics in technical analysis and trading. In his courses
Hank emphasizes the psychology of trading and as well as the use of technical analysis methods. He has published extensively in both areas.
Hank has mentored individual and institutional traders in the field of
technical analysis for many years. He is presently on the Board of Directors
of the Technical Securities Analysts Association of San Francisco and is
past president of that association. Hank was also on the Board of Directors
of the Market Technicians Association (MTA). Hank has served as vice
chair, Americas IFTA (International Federation of Technical Analysts): IFTA
educates and certifies analysts worldwide. For eleven years Hank was the
editor of The Market Technicians Association Journal, the premier publication of technical analysts. From 1982 to 1993 he was a member of the Board
of Trustees of Golden Gate University.
Professor Pruden is a visiting scholar at Euromed Marseille Ecole de
Management, Marseille, France during 2004-2005.
DR. BERNARD PARANQUE

Bernard Paranque is a doctor of economics ( University of Lyon Lumi re


- 1984) and holds the Habilitation diriger les recherches (1995). He
began his career as an associate economist in an accountancy firm in 1984.
In 1990, he joined the Banque de France (French Central Bank) business department. From 1990 to 2000 he produced papers on the financial
structure of non-financial companies (www.ssrn.com). He was a representative of the Banque de France in the European Committee of Central Balance Sheet Offices between 1993 and 2002.
In 1999, he was on secondment from the Banque de France to the Secretary of State to SMEs where he was in charge of the business financing
department. He was also a member of the French delegation to the SMEs
working party of the Business and Environment Committee of the OECD.
His research refer to the conomie des conventions and are focused
on the financial behavior of the non-financial organization and the promotion of specific tools and assessment procedures designed to enhance SMEs
access to financing.
He is co-author with Bernard Belletante and Nadine Levratto of Diversit
conomique et mode de financement des PME published in 2001. He is
also the co-author of Structures of Corporate Finance in Germany and
France with Hans Friderichs in Jahrbcher fr National konomie und
Statistik, 2001.
He is associate researcher of the CNRS team IDHE-ENS Cachan in
Paris and member of the New York Academy of Science.
He joins Euromed Marseille Ecole de Management as Professor of Finance and Head of the Information and finance department.

DR. WALTER BAETS

Walter R. J. Baets is Director Graduate Programs at Euromed Marseille


- Ecole de Management and Distinguished Professor in Information, Innovation and Knowledge at Universiteit Nyenrode, The Netherlands Business
School. He is also director of Notion, the Nyenrode Institute for Knowledge Management and Virtual Education. Previously he was Dean of Research at the Euro-Arab Management School in Granada, Spain. He graduated in Econometrics and Operations Research at the University of Antwerp
(Belgium) and did postgraduate studies in Business Administration at
Warwick Business School (UK). He was awarded a Ph.D. from the University of Warwick in Industrial and Business Studies.
He pursued a career in strategic planning, decision support and IS
consultancy for more than ten years, before joining the academic world,
first as managing director of the management development centre of the
Louvain Universities (Belgium) and later as Associate Professor at Nijenrode
University, The Netherlands Business School. He has been a Visiting Professor at the University of Aix-Marseille (IAE), GRASCE (Complexity
Research Centre) Aix-en-Provence, ESC Rouen, KU Leuven, RU Gent,
Moscow, St Petersburg, Tyumen and Purdue University. Most of his professional experience was acquired in the telecommunications and banking
sector. He has substantial experience in management development activities in Russia and the Arab world.
His research interests include: Innovation and knowledge; Complexity,
chaos and change; The impact of (new information) technologies on
organisations; Knowledge, learning, artificial intelligence and neural networks; On-line learning and work-place learning.
He is a member of the International Editorial Board of the Journal of
Strategic Information Systems, Information & Management and Syst mes
dInformation et Management. He has acted as a reviewer/evaluator for a
number of International Conferences (e.g. ECIS an ICIS) and for the EU
RACE programme. He has published in several journals including the Journal of Strategic Information Systems, The European Journal of Operations
Research, Knowledge and Process Management, Marketing Intelligence and
Planning, The Journal of Systems Management, Information & Management, The Learning Organization and Accounting, Management and Information Technologies. He has organised international conferences in the
area of IT and organizational change.
Walter Baets is the author of Organizational Learning and Knowledge
Technologies in a Dynamic Environment published in 1998 by Kluwer
Academic Publishers, and co-author with Gert Van der Linden of The
Hybrid Business School: Developing knowledge management through management learning, published by Prentice-Hall in 2000. Along with Bob
Galliers he co-edited Information Technology and Organizational Transformation: Innovation for the 21st Century Organization also published in
1998 by Wiley. In 1999, he edited Complexity and Management: A collection of essays, published by World Scientific Publishing. Recently he
co-authored Virtual Corporate Universities, published 2003 by Kluwer
Academic.

JOURNAL of Technical Analysis Winter-Spring 2004

11

12

JOURNAL of Technical Analysis Winter-Spring 2004

The Deviation Oscillator (DO)


Saleh Nasser, CMT

Introduction

Figure 1

The major aim of the Deviation Oscillator, or DO, is to track minor changes
in the strength of a trend. It usually does not track major reversals; however, it
can be very suitable with countertrend corrections. The DO moves in an unbounded range above and below a zero level and it can be used alone and/or
with other indicators. Its objective is to detect weakening bulls or bears as soon
as possible. Sometimes sellers begin to weaken, while the price is still declining; the DO will recognize this weakness and will begin showing some bullish
tendencies, even before prices begin to rise.
This indicator is derived from a chart with three moving averages; a moving average of the close, a moving average of the high, and another one of the
low. It can be observed that the MA of the close deviates between the MA of the
high and the one of the low. When prices rise the MA (close) approaches the
one of the high, when prices decline, it approaches the moving average of the
low. This confirms the notion that during a rise the price usually closes near the
high of the day, and vice versa. Based on this observation, the DO was created.
Thus, the DO calculates the deviation of the moving average of the close of a
certain issue from the moving average of the high and from that of the low.
Whenever the moving average of the close of a certain period deviates from the
low towards the high it indicates strength. When it deviates from the high towards the low it indicates weakness. The DO is very useful when used with
other indicators like MACD, momentum, and the stochastic oscillator. This
paper explains its calculation, its basic interpretation, how it can be used in
combination with other indicators.
The most important aspect of this indicator is divergences. When a divergence occurs it means that a countertrend move should occur. The DO can be
used along with momentum as a confirming indicator, and to filter some of its
bad signals since at times DO diverges with momentum. It can also be used
with MACD as a setup. A MACD buy signal will be triggered when accompanied by a positive divergence between DO and the price. This gives superior
results as opposed to using MACD crossovers alone.
Another oscillator that was extracted from DO is the RCDO. It is the
Rate of Change of the Cumulative function of DO. This oscillator is mainly
used for overbought and oversold conditions. This oscillator and its uses are
also explained in this paper.

Deviation Oscillator (DO) = [MA (high) - MA (close)] - [MA (close) - MA (low)]

Now, to extract the Deviation Oscillator, line 2 is subtracted from line 1:


This oscillator deviates above and below a zero line. Breaking the zero line
to the upside means that prices are getting closer to the lows and vice versa.
To make visual inspection easier, the scale is inverted. Thus rises and declines of the DO will accompany rises and declines in prices.
Figure 2

The Calculation
1. Calculate a moving average of the close, a moving average of the high and
a moving average of the low. These calculations use simple moving averages
and a time span of 20 days.
2. Calculate the distance between the moving average of the high and the
moving average of the close (MA(high)- MA (close)). The greater the
difference, the closer MA (close) goes towards MA (low).
3. Calculate the distance between the moving average of the close and the
moving average of the low (MA (close) - MA (low)).
Figure 1 shows two lines that intersect with each other. When line 1 (MA
high-MA close) crosses line 2 (MA close-MA low) to the upside, then the moving average of the close is closer to the moving average of the low than that of
the high. When line 1 crosses line 2 to the downside, the moving average of the
close is nearer to the moving average of the high.

Microsoft chart with DO, after inverting the y-axis. Note that trading on
zero crossovers is not recommended as it suffers from whipsaws. Now a break
of the zero line to the upside (after the scale is inverted) means that the moving
average of the close is closer to MA high than MA low and vice versa.
A short cut for the calculation: to avoid inverting the scale, a simpler
calculation can be used. (MA close - MA low) - (MA high - MA close). We
will not have to invert the scale by using this calculation.

Use of the Deviation Oscillator


BASIC INTERPRETATION
Zero Crossover

Buying when DO crosses above the zero line and selling when it crosses
below it proved to be a losing technique, resulting in a total loss of 27.05% for
the 30 Dow stocks from 1999-2003. Results improved when a buffer zone was

JOURNAL of Technical Analysis Winter-Spring 2004

13

placed at 0.2 and -0.2. Thus the buy signal was not triggered until the upper
buffer zone was broken to the upside and the position was closed when a violation of the lower boundary occurred. The loss was reduced to 20%. The results
were worst when shorts were added; covering shorts and buying longs above
zero and closing longs and building shorts below zero with a loss of 35.5%
which was reduced to a loss of 24% by using a buffer zone.
Divergences

This is the most important aspect of the Deviation Oscillator. Even when
using DO with other oscillators, divergence analysis is employed. Divergence
is very important as it shows that there is hidden weakness or strength in the
market that is not apparent in the price action.
First type of divergence occurs when DO is rising and the price is still
declining (positive divergence) or the DO curve is declining while the price
is rising (negative divergence). This means (in the case of a positive
divergence) that despite that prices are still declining; the closing price is
getting closer to the high. The 20-day MA of the close is moving away from
the MA of the low and approaching that of the high. The decline is losing its
strength, as buyers are able to bring the closing price away from its lows.
If the price is declining and DO rising, buy at a breakout of a minor top,
with a stop loss below this top or below the nearest minor bottom, depending
on risk tolerance. Use this divergence as a setup and buy at a breakout.
Usually such a breakout will not be false because it was preceded by some
strength. If another indicator confirms this positive divergence, the signal
will be stronger. The same holds true when DO declines while the price is
still rising. It means that the bears are getting stronger as they are able to
bring the closing price away from the highs.
One of the most bullish signals appears when DO rises vertically, while the
price is still in a trading range or slightly declining.
Second type of divergence appears more often: it occurs when the price
makes a lower low while the DO follows a higher low (in the case of a
positive divergence), or when the price forms a higher high, while the DO
triggers a lower high (in the case of negative divergence). A positive
divergence in this case means that during the second bottom the MA of the
close was nearer to the MA of the high than during the first bottom. The
price violated support but with weaker sellers.
Figure 3

Philip Morris (MO) shows a very interesting story. During March 2003, the
DO witnessed a positive divergence with the price. During April and May, the
stocks price began to form a higher low, confirming the previous divergence.
In May, while the price was trading sideways, the DO moved sharply upwards,
hinting of a continuation of the rise. At the end of the stocks rise, from 18 June,
to early July, the DO began to move downwards, while the stock was still rising, signaling potential weakness that came later.

14

Using the Deviation Oscillator with Other Indicators


USING THE DEVIATION OSCILLATOR WITH MOMENTUM
The Deviation Oscillator can be used as a confirming indicator for momentum divergences. Usually, when momentum witnesses a positive divergence,
this divergence will be more meaningful if it is confirmed by a similar divergence in DO. A divergence triggered by both momentum and DO is a strong
signal. A positive divergence in this case means that the decline is decelerating;
and the MA of the close is getting closer to the MA of the high.
Another way to use DO along with momentum is to track divergences between both indicators. Sometimes the price makes a lower low, confirmed by
momentum, which also triggers a lower low formation. This action might not
be confirmed by DO, which follows a higher low formation, thus diverging
with momentum. Such divergences are very useful as they are usually followed
by a minor reversal in the trend. The same can occur at a market peak, when
momentum continues making a higher high, while DO follows a lower high
formation. It was found, however, that positive divergences give better results
than negative divergences.
Testing was done on the 30 Dow stocks to see how positive divergences
between DO and momentum affected the price:
75.8% of the time a positive divergence between DO and momentum led to
a rise in price of more than 5%.
12.9% led to movements less than 5%, either positive or negative. The
divergence had no effect.
11.29% of the time, momentum was a better indicator and a decline exceeded
5% occurred after a positive divergence.
A positive divergence here means that momentum was triggering a lower
low, while DO was showing a higher low formation. The buy signal should be
triggered the day after the divergence occurs, or after an up day with high volumes for more confirmation. A stop loss could be placed below the latest minor
bottom. Using candlesticks patterns for buying can also be useful.
The logic behind such a divergence is as follows: the price is declining, and
still accelerating to the downside, however, MA (close), which is already very
near to MA (low), begins to move towards MA (high). In other words, buyers
are getting stronger as they are able to close the market away from its lows.
Figure 4

The chart of Newmont Gold (NEM) shows a positive divergence between


DO and Momentum during July 2002. As the price was making a lower low,
momentum confirmed this weakness, while DO triggered a higher low formation. Prices rose afterwards from around 24.5 to 30. During October and early
December 2002, both DO and Momentum diverged with the price action, thus
confirming each others strength. As the price was trying to find support near
its first bottom, both indicators witnessed a higher low formation. A healthy
rise followed afterwards. In the beginning of April 2003, as price was slightly
rising from 25, DO witnessed a sharp rise to the upside, indicating that prices
are moving rapidly to their highs. Momentum was rising but at a slower pace.
Usually a sudden rise in DO is considered as a very bullish action as it means
that the closing price is moving quickly towards the highs.

JOURNAL of Technical Analysis Winter-Spring 2004

USING THE DEVIATION OSCILLATOR WITH MACD


One very useful technique is to use DO as a setup for buying and use MACD
crossovers for actual buying and selling signals. The MACD crossover method
generates buy and sell signals when the MACD line crosses above or below its
signal line. The MACD is one of the indicators that give early signals when a
new trend is underway. This is a very good merit of the MACD, but obviously
a merit that often suffers from whipsaws. Eliminating bad MACD signals by
using another indicator enhances our trading results. Using D.O. along with
MACD reduces whipsaws.
The tactic used is to buy when the MACD line crosses above its signal line
only after a positive divergence occurred between the DO and the price. Exit
on the first bearish MACD crossover. The main drawback of this system is that
it exits early. Traders and technicians can find better exits by additional research.
Main Rule for combining D.O. and MACD: Buy when the DO creates a
positive divergence with prices and the MACD triggers a bullish crossover.
Exit after the first MACD bearish crossover.
This tactic can also be used with other indicators. The reason why the DO
can be used as a setup when it triggers divergences with prices is that its divergences are even more meaningful than momentum divergences.
To increase objectivity, three distinct buy signals can be defined, dependent
on the behavior of MACD.
One cross system is a positive divergence occurs between the DO and
the price, and then MACD triggers a buy signal after or during the second DO
bottom. The MACD thus gives only one bullish crossover after the divergence
between the DO and the price. The buy is executed when the MACD signals a
bullish crossover after the DO positive divergence and exit at the first bearish
crossover.
Figure 5

The chart of JP Morgan Chase shows the One cross buy signal. During
February 2002, a positive divergence occurred between DO and the price action. Following this divergence, a bullish MACD crossover occurred (see the
vertical line). Only one MACD buy signal occurred after the DO divergence.
The two vertical lines show the buy and sell signal. As stated, the exit signal is
triggered with the first MACD bearish crossover after a buy is signaled.
Two cross system occurs when MACD triggers two buy signals. The
first crossover coincides with the first DO bottom, while the second MACD
crossover coincides with the second DO bottom. During this time, the DO triggers a higher bottom, while the price follows a lower bottom formation (positive divergence). What really happens is that during the first DO bottom the
MACD gives a buy signal. During the second DO bottom, an MACD bearish
crossover, followed by a new bullish crossover occurs. The trick of this tactic is
that it gives us a false bearish crossover; however, using DO in conjunction
with MACD will eliminate such a whipsaw. Even if the trader is whipsawed by
selling at the MACD bearish crossover, he will quickly re-enter with the new
buy signal as it coincides with a positive divergence in the DO.

Thus, the buy signal will be triggered at the second MACD bullish crossover after a positive divergence between the DO and the price. Exit will take
place at the first bearish MACD crossover.
The rationale of the two cross system is that more strength appeared before the actual buy signal. A bullish MACD crossover during the first DO bottom tells us that there was more strength in the market than the first one cross
system. Obviously, as the market makes a lower low, the MACD will trigger a
bearish crossover, which will be followed by a new bullish crossover while the
DO diverges with prices.
Figure 6

The S&P 500 chart shows an example of the two cross system. During
February and March 2003, DO witnessed a positive divergence with price action. In February, during the first bottom, MACD triggered a bullish crossover.
As the price declined during March, MACD witnessed a bearish crossover,
followed by a new bullish crossover, which coincided with a higher DO bottom. This is a positive divergence between DO and the price action, followed
by a MACD buy signal. The only difference here is that the MACD witnessed
two bullish crossovers instead of one. The letters A and B on the chart
show the two MACD crossovers. The two vertical lines show the buy and exit
signal. This trade was profitable, however, prices continued moving to the upside after the exit was triggered. As was mentioned previously, the main drawback of this system is that it gives a premature exit signal.
Cross and a test system should be expected to give the best results as
the MACD witnesses a bullish crossover during the first bottom, but does not
witness a bearish crossover afterwards. During the second bottom, and while
the DO is positively diverging with prices, the MACD line declines slightly to
test its signal line, before rising again. The buy signal is triggered as soon as a
positive divergence between the DO and the price is identified and the MACD
line moves upwards after testing its signal line. The logic of this system is that
there was strength from the beginning (bullish MACD crossover during the
first bottom) but the temporary weakness was much less than that of the two
cross system, as the MACD line did not witness a bearish crossover. It only
tested its signal line and moved upwards again. The buy will be triggered the
second day as the MACD line begins moving upwards once again.
Figure 7

JOURNAL of Technical Analysis Winter-Spring 2004

15

During February and March 2003, McDonalds chart shows the DO witnessed a positive divergence with price. MACD triggered a bullish crossover
during the first bottom, and a test between the MACD line and its signal line
took place during the second bottom. No bearish crossovers occurred. The buy
was triggered at point B and the exit signal took place with the first bearish
crossover afterwards. This system is very profitable and it has the merit of
being objective. Its drawback is the premature exit signals that often occur.
The DO and MACD system was tested across the 30 Dow stocks from 1999
through 2003 with relatively good results. The two cross and cross and a
test gave a superior results compared to the one cross in terms of % profit
per trade. On the other hand, the one cross was better in terms of % of profitable trades than the two cross. Most of the buy signals fell in the category of
one cross and two cross. A small percentage triggered the cross and a
test system. Usually when the MACD gives a buy signal and begins to decline
again, it will witness a temporary bearish crossover before witnessing a new
buy signal.
Overall, 41.4% of the buy signals were triggered by the one cross system;
48.7% were triggered by the two cross; while only 9.7% were cross and a test.

Testing results of the DO versus MACD

tive. The result is an oscillator that moves slower than the normal Deviation
Oscillator but can show overbought and oversold conditions when used in combination with other oscillators.
The ROC of the Cumulative Deviation Oscillator moves faster and when
used with the stochastic oscillator it serves as a confirming indicator for overbought and oversold conditions. Obviously, the indicator can be used in many
ways and with other indicators; here it used as a confirming indicator for the
stochastic and Bollinger Bands. When all three indicators confirmed each other,
a buy was triggered. The upper boundary of the Bollinger Bands was used as an
exit signal. Obviously, exit signals were not perfect, but the important thing is
that nice profitable moves followed buy signals. The technician should find
other exit tactics than the ones used here, especially when profitable moves
occur.
A buy signal is triggered when the stochastic reaches oversold, the RCDO
reaches oversold, and the price tests the lower boundary of the Bollinger Bands.
There is a small problem here. The RCDO is unbounded, unlike the stochastic,
so oversold can be identified after a certain area is touched at least two times.
There are no pre-defined levels to be used as oversold and overbought.
Figure 8

OVERALL RESULT
% of positive trades
(profits above 5%)

% of negative trades
(losses above 5%)

% of even trades
(less than 5% trades)

73.17%

6.5%

20.33%

% Profit/ trade

% loss/ trade

17%

7%

73% of the trades were profitable with an average profit of 17% per trade. On the
other hand, 6.5% of the trades were negative, with an average loss of 7% per trade.
The rest, 20.33%, were even trades with almost no profit or loss. Some of these even
trades witnessed sharp rises afterwards, but only after the MACD gave an exit signal.
No. of days
for profitable trades

No. of days
for negative trades

30

18

No. of days
for even trades

23

This shows us the average number of days in each trade. Profitable trades were held
almost a month, on average, before selling.
Largest profit

Largest loss

53.2% (INTC)

10.88% (AA)

% profit/ trade

74.51%

13.36%

2. two cross
% of profitable trades

% profit/ trade

68.33%

18.23%

3. cross and a test


% of profitable trades

% profits/ trade

91.67%

BUY when the stochastic oscillator reaches oversold, the RCDO reaches
oversold and the price touches the lower boundary of the Bollinger Bands.
EXIT either when the price touches the upper boundary OR when it violates
the 20 days moving average to the downside (after rising from the lower
boundary and breaking the moving average upwards).
Stop loss should be placed below the lower boundary of the Bollinger Bands.
This system was tested on the Dow 30 stocks and the results were promising. While 22% of the trades were breakeven trades (plus or minus 5%), 62.5%
of the trades were profitable with an average profit of around 14% per trade,
while 15% were losing trades with an average loss of 9.1% per trade.:
All of the testing was done with visual inspection. More precise testing
might be slightly different from the results presented here.

19.95%

RCDO
RCDO is an oscillator extracted from the Deviation Oscillator that is mainly
used for overbought/oversold purposes. The RCDO is the Rate of Change (ROC)
of the cumulative function of the Deviation Oscillator, in this paper a 5-day
ROC is used. RCDO smoothes the Deviation Oscillator. While the cumulative
function alone can be used to show longer-term trends, the cumulative curve,
does not provide actionable information. Taking its ROC makes it more sensi-

16

To summarize the trading rules:

DETAILED RESULTS
1. one cross
% of profitable trades

Novellus (NVLS) shows the price, the DO, the RCDO, and the stochastic.
During December 2000- September 2001, there was three times where the stochastic and the RCDO reached oversold, while the price was testing the BBs
lower boundary. A rise followed this situation in all three instances.

Conclusion
The DO is a tool that can be added to the technicians arsenal. It is by no
means a full system of its own. As all other technical indicators, the DO is a
subjective indicator that can be interpreted differently from one technician to
another. This paper did not examine weekly and monthly charts, but at times,
major divergences are revealed in long-term charts. Figure 9 shows the weekly
S&P 500. Bullish action in the weekly DO occurred during October 1990 and
Jan 1991, as it was rising sharply, hinting that a big rise in the stock market
might be under way.

JOURNAL of Technical Analysis Winter-Spring 2004

Metastock Formulas

Figure 9

To calculate the Deviation Oscillator:

h-c: Mov(H,20,S)-Mov(C,20,S)
c-l: Mov(C,20,S)-Mov(L,20,S)
Deviation Oscillator: Fml(h-c)-Fml(c-l)
(Do not forget to invert the scale of the DO)

To calculate the CDO:

CDO: Cum(Fml(Deviation Oscillator))

To calculate the RCDO:

RCDO: ROC(Fml(CDO),5,$)*100
This paper used a 5-day ROC of the CDO. Other values can be used to
change the sensitivity of the RCDO.

Biography
The DO can be used as a confirming indicator or as a setup for other technical tools (as shown with the DO-MACD system). The default time period for
daily charts is a 20-day simple moving average for the high, low, and close.
Changing this time period can be done to increase or decrease the sensitivity of
the indicator.
It is important to note that one of the strongest signals that the DO presents
occurs when price is moving sideways (or slightly declining) while the DO
witnesses a vertical move to the upside. This action indicates that the moving
average of the close is quickly running towards the moving average of the high,
despite the apparent stability in price action. This is a very strong signal of a
potential strength.
A final note that is worth repeating here is that the DO proved to be more
useful in signaling price strength. A positive divergence is much more important than a negative divergence. DO is best used as a tool to enter the market;
however, exits should be based on other tools.

Saleh Nasser, CMT is the Chief Technical Analyst for Commercial International Brokerage Company (CIBC) in Cairo, Egypt. His main job is to
recommend to brokers and investors of the company what to buy/sell and
how to manage their positions. CIBC is the largest brokerage firm in Egypt.
Saleh began working in the stock market using technical analysis in
1997 at United Brokerage Corporation, a small brokerage company based
in Cairo. He then worked as Chief Technical Analyst for Fleming CIIC,
also in Cairo, Egypt. Saleh is the head of the education committee in the
Egyptian Society of Technical Analysts (ESTA), as well as the Treasurer
and Member of the Board of Directors of ESTA. He conducted many courses
and seminars, teaching brokers, investors, and undergraduate students about
technical analysis. Saleh was graduated from Cairo University in 1995 with
a BA in Economics.

JOURNAL of Technical Analysis Winter-Spring 2004

17

18

JOURNAL of Technical Analysis Winter-Spring 2004

Momentum Leads Price:


A Universal Concept With Global Applications
Timothy W. Hayes, CMT
Momentum leads price. This Dow Theory tenet is the force behind an everexpanding universe of applications, from overbought/oversold and trend-following indicators to trading systems that use moving rates of change to compare individual stocks and market sectors. The benefits of using relative price
momentum for U.S. stock and sector selection have received academic attention and have been applied to active portfolio management1. But can relative
price momentum be applied to global strategy, allocation, and selection decisions? This paper demonstrates that the answer is yes, pointing to real-time
performance data in detailing the methodologies behind systems that use momentum to rank market indices and sectors from different countries.
The global application of relative momentum has far-reaching implications
the potential uses of momentum as a leading indicator of price changes extend well beyond national borders. While major market moves tend to be global in scope, some markets are stronger than other markets in these moves and
some sectors are stronger than other sectors, enabling investors to maximize
bull market profits by identifying the leaders and avoiding the laggards. Market profits can be realized by allocating to the right country, sector profits can
be realized by allocating to the right sector, and the optimal mix is allocation to
the right sector within the right country. An awareness of the weakest markets
and sectors can benefit portfolio managers with equity exposure mandates or
traders who can profit by shorting in a bear market. The challenge is to identify
emerging strength and weakness with accuracy and consistency.
How relative momentum facilitates this process, and why momentum
leads price, is that it detects acceleration and deceleration. For example, if
two cars leave a starting point with the same acceleration, and if the drivers
stop accelerating at the same time, the cars will subsequently coast in tandem,
all else being equal. But if one driver accelerates, or keeps the pedal on the
metal for a longer period of time, his car will coast further. If the driver of the
second car starts to accelerate while the first car is coasting, that car could take
the lead. When the field includes dozens of cars i.e., markets or sectors
identifying the accelerators can be next to impossible in the absence of a proven
systematic approach, one that has not only performed well in a back-test period, but also stood the test of real time.

After identifying 42 markets with sufficient data history for back-testing,


including indices for 22 developed markets and 20 emerging markets, we developed a proprietary momentum formula and tested various strategies for
overweighting and underweighting. Cognizant that overfitting can lead to disappointment when a system becomes operational, we tested the momentum
formulas and strategies in-sample over a period of about two years from early
1994 to early 1996, developed the system, and then confirmed its effectiveness
in an out-of-sample period from early 1996 to August 1999. But the biggest
test would be the real-time test, the test of whether the system would provide
value-added information when put to use in real-time.
Before reviewing the results of that test, lets take a look at how the system
works. Ranking the markets from strongest to weakest by applying the same
weekly momentum composite to each market, we developed a system that demonstrates the tendency for momentum to lead price. The optimal results showed
that when a market has gained relatively strong momentum, that market has
tended to enjoy subsequent and persistent relative strength. Specifically, a
market gains overweight status (i.e., its a buy) when it rises into the top three
of the 42-market ranking, remaining an overweight until it drops out of the top
13. A market drops to underweight status when it falls into the bottom three,
remaining an underweight until it rises out of the bottom 13.
Chart 1

The Global Market Ranking


In the late 1990s, we set out to determine if a system based on relative price momentum could be developed using primary indices for markets around the
world. Such a system could help identify relative
strength shifts among regions, between developed and
emerging markets, and among specific countries. We
hypothesized that a methodology used successfully to
rank U.S. sectors and groups would be effective in ranking the market indices. Specifically, we used a Ned
Davis Research approach that applies a momentum
composite to each sector or group in a list, sorts the
list from the highest momentum composite to the lowest, and applies a strategy that overweights those with
strong momentum and underweights those with weak
momentum. The use of a momentum composite (for
example, the total of four-week, 10-week, and 40-week
rates of change) is intended to reduce whipsaws and
allow the system to more accurately identify significant changes in momentum.

Table 1
Global Market Ranking System Ranking Statistics
Overweight Performance
% gain per annum
% of weeks outperformed universe
Standard Deviation (annualized)
Information Ratio*
Universe Performance
%gain per annum
Standard Deviation (annualized)
Underweight Performance
% gain per annum
% of weeks outperformed universe
Standard Deviation (annualized)
Information Ratio*

In-sample
1/23/94 - 2/11/96

Out-of-sample
2/11/96 - 8/19/99

Real-time
8/19/99 - 6/29/03

Entire period
1/23/94 - 6/29/03

25.1
57.9
21.1
1.12

38.4
65.8
21.0
1.90

9.6
55.7
17.5
1.05

23.1
60.0
19.7
1.34

3.3
9.1

11.6
15.0

-2.5
13.8

3.8
13.4

5.0
50.5
15.4
0.17

4.9
41.3
23.7
-0.29

2.5
50.2
20.6
0.51

3.9
47.0
20.8
0.11

*The information ratio measures the excess return per unit of risk. It is calculated by dividing the annualized average of the one-week excess returns
by the annualized standard deviation of the one-week excess returns.

JOURNAL of Technical Analysis Winter-Spring 2004

19

Table 2.
Global Market Ranking
Rank
Overweight

Previous Week

4 Weeks Ago

Composite
Reading

Market

Position
Entry Date

Entry Price

Current
Current Price Gain/Loss (%)

Ranked 1-3 - Buy/Overweight

1
2
3

1
2
3

3
3
2

Indice D.C. Bursatil


Merval Index
IBB General Index

210.45
169.43
124.57

9/22/2002
6/30/2002
6/16/2002

7347.61
350.65
1252.08

13852.41
733.85
2075.77

88.53
109.28
65.79

102.36

1/26/2003

1559.49

1826.61

17.13

102.36
2.33

1/12/2003
6/15/2003

628.36
5540.84

677.28
5626.86

7.79
1.55

-3.40
-3.56

7/28/2002
6/15/2003

484.70
1948.02

434.80
1940.66

-10.30
-0.38

Ranked 4-13 After Reaching Ranks 1-3 - Hold/Continue to Overweight

Lima Exchange Index

Underweight
Ranked 30-39 After Reaching Ranks 40-42 - Continue to Underweight

33
39

34
39

34
32

Seoul Exchange Index


Helsinki HEX General

42
39

Amsterdam ANP-CBS General


Brussels Bel-20 Index

Ranked 40 -42 - Sell/Underweight

40
41

40
42

Full Rank
Rank

Previous Week

4 Weeks Ago

1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42

1
2
3
4
8
6
5
7
9
11
14
10
17
15
13
16
12
22
20
18
21
25
19
31
32
23
35
24
30
28
29
27
34
33
38
26
37
36
39
40
42
41

1
3
2
4
12
6
10
7
5
15
16
9
11
22
13
21
8
31
17
26
18
24
35
40
28
19
41
20
25
36
38
37
34
30
14
23
29
27
32
42
39
33

Rank Date: 6/29/2003

20

Market

Indice D.C. Bursatil


Merval Index
IBB General Index
Lima Exchange Index
Colombo Exchange Index
Mishtanim 100
Bangkok SET Index
Jakarta Exchange Index
Sao Paolo Exchange Index
BSE 100
I.P.C.
IGPA Index
Austrian Traded Index**
Manila Exchange Index
Warsaw WIG Index
Madrid General Index**
Prague PX-50 Index
OBX Stock Index**
S&P 500 Index**
Taiwan Trade-Weighted Index
S&P/TSX Composite**
Stockholm Affarsvarlden**
Straits Times**
Frankfurt Xetra DAX**
KFX Copenhagen**
Milan MIBtel Index
Athens Exchange Index**
NZSE Capital Top 10**
Kuala Lumpur Composite
Topix Index**
Paris CAC 40**
Swiss Performance Index**
Seoul Exchange Index
London FTSE 100**
Budapest Exchange Index
Hong Kong Hang Seng**
All Ordinaries**
ISEQ Overall Index**
Helsinki HEX General**
Amsterdam ANP-CBS General**
Brussels BEL-20 Index**
Johannesburg All-Shares Index

Country

Venezuela
Argentina
Colombia
Peru
Sri Lanka
Israel
Thailand
Indonesia
Brazil
India
Mexico
Chile
Austria
Philippines
Poland
Spain
Czech Republic
Norway
U.S.
Taiwan
Canada
Sweden
Singapore
Germany
Denmark
Italy
Greece
New Zealand
Malaysia
Japan
France
Switzerland
South Korea
U.K.
Hungary
China
Australia
Ireland
Finland
Netherlands
Belgium
South Africa

** = Developed Market

JOURNAL of Technical Analysis Winter-Spring 2004

Composite

Current Price

210.45
169.43
124.57
102.36
82.64
81.55
74.25
66.76
66.74
57.66
51.63
49.83
43.15
43.07
41.68
40.93
35.42
35.25
27.38
23.61
23.50
20.79
20.54
20.45
19.55
19.38
17.11
16.57
15.75
14.34
13.17
9.25
7.59
7.01
5.47
5.21
3.21
2.48
2.33
-3.40
-3.56
-25.36

13852.42
733.85
2075.77
1826.61
1051.43
459.42
457.51
506.78
13024.12
1810.34
7083.45
5958.84
1313.11
1236.60
15930.57
728.03
535.50
500.84
976.22
976.22
6979.12
156.66
1477.73
3224.66
217.65
18615.00
1901.48
2108.22
691.45
903.06
3109.02
3459.41
677.28
4067.80
7858.58
9657.21
3018.00
4257.11
5626.86
434.80
1940.66
8347.23

The system is thus symmetrical, as the relative momentum strength needed


for a market to gain overweight status is of the same magnitude as the relative
momentum weakness needed for a market to enter the underweight category.
Accordingly, the number of overweight markets has tended to be in line with
the number of underweight markets. We estimate that over the course of the
simulated and real-time periods, markets have remained in the overweight category for an average of 26 weeks, while the average holding period for the
underweights has been 17 weeks.
Chart 1 features the equal-weighted composites of the overweights and
underweights, constructed with weekly rebalancing. The performance of the
overweights and underweights can be compared to the performance of the equalweighted 42-market composite, which is represented by the dashed line in the
chart. As indicated in the top row of Table 1, the overweights have gained 23%
per annum over the entire time frame, outpacing the universe gain per annum
of 4%. They have beaten the universe in 60% of the weeks, as indicated in the
second row. Most significantly, the overweights not only outperformed during
the in-sample and out-of-sample periods, but also in real-time, passing the test
of its ability to identify markets with relatively strong momentum and thus
persistent relative strength. Also throughout, they have performed well on a
risk-adjusted basis, as indicated by an information ratio of more than 1.0. This
ratio is calculated by dividing the annualized average of the one-week excess
returns (the performance of the overweights less the performance of the universe) by the annualized standard deviations of those excess returns, thereby
measuring the excess return per unit of risk.
When comparing the per annum performance of the underweights to the
universe per annum gain, we would want to see persistent underperformance.
But in fact, the underweights have performed about as well as the universe
over the entire period and have actually outperformed in real time, with no
greater tendency to outperform in a given week than to underperform. Clearly
the systems value is its ability to identify winning markets, not losing markets.
Among the systems most useful indications was its identification of strong
relative momentum among emerging markets in late 2001 and 2002, supporting the case for emerging markets, in the aggregate, to outperform developed
markets. And for individual markets, one of the rankings best real-time calls
was its overweighting of Argentina in June 2002, a time of political instability
and economic worry. The market, however, sensed that the fears were overdone and began to rally. The market has remained overweight ever since, and
at this writing had gained 109% over the period, as indicated in Table 2 featuring the Global Market Ranking. Over the same period, the 42-market universe
gained 3%.
Table 3
Global Market Ranking System Ranking Statistics
Sector

Sectors
Ranked

Automobiles
4
Banks
10
Basic Resources
5
Chemicals
4
Construction
7
Cyclical Goods & Services
10
Energy
5
Financial Services
9
Food & Beverage
8
Health Care
7
Industrial Goods & Services
12
Insurance
8
Media
8
Non-Cycliacal Goods & Services 8
Retail
5
Technology
8
Telecom
6
Utilities
7

Country

Australia
Canada
Denmark
France
Germany
Greece
Hong Kong
Italy
Japan
Netherlands
Singapore
Spain
Sweden
Switerland
U.K.
U.S.

Sectors
Ranked

11
16
1
8
8
1
10
6
18
3
6
3
2
4
16
18

Chart 2

Of course, not all of the overweights continue to perform well. Some exit
the list with a loss. But a reassuring quality of the system is that, by staying
with strong markets for big gains and dumping decelerating markets with nothing worse than a small loss, it holds to the adage, let profits run and cut losses
short. And as exemplified by the Argentina example, it cares not about why a
market is doing what its doing, or whether its doing what it should be doing
based on the fundamentals. Rather, its only objective is to identify relatively
strong momentum and get on board, without the fundamental distractions.

The Global Sector Ranking


The next challenge was applying the concept and approaches to global sectors, an undertaking that started with the development of a sector line-up. For
this we used the capitalization-weighted, U.S. dollar-priced Dow Jones sector
data, replicating the global sectors on an equal-weighted basis. By giving all of
a sectors stocks the same weight, a single stock with an exceptionally high
market-cap will not dictate a sectors relative strength changes. We required
that a sector include at least four stocks large enough to surpass our market-cap
cut-off, resulting in 130 sectors. After a 2002 rebalancing, the line-up included
131 sectors, with 18 industry classifications and 16 countries represented. The
breakdown is shown in Table 3.
With the sectors established, we set out to develop a system using the same
methodologies used to create the market ranking, formulating a momentum
composite assigned to each sector, ranking the sectors in descending order from
100 to 02, testing in-sample to determine the optimal strategy for overweighting
and underweighting, and then confirming the reliability of the system in an
out-of-sample period. Like the market ranking strategy, the resulting sector
ranking strategy overweights a sector when its relative momentum is one of the
strongest, then holds the sector even as the relative momentum recedes. It does
the opposite for underweighting. This system provides another demonstration
of how momentum leads price, illustrating that after a sector experiences unduly strong momentum, its relative strength is likely to persist even after the
relative momentum has started to worsen. Specifically, a sector earns overweight status when it reaches a ranking of 95 and remains overweight until it
drops to 60 or lower. A sector becomes an underweight when it drops below 5
and remains underweight until it rises to 40 or higher.
Thus like the market ranking, the sector ranking system is symmetrical.
But the sector system is faster than the market system, as indicated by estimated average holding periods of 13 weeks for the overweights and 12 weeks
for the underweights. As indicated in Chart 2 and Table 4, other differences
are the longer in-sample period (January 1985 to January 1993), longer out-ofsample period (January 1993 to May 2001), and shorter real-time period (May
2001 through June 2003).
In the case of this ranking system, its the underweights that have shined in

JOURNAL of Technical Analysis Winter-Spring 2004

21

the sector and/or the market, and likewise identifying the


risks, the Global Sector Ranking allows for a more comprehensive assessment than could be gained by ranking
In-sample
Out-of-sample
Real-time
Entire period
1/13/85 - 1/8/93 1/8/93 - 5/4/01 5/4/01 - 6/29/03 1/13/85 - 6/29/03 the markets or sectors separately.
Overweight performance
Although the sector rankings real-time history is
% gain per annum
26.8
29.1
-10.3
22.8
shorter than that of the market ranking, it has several suc% of weeks outperformed universe
56.4
61.3
55.4
58.5
cesses to its credit. During the bottoming process of JulyStandard Deviation (annualized)
17.0
16.4
14.5
16.5
October 2002, the ranking detected relative strength among
Information Ratio*
1.01
1.29
0.24
1.07
Technology sectors and Canadian sectors. Accordingly,
Universe performance
as indicated in Table 5 showing the Global Sector
%gain per annum
15.9
12.4
-12.8
10.6
Rankings overweights and underweights, the Canadian
Standard Deviation (annualized)
13.9
11.9
18.2
13.7
Technology sector attained overweight status in early NoUnderweight performance
vember 2002 and had gained 48% as of the end of June
% gain per annum
7.1
5.0
-26.1
1.7
2003. The Canadian Telecom sector has been letting its
% of weeks outperformed universe
46.0
45.9
41.1
45.4
profits run for an even longer period, gaining 67% from
Standard Deviation (annualized)
16.7
20.4
30.1
20.3
the end of September through June.
Information Ratio*
-0.78
-0.40
-0.83
-0.60
In revealing momentum deterioration and assigning un*The information ratio measures the excess return per unit of risk. It is calculated by dividing the annualized average of the one-week
derweight
status, the ranking proved prescient with its
excess returns by the annualized standard deviation of the one-week excess returns.
warnings of worse things ahead for European insurance
sectors. Between early November 2002 and early February 2003, the insurreal-time. While the composite of the overweights has dropped -10% per anance sectors for France, Germany, the U.K. and Switzerland all dropped to
num in the real-time period, the universe has lost -13% per annum, a modest
underweight status, and by mid-March all four were down by more than 20%.
excess return. And the overweights have outperformed in 55% of the real-time
By mid-May they had all exited the underweight category, confirming that the
weeks. Meanwhile, the underweights have substantially underperformed, losrisks had diminished for those sectors. In fact, it was European sectors in gening -26% per annum in real time. And they have outperformed in only 41% of
eral that dominated the underweight category in mid-March, then dominating
the real-time weeks, with a decisively negative information ratio.
the overweights by mid-May. Sectors from the Pacific region were then pervaIt should be recognized that for most of the real-time period, the global
sive among the underweights.
market trend has been pointed lower, so we have yet to see what the results will
look like in a sustained global uptrend. But the out-of-sample results could be
Uses and Complements
an indication, as the market trended higher during most of that period. The
The sector rankings information can thus be applied in numerous ways. It
overweights gained 29% per annum, with a high information ratio and
can be used to identify a strengthening sector of stocks in a specific country,
outperformance in 61% of the weeks. The underweights underperformed but
serving as a screen for investors looking for the strongest stocks in the stronmanaged to gain 5% per annum. Over the entire time frame, the overweights
gest countries. Conversely, it can be used to identify potential underperformers
have gained 23% per annum and outperformed the universe in 59% of the weeks,
among a list of buy candidates, warning against buying a stock in a relatively
the universe has gained 11% per annum, and the underweights have gained 2%
weak sector within an underperforming country. It can also be used strictly
per annum, outperforming the universe in 45% of the weeks.
along sector lines or country lines.
Even considering the modest real-time outperformance by the overweights,
More broadly, it can be used to gauge the extent to which a sector theme is
we can be confident that over the long-term, the Global Sector Ranking will
global in scope, or a country theme regional in scope. For instance, overweight
prove itself effective in identifying overweights as well as underweights. Such
status in the vast majority of Technology sectors would confirm the global
a statement cannot be said about the Global Market Rankings ability to idenscope of that sectors relative strength, while overweight status in the vast matify underweights. Why is the sector ranking more effective in identifying
jority of European sectors would carry a strong message of regional relative
underweights? One possible explanation is the sector rankings shorter holdstrength.
ing period. Since the sector ranking uses a momentum formula with rates of
The system can also be used for its indications about the global market
change that are shorter than those used in the market ranking, it keeps the sectrend. With a preponderance of defensive sectors, such as Food & Beverage,
tor ranking more sensitive to market declines, which typically are shorter than
among the overweights, and higher beta sectors, such as Technology, among
market advances with endings that are typically more climactic, decisive, and
the underweights, the system would describe the market as risk averse. With
faster to complete3. The slower market ranking has tended to be late in identiHealth Care and Technology sectors dominating the overweights, and Banks
fying the underweights and late to remove them from underweight status. The
and Utilities dominating the underweights, the system would reflect a market
market ranking has had far better luck with the overweights, especially during
preference for growth over value. It could then be determined if those indicasustained market advances.
tions were consistent or inconsistent with those provided by a domestic rankAnother attribute of the Global Sector Ranking is that it helps answer the
ing system. The greater the confirmation, the stronger the message of global
question of whats currently more important, country or sector? At times, the
participation and sustainability.
overweights will be dominated by different sectors from a specific country,
Other good complements to the rankings indications are breadth measures
indicating that allocation to that country is the key to outperformance. At other
that can be created using the global sector database, indicators on the breadth
times, the overweights will be dominated by a sector from different countries,
of everything from the global universe itself to regions, countries, global secindicating that allocation to that sector is key. But over the long-term, both are
tors, and sectors within individual countries. For example, with the majority of
important. Peter Hopkins and C. Hayes Miller explained in a 2001 paper that
Technology sectors overweight in the sector ranking, a sign that the sectors
it is not yet totally clear that geographical importance has permanently diminrelative strength is global in magnitude, we could turn to Charts 3 and 4 (on
ished on a global basis or that sectoral importance has increased globally ...
next page) for confirmation of strength among the stocks within the sector.
from 1992 through 1995, country effects were 1.5 to two times as important as
The top two clips of Chart 3 plot the daily price and relative strength lines for
industry effects, but now the importance of country and the importance of secthe global Technology sector, the aggregate of all the stocks in the rankings
tor or industry group are about equal.4 By identifying opportunities driven by
Table 4
Global Sector Ranking System Ranking Statistics

22

JOURNAL of Technical Analysis Winter-Spring 2004

Table 5
Global Sector Ranking

Rank

Previous 4 Weeks
Week
Ago

Sector

Country

Composite
Reading

Position
Entry Date

OVERWEIGHT
Ranked 95-100 Buy/Overweight:
100
90
98
Telecom
Canada
94.50
09/29/2002
99
75
69
Technology
Canada
93.74
11/10/2002
98
78
100
Telecom
U.K.
90.53
05/18/2003
97
98
32
Technology
Singapore
88.70
06/22/2003
96
96
79
Media
Canada
88.09
03/23/2003
*96
82
84
Utilities
Canada
82.44
06/29/2003
*95
87
87
Construction
Australia
82.29
06/29/2003
Ranked Greater Than 60 and Less Than 95 After Reaching Ranks 95-100 Hold/Continue to Overweight:
93
91
96
Banks
Australia
80.00
03/30/2003
91
97
30
Cyclical Goods & Services
Italy
77.86
06/22/2003
90
65
99
Technology
U.S.
76.34
05/11/2003
90
74
52
Insurance
Canada
75.88
06/08/2003
88
83
64
Banks
Canada
73.74
10/20/2002
87
95
85
Utilities
Spain
72.67
12/08/2002
87
100
83
Financial Services
Germany
72.67
05/04/2003
80
94
72
Industrial Goods & Services
Denmark
68.40
04/27/2003
79
80
44
Technology
Germany
67.79
06/08/2003
78
96
77
Banks
Spain
66.87
04/06/2003
77
93
60
Banks
Italy
66.11
04/27/2003
76
68
88
Technology
U.K.
65.50
05/18/2003
70
99
75
Banks
Greece
62.14
05/11/2003
69
61
91
Media
Australia
61.83
04/06/2003
67
67
83
Media
France
60.31
05/25/2003
66
64
68
Technology
France
59.85
01/19/2003
61
63
87
Financial Services
U.K.
55.57
06/15/2003
61
77
80
Retail
Germany
55.57
05/04/2003
UN DER WEIGHT
Ranked Greater Than 5 and Less Than 40 After Reaching Ranks 0-5 Continue to Underweight:
33
34
16
Cyclical Goods & Services
Australia
41.37
03/23/2003
32
15
8
Insurance
Japan
40.92
06/15/2003
29
3
9
Non-Cyclical Goods & Services
Singapore
38.32
05/04/2003
25
9
6
Retail
Japan
36.03
06/08/2003
22
7
26
Telecom
Hong Kong
33.44
03/30/2003
12
10
3
Health Care
Australia
27.18
05/25/2003
10
22
3
Media
Japan
25.50
11/17/2002
9
6
25
Utilities
Hong Kong
24.73
04/20/2003
8
6
27
Media
Hong Kong
24.43
04/20/2003
7
9
36
Food & Beverage
U.S.
23.05
05/18/2003
6
22
1
Health Care
Japan
22.44
05/04/2003
Ranked 0-5 Sell/Underweight:
4
2
2
Media
Netherlands
16.18
05/11/2003
*3
17
12
Food & Beverage
U.K.
15.88
06/29/2003
3
4
48
Utilities
Japan
15.57
06/22/2003
2
3
18
Chemicals
U.S.
10.53
06/15/2003
1
1
9
Basic Resources
U.K.
7.33
03/30/2003
0
0
0
Chemicals
Switzerland
1.22
03/02/2003
* = New Overweight or Underweight

Entry
Price

Current
Price

Current
Gain/Loss(%)

56
143
261
69
244
201
410

93
212
290
66
302
201
410

67.0
47.7
11.2
-3.4
24.0
0.0
0.0

633
98
1727
1446
271
1324
2401
3857
2476
1363
368
345
422
825
1110
756
902
371

790
95
1855
1412
365
1695
2748
4636
2406
1596
413
355
497
970
1147
950
845
394

24.7
-2.3
7.4
-2.4
34.9
28.0
14.5
20.2
-2.8
17.1
12.4
2.7
17.9
17.6
3.3
25.6
-6.3
6.2

228
302
513
345
74
1767
488
526
79
1968
256

264
310
552
354
81
1843
475
570
91
2055
261

15.5
2.6
7.6
2.5
9.7
4.3
-2.6
8.3
16.0
4.4
2.3

346
587
369
740
402
2915

369
587
363
713
465
2949

6.6
0.0
-1.8
-3.7
15.5
1.2

Rank Date = 6/29/2003

JOURNAL of Technical Analysis Winter-Spring 2004

23

additional overlay, useful for assurance that the sector rankings indication of
market relative strength has longer-term confirmation. If, for instance, the sector ranking would indicate relative strength among Japanese sectors, we would
gain more confidence in the staying power of that relative strength if Japans
Topix Index would rise to overweight status in the market ranking. More broadly,
with sectors from Asia Pacific countries dominating the overweights of the
sector ranking, our longer-term confidence would increase if the regions market indices would dominate the market rankings overweights.
Separately or in conjunction with one another, the sector and market rankings
are thus useful for identifying changing themes, information thats essential
when developing global market strategy and making allocation recommendations. The rankings can also be used as screens and for input to the decisionmaking process i.e., whether to buy a certain ETF, a country fund, or a stock
in a specific sector. The next generation of these systems would combine a
global sector ranking with a ranking of individual stocks that can be bought
upon rising to overweight, sold when dropping from overweight, shorted upon
falling to underweight, and covered when rising from underweight. Such an
executable, long-short system would be especially appealing to hedge funds,
demonstrating that in leading price, momentum leads to profits as well.

Chart 3

Conclusion
This paper has demonstrated how relative momentum can be used to develop a ranking of 42 markets around the world, a ranking that has proven
effective in identifying winning markets. The paper has also shown how relative momentum can be used to develop a ranking of global sectors, a ranking
that has held its own in identifying relative strength in a down market while
proving adept at identifying underperformers. Moreover, based on our realtime experience using these systems, we can say that they certainly deserve to
be the starting point for identifying new themes and emerging leadership. Knowing that a market or sector is emerging as a momentum leader is far more important than knowing why it is doing so, a determination that often can only be
made in hindsight. Rather, understanding the markets current dynamics, that
the current differences in relative momentum will lead to differences in performance that momentum leads price is the most valuable and useful knowledge that one can have.

Chart 4

Endnotes

eight Technology sectors. And the bottom two clips plot the sectors advance/
decline line and percentage of issues at 30-day new highs. Chart 4 uses weekly
data to feature the global Technology sector along with the percentages of the
sectors stocks that are above their 10-week and 40-week moving averages.
The sectors relative strength would have short-term breadth confirmation with
its advance/decline line above it 50-day moving average and moving higher
with a rising percentage of 30-day new highs. And the sector would have longerterm breadth confirmation with more than 70% of the sectors stocks above
their 10-week moving averages and more than 55% above their 40-week moving averages.
For regions and countries, the Global Market Ranking could serve as an

24

1. The Journal of Finance published Do Industries Explain Momentum? by


Tobias J. Moskowitz and Mark Grinblatt (1999) and The Profitability of
Momentum Strategies by Louis K.C. Chan, Narasimhan Jegadeesh, and Josef
Lakonishok (1999). The Rydex Sector Rotation Fund ranks industries based
on several measures of price momentum. The fund buys baskets of stocks
to replicate the performance of the top-ranked industries.
2. Since 131 sectors are ranked from 100 to 0, more than one sector can have
the same rank.
3. According to Ned Davis Research, there have been 33 bull markets since
1900, the median bull lasting 573 days. There have been 32 bear markets,
the median lasting 375 days.
4. Country, Sector, and Company Factors in Global Equity Portfolios
published by The Research Foundation of the Association for Investment
Management and Research.

Biography
Timothy Hayes, CMT, is the Global Equity Strategist for Ned Davis Research. Tim oversees the firms global and U.S. equity allocation services,
authoring the firms weekly Stock Market Focus and International Focus publications. He also is editor of the firms bi-monthly Investment Strategy. Tim
holds the Chartered Market Technician designation and is an MTA member.
He has written a book, The Research-Driven Investor, published in November
2000. He is a regular guest on CNBC television and is often cited in The Wall
Street Journal and other publications. In 1996, Tim won the Charles H. Dow
Award for groundbreaking research in technical analysis.

JOURNAL of Technical Analysis Winter-Spring 2004