Technically Speaking, August 2023

I hope everyone in the Northern Hemisphere is enjoying their summer. I cannot stress enough the importance of taking time away from markets to focus on friends, family, and other hobbies. The market never sleeps but it will absolutely be there when you return from a mental break both ready and rested! The last four weeks have been a busy period for the CMT Association. Here is why:

Joel Pannikot, the head of APAC for the CMT Association, accompanied the All Star Charts team (Sean McLaughlin and Steve Strazza) on an Asia roadshow throughout July. The group visited CMT communities in Singapore, Kuala Lumpur, Ho Chi Minh City, Bangkok, Manila, Hong Kong, and Tokyo, hosting several in-person networking events. APAC continues to be a major growth driver for the CMT Association with nearly half of our candidates from the latest exam cycle hailing from the region. We have all seen first-hand the dedicated leadership that has emanated from the CMT’s volunteer base in APAC and I would like to thank the following lead volunteers for facilitating these efforts: Jake Chow and Isaac Lim (Singapore), Jeff Toh (Malaysia), Duc Toan Mai (Vietnam), Pongpat Khamchoo (Thailand), Nikki Yu (Philippines), Ananda Bhaumik (Hong Kong), and Akira Homma (Japan).

The Board of Directors conducted its Long-Range Planning Meeting during the first weekend of August. Much of our conversation centered around the fact that our volunteers are the currency that makes CMT membership relevant. Yes, our curriculum is world-class; our annual symposium and regional events are excellent. However, we could neither build a curriculum nor host a symposium without the help of volunteers! Take this letter as a pseudo “call to arms” for those CMT members who would like to volunteer in their respective region to assist with future chapter meetings, outreach to local universities and financial industry partners, and help staff committees of the Association that drive our agenda. If you are interested, please reach out to me or the Staff and we will gladly accept your help.

Lastly, Covid shut down one of our most human functions, social interaction, but it is nigh time to reinvigorate our technical analysis communities globally. The CMT Association and its indu, and hopefully a burgeoning volunteer group, will be offering one-day continuing education events in N. American states cities such as Texas, Chicago, Toronto, Tampa, Seattle, and Las Vegas in the coming months. Please look out for e-mail communications from CMT News and check your social media feeds for registration links.

One popular topic of discussion is U.S. treasury bonds. They have been falling for more than 2 years, since their March 2020 peak. Prominent technicians have identified a secular trend reversal on the charts, presenting the case that the uptrend which had been in force for more than 40 years, since the 1980s, has reversed. The new secular trend for US treasures is lower. As of now, in the 3^rd quarter of 2023, hedge funds, large speculators, and money managers have some of their largest short positions in history, and, on monthly charts, US treasury bonds are the most oversold in history. This has many technicians considering if the next move in US treasury bonds will likely be a contrarian move higher.

Enter John Murphy(JM), one of the more underappreciated technical analysts. He championed what he calls Intermarket Analysis(IA). JM believes all markets are interrelated. He defines IA as the study of these linkages.

US DOLLAR & COMMODITIES

Throughout history, the US dollar index and commodities have generally trended in opposite directions. In JM’s words, the negative correlation between the US dollar index and commodities is “…one of the most consistent intermarket themes…”¹ JM advises, “The relationship of the [US] dollar [index] to bonds…makes more sense…when factored through the commodity markets.”² In other words, because the bond market is influenced by inflation expectations, demonstrated by the trend of commodities, we have to look at trend of the US dollar index because it dominates inflation expectations. JM describes a falling US dollar index as inflationary. This falling dollar, in theory, lifts commodity prices which pushes US treasury bonds lower.

The chart below plots commodities, using the DBC ETF, in black, and the US dollar index, DXY, in green. The arcs illustrate highs and lows. A clear negative correlation is visible. One market peaks and the other troughs. For example, the DXY bottomed in 2008 and then DBC topped a few months later. This negative correlation has remained in place, with varying lag times, for the last 15 years.

Looking at the most recent price action, we see the DXY peaked in 2022. Now, in the middle of Q3 2023, DBC has broken above its dashed trend line. Circled in black, this trend line break signals a potential bottom and resumption of its uptrend. The DXY shows lower-lows and lower-highs. Unless the trend of the DXY changes, we should expect DBC to continue higher and the traditional negative correlation to remain in place.

COMMODITIES & BONDS

Another traditional intermarket theme is the negative correlation between treasury bond prices and commodities. In JM’s words, “Rising commodity prices are viewed as a leading indicator of inflation. As a result, an inverse relationship exists between bond and commodity prices. … Rising commodity prices normally cause treasury bond prices to fall. Falling commodity prices normally result in higher bond prices.”³

The chart below plots commodities, using the DBC ETF, in black, and long-duration US treasury bonds, using the TLT ETF, in brown. The arcs illustrate highs and lows. The arrows, prior to 2014, highlight the positive correlation.

At the start of 2014, in the middle of the chart, the dashed brown arc under the treasury bond price series shows TLT bottoming. This was the resumption of the traditional negative correlation which persists to this day, more than 9 years later. Before the 2014 resumption of the negative correlation, the relationship was positively correlated. JM tells us about that period, “Since 2002, commodity inflation has coexisted with interest rate deflation, which is somewhat unusual.”⁴

Looking at the most recent price action, DBC turned lower in the middle of 2022. TLT, after initially turning higher, printed a failed breakout. See the brown circle. Bonds then headed lower and broke down below its dashed trendline. This nonconfirmation of DBC’s top was noteworthy. The bond market called the turn in commodities ahead of time. The traditional negative correlation remains in force with DBC moving higher and TLT moving lower. If DBC does continue to rise, we would expect TLT to continue to fall or to first move sideways due to its historic oversold condition.

CONCLUSION

So, What Is Intermarket Analysis Telling Us About U.S. Treasury Bonds? Recall, JM advises us to observe bonds through the lens of commodities which are strongly influenced by the US dollar index. Should the dollar index begin to rise significantly, it will create noninflationary headwinds for commodities which will make their rise more difficult. This should, in time, cause US treasuries to stop falling. Until then, the current configuration is textbook. Just as JM describes, a falling US dollar is causing commodities to trend higher and US treasury bonds to trend lower. As fun and interesting as IA is, correlations change. As with all other indicators, IA is secondary to the message from the highs and lows of price.

References

1. Murphy, J. J. (2013). Trading With Intermarket Analysis: A Visual Approach To Beating The Financial Markets Using Exchange-Traded Funds (p. 142). John Wiley & Sons, Inc., Hoboken, New Jersey.
2. Murphy, J. J. (1991). Intermarket Technical Analysis: Trading Strategies For The Global Stock, Bond, Commodity, And Currency Markets (p. 56). John Wiley & Sons, Inc., New York, Chichester, Brisbane, Toronto, Singapore.
3. Ibid, (p. 198).
4. Ibid, (p. 197).

“Don’t Fight the Fed” is a rule that we have all heard numerous times in our careers. It is the rule for which Dr. Martin Zweig is most famous. However, Dr. Marty had 16 other rules that he developed in this illustrious tenure as a money manager. According to Mark Hulbert, Zweig “brought a rigorously empirical and scientific approach to beating the market, which, surprisingly, was not the norm among advisers when he began his career.”

This appeals to the way we view the investment world at Potomac. I am not going to do a deep dive on Marty. That has been done numerous times. Instead, I am going to take each of his 17 rules and provide my interpretation of them.

1. The trend is your friend, do not fight the tape.

The simplicity of this rule is the reason that many investors ignore it. Many people feel that it is not intellectual enough to simply follow price trends. The fundamental CFAs often mock the trend following CMTs with jokes like “number go up bro!” as if they are above it. But the profits that you make from trend-following are real. It is more intellectual to understand that PRICE (not the balance sheet, not the income statement, not the cash flow statement) is the ONLY thing that pays you.

2. Let profits run, take losses quickly.

This is another simple concept that many investors fail to grasp. Taking a loss is an admission of failure, of being wrong and, as humans, we hate being wrong. Think about how hard it is to apologize to another person. Taking a profit feels good, it makes us feel smart. As humans, we like that; it means we are winners. Therefore, the tendency is to take a lot of small wins (to feel smart) and keep losing trades for a long time (it is not a loss if you do not sell it, right?).

3. If you buy for a reason, and for that reason if discounted or no longer valid, then sell!

When the facts change, change your mind. Unfortunately, narrative-based investors often become too entrenched in their views. This year gives us a great example of this. They entered the year with a bearish view based on the inverted yield curve, slowing economic growth, and a Federal Reserve that was still raising rates. As the market went higher, these investors remained bearish because breadth was bad, only seven stocks were leading the market higher. As this thesis was debunked by broader participation, the bears have now concluded that the rally is not sustainable because it has been driven by multiple expansions. Beware of “thesis shifting” on your part and on the part of those you follow.

4. If the values do not make sense, then do not participate. (2+2=4)

This rule is geared for the fundamental crowd. My only pushback here is that “value” is subjective. As such, an analyst can twist numbers to make a compelling case on any stock.

5. The cheap gets cheaper, the dear gets dearer.

This is another way of saying stay with the trend, in my view. Also, blindly buying stocks because they are “cheap” on some value metric makes almost no sense. Likewise, rejecting a stock simply because it is “expensive” also makes little sense. Cheap stocks are often cheap for a reason. Expensive stocks are usually expensive for a reason. You can spend time digging for those reasons, or you can simply follow the price trends.

6. Do not fight the FED (less valid than #1).

The rule for which Dr. Marty is best known. Interesting that it is not #1. The Federal Reserve controls the ebb and flow of liquidity in the market. More liquidity usually equates to greater demand for stocks. The opposite is often true as well. But note that even Marty admits that rule #1 is more important. At Potomac, we incorporate both rules into composite models. Those who have been following in 2023 know that our long-term trend model became bullish in January (Rule #1). However, the ”Don’t Fight the Fed” rule has made it hard to stay fully invested for extended periods of time.

7. Every indicator eventually bites the dust.

You must always test your systems and indicators. You should always be looking for new ideas that can add value. At Potomac, we use a metric called max drawdown. If any indicator that we use violates its max drawdown, we immediately begin to reevaluate.

8. Adapt to change.

This is a good rule for life, in general, not just investing.

9. Do not let your opinion of what should happen bias your trading strategy.

This is another rule that many have a challenging time following. We all have opinions; the market does not care. I have had my worst trades (as a discretionary trader) when I have formulated some elaborate opinion on why the market was wrong. THE MARKET DOES NOT CARE ABOUT YOUR OPINION. The problem with having a strong opinion (especially if you have expressed it publicly) is that changing your mind is to admit being wrong (see Rules 2 & 3).

10. Do not blame your mistakes on the market.

Take accountability. At the end of the day, you are the key decision-maker.

11. Do not play all the time.

“Timing” the market is better than “Time In” the market. I know this will upset the passive buy-and-hold crowd.

12. The market is not efficient but is still tough to beat.

I agree with this and push back on the Nobel Prize-winning Efficient Market Hypothesis. However, I believe that the market is extremely efficient, just not completely efficient. It is in the small gap between extremely and complete that active managers go to war with Mr. Market. Ask yourself, do you really want to take on that battle with subjective ideas like valuation and entrenched narratives? I prefer a systematic, rules-based approach with a focus on price trends.

13. You’ll never know all the answers.

The best that you can do is have a solid framework for generating probabilities. If you wait for perfect information, you will likely spend much of your time on the sidelines seeing your hard-earned money succumb to inflation.

14. If you can’t sleep at night, reduce your positions or get out.

Many investors think that they can handle risk when you ask them to fill out a questionnaire. But the true test comes when their capital is put to work. If they are tossing and turning at the sign of the first drawdown, then they are not capable of handling their current level of risk. That’s fine; we are all different.

15. Do not put too much faith in the “experts.”

I love this rule, and technically we are experts. However, this applies more to newsletter writers and even sell-side research analysts. Remember, all investors have different goals and risk profiles. These are usually different from those of the experts. Do your own homework. If you cannot do the work, there are plenty of licensed professionals who can add value.

16. Do not focus too much on short-term information flows.

Learn to decipher signals from noise. We live in a 24/7 soundbite world. The best investors have the best filters.

17. Beware of “New Era” thinking, i.e., it is different this time because…

I started my career at the absolute top of the dot-com bubble. “It’s different this time because of the internet.” I had friends who were graduating college and going to be “day traders” because it was so easy to make money. None of them are in the business today. If you missed the dot-com bubble, you could look at crypto leading into 2022. Matt Damon told you that “fortune favors the brave” in a Super Bowl commercial. It is never different; it is always cyclical.

As investors, it’s essential to stay grounded and not fall for the trap of believing that “this time it’s different.” History has shown that market cycles repeat themselves, and the emotional behavior of investors remains remarkably consistent over time.

In conclusion, Dr. Martin Zweig’s rules provide valuable insights for navigating the investment world. Following trends, managing profits and losses, adapting to change, and avoiding excessive reliance on short-term information flows are just some of the principles that can help investors make better decisions. Ultimately, successful investing requires discipline, objectivity, and the ability to stay true to a well-defined strategy, regardless of prevailing market narratives.

Brent Crude Oil, among various commodities, has encountered a challenging year thus far. From a technical perspective, Brent has mainly operated within a defined range but has yielded positive returns on a year-to-date basis, registering a modest 4.95% gain within a relatively wide trading range.

Nevertheless, a comprehensive analysis of Brent Crude Oil across different timeframes unveils intriguing insights. While scrutinizing the Daily charts, there seems to be an approach towards multiple resistance levels. Yet, delving into higher timeframe charts unveils a compelling narrative. Brent has not only elevated its support levels but has also established a robust base.

Furthermore, the interaction between Brent Oil and the 40-Week Moving Average reveals a noteworthy pattern. Historically, crossovers and crossunders of Brent Oil with this Weekly Moving Average have provided valuable foresight into the commodity’s future directional bias.

Upon examining the Daily chart, Brent Crude Oil transitioned from a descending channel to form a Symmetrical Triangle, attempting a breakout. Despite the breakout failing to yield a pronounced directional trend, Brent oscillated within a broad range of $71 to $87.50. Currently, the commodity hovers in close proximity to the $87.50 resistance, potentially encountering substantial resistance at this juncture.

This assessment holds particular relevance when considering a short-term perspective for Crude Oil. However, a thorough evaluation of Weekly and Monthly charts indicates a more robust trajectory ahead for Brent Crude. The commodity has not only fortified its foundational support but has also raised its support levels.

The Weekly chart highlights Brent’s repeated testing of the 200-Week Moving Average, positioned at 72.21, during the months of March to June in the present year. Notably, this level emerged as a resilient pillar of support.

Another noteworthy observation on the weekly chart pertains to the interplay between price and the 40-Week Moving Average, currently positioned at 81.22. The profound relationship between Brent Crude’s price and the 40-Week Moving Average has consistently provided strong directional cues. Notably, following Brent Crude’s crossing above the 40-Week Moving Average from its low of $15.99 in April 2020, it embarked on an impressive ascent, ultimately marking a 238.36% increase by March 2022 when it formed a high of $137.

Throughout this upward trajectory, Brent Crude found support at the 40-Week Moving Average twice, each time leading to resounding rebounds of 34% and 83% respectively.

A significant turning point occurred in August 2022 when Brent Crude dipped below the 40-Week Moving Average, subsequently experiencing a nearly 30% decline before finding support at the 200-Week Moving Average.

Crucially, in the week ending July 28, 2023, Brent Crude once again crossed above the 40-Week Moving Average, which is currently positioned at 81.22. This development signals a crucial indicator for an emerging uptrend in the upcoming weeks.

A glance at the extensive monthly chart also underscores July’s closure with Brent’s price surpassing the 200-Month Moving Average at 78.43.

Drawing insights from the aforementioned technical analyses, it is reasonable to infer that the short-term charts indicate Brent’s approach towards various resistance levels, notably at $87.60. Subsequent to testing these levels, a possibility of minor corrective retracements and short-term consolidation emerges.

However, an examination of higher timeframe charts reveals that Brent has effectively raised its support levels within the $79-$81 range, and the recent crossover of the 40-Week Moving Average lays the groundwork for a forthcoming upward trajectory. It is noteworthy that any close below 72 would nullify this particular technical configuration.

CMT Association’s Market Insights features timely technical analysis of current global markets by veteran CMT charterholders. Each post appears on www.tradingview.com/u/CMT_Association/ in an effort to explain process, tools, and the responsible practice of technical analysis. Shared content and posted charts are intended to be used for informational and educational purposes only. The CMT Association does not offer, and this information shall not be understood or construed as, financial advice or investment recommendations. The information provided is not a substitute for advice from an investment professional. The CMT Association does not accept liability for any financial loss or damage our audience may incur.

https://www.tradingview.com/chart/DX1!/AadiQME9-Reversal-Bar-Patterns-Part-3-Buying-and-Selling-Climaxes/

Reversal Bar Patterns Part 3: Buying and Selling Climaxes

US DOLLAR INDEX� FUTURES ICEUS:DX1!

CMT_Association

In parts one and two we covered the basics of reversal bar patterns including hooks, pipes, and keys. In this piece we focus on the buying and selling climax. In the final installment we will focus on upthrusts and springs.

The patterns covered in this series represent an overt change in the balance of supply and demand. Importantly, very few patterns set up as they would in textbooks or in my examples, but the principles are consistent. Understanding why they occur and developing analysis and trading judgement around them is a primary skill. In this regard, there is no substitute for staring at thousands of bar and candle charts.

One of the more important chart patterns is the buying and selling climax (BC & SC). Climaxes are exhaustion/capitulation patterns. A selling climax (SC) develops as weak handed buyers capitulate. Buying climaxes build as shorts capitulate and timid buyers who missed out on the rally are finally induced to enter. Selling climaxes are more about existing longs capitulating and selling. In general, the complete (perfect) pattern sequence consists of preliminary demand (PD) selling climax (SC), minor test (MT), automatic rally (AR) and secondary test (ST). Of the six, the minor test and preliminary demand are optional.

For simplicity we will focus on the selling climax. Buying climaxes conditions are the direct opposite with the exception that they tend to occur on lower volume than selling climaxes.

Climaxes typically occur in extremely extended markets that have trended a long while. The climax low is often made in conjunction with extremely bearish news flow, dismal sentiment, and a palatable bearishness. Put/Call ratios and other derivative measures are typically at extremes. I begin actively monitoring for the pattern when oscillators reach extreme readings or after a long period of trending behavior. I am more attentive on the second or third foray into oversold/overbought, particularly if there is a pronounced momentum divergence. The appearance of the climax strongly suggests that bad news has already been discounted.

Trends are often defined by three successively steeper trendlines. The 3rd and final trendline is often parabolic and defines the terminal portion of a trend. I am particularly attentive for the pattern to develop after the third trendline develops.

Climax structures are not created by strong handed/well informed buyers buying the weakness, but by over-levered and poorly placed longs capitulating and liquidating positions as their pain becomes too much to bear. The bearish news also lures in new weak handed/trading shorts, who, trapped by the sudden reversal, are forced to cover. The combination of the two clears the immediately available supply.

Once the immediately available supply is cleared, there is not much resistance to the market advancing. In Wyckoff terms the initial rally from the selling climax low is labeled the automatic rally (AR). As the AR develops, shares are often distributed back from strong hands to weak hands. Since supply has been exhausted, the AR can often cover significant ground. Opportunistic short-term buyers of the selling climax often use this rally to sell a large portion of the position built during the climax. Remember that the buyers during the SC are not generally long-term investors but are more likely sophisticated agile traders. They often take advantage of the reaction rally to take trading profits.

While climax behaviors often represent intermediate or long-term turning points, they can also represent shorter term exhaustion of the immediately available supply/trend. As the automatic rally develops new supply will emerge. Longs who resisted selling during the sharp decline to the climax lows, opportunistic traders who bought into the reversal behavior and new shorts all sell into this rally. Additionally, strong handed bearish fundamental traders may increase their line. This is why, for a climax to be trusted, there must be a secondary test (ST) that is well separated in time from the initial low.

In the weeks and months that follow a weekly perspective SC, the market will test near the climax low. The successful completion of the test generally represents an all clear for longer term positions.

The pattern is fractal. That is it shows in all time perspectives. The key is that the secondary test is well separated in time from the climax structure.

Preliminary Demand: There is often a sharp rally just prior to the selling climax. Wyckoff labeled this as preliminary demand (PD), a point at which strong handed longs are beginning to accumulate shares in anticipation of a turn. The PD is an alert to begin monitoring for a selling climax. The PD rally should be noticeably stronger than the rallies that preceded it.

Selling Climax: Climax patterns are typified by extremely heavy volume, much wider than normal price spreads and typically feature a clear reversal pattern (often a key reversal) bar or bars. There is generally an acceleration of the trend, with wider price spreads and a steeper angle of decline. At one time climaxes were mostly single bar affairs, but now the climax structure often builds over several trading days.

Minor Test: In the hours and days after the automatic rally begins, the market will often suffer a setback toward the SC. The appearance of demand on this setback solidifies the odds that the AR rally will cover reasonable ground. In many cases the minor test will only appear on intraday charts.

Automatic Rally: In the days following the SC the market will rally sharply. Volume is typically very strong near the beginning and tails off as the rally progresses. The AR often has a noticeably different character than prior corrections in the downtrend in that they cover more ground and volume is better. Distance traveled is important, the greater the reaction after the climax the more significant its implications. Small ARs are not to be trusted.

Secondary Test: Selling climaxes clear out the immediately available supply in that price zone. Even short-term climaxes can stall the market for a period of time (think trading range). But they can fail, and when they fail rapidly it is a solid indication of a continuing bear market. This is why climax structures MUST BE SUCCESSFULLY TESTED before they represent anything other than short term capitulation.

The test should be well separated in time, and occur on generally lower volume. Selling should be far less intense than on the initial decline. This is demonstrated by the general decline in volume and the angle of the testing decline. In other words, the angle of the decline to test should be significantly less than the angle of the original decline. I prefer to see them play out over several weeks (assuming a daily perspective outlook).

Trading Range: Often the test will take the form of a trading range during which strong hands, usually large institutions, accumulate new long positions. In future installments we will cover the analysis of trading ranges.

At times the market will make a V bottom with no test. In that case, when the new trend becomes unmistakable, you should begin utilizing traditional trend-based entries into positions.

To Repeat: The huge volume and the reversal bar offer a warning that things may be changing. But, without the completed test, a trend reversal is only conjecture. YOU MUST HAVE A COMPLETED TEST before deciding that a low of any consequence has been made.

Climaxes are fractal. They appear in literally every time frame. But the larger the time perspective, the more important the climax. It is also worth noting that the notes around sentiment are not particularly meaningful when working in time frame shorter than daily.

And finally, many of the topics and techniques discussed in this post are part of the CMT Associations Chartered Market Technician’s curriculum.

Good Trading:
Stewart Taylor, CMT
Chartered Market Technician

Shared content and posted charts are intended to be used for informational and educational purposes only. The CMT Association does not offer, and this information shall not be understood or construed as, financial advice or investment recommendations. The information provided is not a substitute for advice from an investment professional. The CMT Association does not accept liability for any financial loss or damage our audience may incur.