Technically Speaking, June 2008

At the MTA One-Day Symposium on May 16, 2008, three technicians discussed their best trading ideas for the rest of the year.

Roque began by displaying a chart of the CRB Index relative to the S&P 500. In his opinion, this chart illustrates that we are not in a commodities bubble and commodities can move much higher off the 2001 bottom in that relationship.

Roque also presented a series of innovative charts showing the weighting of several sectors within the S&P 500. Stocks in the financial sector represented 23% of the market cap of the S&P when they peaked in late 2006. They currently represent 17% of the index, and have historically, on average, made up 13% of the index. His conclusion is that they still have room to go lower. As an additional bearish factor weighing down this sector, Roque pointed out that some of the large financial stocks are making 10 year lows in price, and he could not find examples of stocks recovering quickly after breaking down so badly.

Basic material stocks represent only 3% of the market cap of the S&P 500, compared to their long-term average of 9%. Energy stocks, at 14% are slightly above their long-term average of 12%. Bullish on both groups, Roque pointed out that we are in a “reversion beyond the mean business” and sector weightings, just like stock prices, tend to move significantly above and below their long term averages.

Looking at the ratio of gold prices to the Dow Jones Industrial Average, Roque pointed out a 14-year cycle. The most recent cycle started in 1999, and he expects gold to continue outperforming stocks.

He presented several yearly price charts, offering a long-term perspective on a few stocks. Alcoa (AA), El Paso Corp (EP), and other natural resource stocks are bullish, in his opinion. Both the Dow Industrials and Transports look to be bullish, as is Thailand. A significant upward move in Japan is possible from current levels which have offered support in the past, and Mitsubishi is one name that he likes. Roque showed the yearly chart of Dell (DELL) which he thinks is particularly bearish, and said it may become “the RCA of our generation.” (Editor’s Note: RCA was the high fl yer of the bull market culminating in the 1929 crash, appreciating 936% in the five years leading up the crash. It declined by 97% in the ensuing bear market.)

Yamada followed and agreed with Roque’s bullish comments on gold, noting that gold reversed a 22-year downtrend in 2002 and is now in a structural bull market. The CRB Index broke a 23-year downtrend in 2002/2003 and is also in a bull market – she especially likes the long-term charts of the agricultural commodities. Oil prices overcome longstanding resistance levels which had repelled advances for 24 years in July 2004. Her very long-term target for oil, in the coming decades, is as high as $450 a barrel. (Editor’s Note: Although time constraints prevented her from expanding on this target, interested readers can see the supporting analysis for this projection at her web site, http://www.lyadvisors.com/samplereports/TechnicalPerspectives.Oct31.2007.Oil.pdf.)

In the stock market, Yamada noted that mid cap stocks have been outperforming other segments of the market. Her well-known Capital/Consumer Ratio has been showing strength in capital goods since 2002. Due to a pattern of alternation between short and long cycles, she expects this cycle to last 10-12 years. She is bearish on financials, with some exceptions such as AFLAC (AFL), consumer discretionary companies, and healthcare. There were many point-and-figure charts of individual companies she shared which showed long-term downtrends in these areas.

Industrial stocks, energy, utilities and some IT stocks should do well in her opinion. Specific names that have bullish point-and-figure charts included Eastman Chemical (EMN) and DuPont (DD). Within IT, she cautioned that selectivity is very important due to rapid commoditization within the technology sector. Sybase (SY), BMC Software (BMC), and MacAfee (MFE) were names she mentioned. Yamada stressed that small and mid cap stocks will likely outperform large caps in these industries.

When discussing energy, Yamada reinforced Roque’s point about studying the market cap of a sector within the S&P 500. These stocks represented 27% of that index at their peak in 1980, and only 6% at their low in 2003. There is significant potential for further gains from their current weighting of 14%. She highlighted Chevron (CVX), Anadarko Petroleum (APC), and Halliburton (HAL).

As readers of her classic book Market Magic are well aware, Yamada brings unique macroeconomic insights into the field of technical analysis. In this short talk, she alerted the audience to the fact that everyone may be looking for inflation in all the wrong places. She sees increasing prices for food, water and energy impacting the global economy of the future. Agriculture accounts for approximately 40% of the CRB Index, but uses about 80% of the world’s water. As more agricultural production goes towards energy, increasing demand will increase the need for water, which is actually a limited resource in much of the world. With increasingly higher oil prices driving demand for electric cars, she noted that the electric grid is perhaps the weakest link in that energy infrastructure and upgrades will be needed to seriously challenge the role of oil in transportation. In all, it was a thought provoking presentation.

Larry Berman concluded the panel discussion with very specifi c recommendations supported by his agreement with the other two panelists that hard assets are likely to continue to do well and chart analysis:

• iShares MSCI Emerging Markets Index (EEM)
• Materials Select Sector SPDR (XLB)
• Financial Select Sector SPDR (XLF)
• Market Vectors Steel ETF (SLX) offers exposure to global steel companies
• Market Vectors Global Agribusiness ETF (MOO) which includes Potash as one of its largest holdings. This fertilizer company has the largest market capitalization in the Canadian stock market.
• Energy Select Sector SPDR (XLE) which Berman noted can be highly volatile.
• KBW Regional Banking ETF (KRE) will be a trade after a dip.

Obviously a strong proponent of ETFs, Berman noted that healthcare is one area where ETFs fail to provide exposure to the stocks likely to be the biggest winners. Large cap stocks will dominate sector indexes and ETF holdings in this and any other sector. But in this field, the biggest winners are likely to be the small cap stocks that find new cures and develop the breakthrough technologies.

As a trade on narrowing spreads in US treasuries, Berman suggested going long ProShares Ultra Short Lehman 20+ Year Treasury ETF (TBT) and long iShares iBoxx Invest Grade Corp Bond (LQD).

You can’t open a financial media outlet without seeing a story on Bear Stearns [BSC]. One of the most recent stories I have seen about the stock, other than the fact JP Morgan could increase its bid to $10 a share, is the SEC is probing into sell transactions on BSC and if someone had inside information. It makes me think back to the days of late 2001 when Imclone [IMCL] imploded on a bad FDA report, and sold off sharply from the 60’s to an eventual low in the single digits. It was the sale of IMCL on reported insider information and subsequent lying to the Fed’s that landed Martha Stewart in jail. The infamous scribble note to sell “at $60” and what precipitated that note will go down in history. Of course had Martha Stewart just been looking at the Point & Figure chart of IMCL the reason she sold at $60 would have been quite apparent. In fact, IMCL had been a buy recommendation of ours with a stop loss point of $62 and another sell recommendation at $60 on a second consecutive sell signal. Here’s the exact quote from our reports back in 2001:

If we take a look at the Point & Figure chart of the Bear Stearns [BSC] in the spring of last year, 2007, it was quietly telling us that supply was gaining the upper hand. The Point & Figure Methodology is merely a logical organized way of recording the supply and demand relationship. The Point & Figure chart just takes a string of numbers, the high and low data, and put it into a logical organized fashion. If I gave you the following numbers, what do they mean?

8043208511

It probably doesn’t mean anything. However, what if I put those exact same numbers into the following format? What does it mean to you?

804 – 320 – 8511

Now you know instinctively that is a phone number. The first three digits tell you the area code or a region. Then the next three digits pin points a smaller area within that region and the final three digits tell you the exact phone location. The Point & Figure chart merely takes the high and low string of data for a stock and put it into a very usable format that we can make sense out of. In fact, take a look at the string of data on the next page and the corresponding Point & Figure chart.

This chart is of Bear Stearns in the spring of 2007. Notice that just looking at the high and low data you wouldn’t have known that it was clearly showing a series of lower tops and lower lows. In fact, if we put this chart into a longer term context, it would have shown that the long term bullish support line was being violated. In our Daily Equity & Market Analysis Report we featured BSC and recommended that those who owned the stock move to the sidelines or hedge in some manner. Here is that feature from June 26th 2007.

Reprinted from Tuesday, June 26th 2007 Report: DWA Comments on Bear Stearns, Inc. leading up to the Collapse [BSC] Bear Stearns ($142.06): This Wall Street company was a sector leader for years. A look at the peer relative strength chart of BSC shows a buy signal on August 3rd 1999 to suggest that the stock is likely to outperform a basket of Wall Street names. BSC did indeed lead the way for the sector, posting gains of 244% compared to 140% while its peer relative strength chart was in X’s. That eight year run has come to an end though as the peer relative strength chart for BSC moved to a sell signal on June 20th. But this is not the only ominous technical sign for BSC. The stock’s market relative strength chart has reversed down into O’s and the trend chart has turned negative. The overall trend of BSC has been positive since 2003 and the bullish support line just recently violated in March at 140 had been in effect since 2005. Besides just violating the trend line, BSC has been making lower tops and lower lows with the most recent breakdown coming at 142 last week, a bearish catapult formation. The best way to summarize this data is through the technical attribute score. For BSC this score was a 3 or better, indicating strength versus both the market and the peer group, from June 25th 2004 to June 20th 2007. Now that the technical attributes have slipped to only one positive, it suggests that the odds are no longer stacked in BSC’s favor. Those long BSC should look to move to the sidelines or at least hedge their positions in some manner through reducing exposure or the options market. On the downside, the next support for BSC is going to be the 122 to 132 area.

Additionally, BSC made its way onto the DWA Equity Roster that same day as a recommended short citing in the June 26th Daily Equity Report as well that “BSC is a member of the Average Wall Street sector. This particular group has been sluggish lately, with BSC being the poster child for this negative action. BSC had been a perennial leader in the group until January when it peaked at 172. Instead of continuing to move to new highs, BSC has since faltered from that January peak, showing a series of lower tops and lower bottoms. As well, the long term trend has turned to negative (back in March); and more recently, the RS has started to deteriorate. Specifi cally, BSC has given a Peer RS sell signal, and the market RS chart has reversed to O’s. In all, the technical attributes have downticked to a lowly 1 for 5. Strong initial resistance has formed at 152, while the longer term bearish price objective is 106 based on a vertical count. Momentum is negative on both a weekly and monthly basis. In all, BSC is one to avoid (as outlined in the Market comment section). In addition, BSC is one to consider as a short, for those so inclined. Ok to sell BSC short on a slight bounce back up (140-146 range). We would then use 154 as the buy stop point as that would break a triple top and violate the downtrend line.”

The ensuing months didn’t alter the picture for BSC. The stock continued to show negative relative strength versus both the market and the peer group as it maintained a negative technical attribute rating. As well, we continued to see the Point & Figure chart give sell signals to tell us that supply still firmly had the upper hand over demand. So while we never know whether a breakdown like that of Imclone at $62 and Bear Stearns at $142 will lead to a sharp decline that takes the majority of investors money away, we do know that the supply and demand picture is changing for the issue and we’d rather err on the side of caution and move our money out of harm’s way. We can always make up opportunity but it’s hard to make back that money. 

This was originally published by Dorsey Wright and Associates on March 25, 2008 and is reprinted here with permission. For additional information, please visit their web site (www.dorseywright.com) or contact Susan Morrison at [email protected].

Relative strength was used by two technicians to identify the deteriorating conditions of BSC. Kristin Hetzer, CMT, CIMA, CFP, submitted the chart of BSC relative to the S&P 500 index (Figure 1). She noted that “the decline in relative strength and sell signals could have been used along with the price chart strongly suggesting exit from this stock.” Her annotations can be seen on the chart. Kristin is the Principal at Royal Palms Capital LLC.

Robert Peirce, principal and co-founder of Cookson, Peirce & Co., Inc., noted that “on a weekly basis, the high was 01/12/07 at 169.67. Under our current rules, we would have sold three weeks later at 164.56 when the Alpha rank reached 21. Had we held the stock under the old rules, we would still have been out after 03/02/07, when the rank reached 54 and the price was 145.90. Either way, there was no reason to hold the stock below 140.

Our current rules are to sell a stock held longer than 15 months when its rank goes to 21 or higher. We used to wait until it got weaker than the market (rank over 50), but we decided, once you had a long term gain, why wait? Testing bore that out.”

It’s interesting that at least three fi rms would have had clients completely out of BSC, long before the collapse, by relying on the principles of technical analysis.

The recipients of the 2008 Charles H. Dow Award are Assistant Professor Samuel L. Tibbs, Professor Stanley G. Eakins, and Mr. William DeShurko, CFP, for their paper entitled “Using Style Index Momentum to Generate Alpha.” Dr. Tibbs summarized the results of their research at the MTA Symposium on May 16, 2008.

We have all heard that “past performance is no guarantee of future results,” but recent work provides some support otherwise. Specifically, this research demonstrates that Russell style indexes exhibit significant momentum, particularly after medium term relative out- and underperformance.

Prior research provides evidence of style momentum at the firm level, but the construction of such portfolios can be costly. Therefore, we measure style momentum at the index level, which can easily be represented by exchanged traded funds, thereby providing a low expense, diversified method to exploit such momentum.

We are motivated to test the existence of style index momentum due to the proliferation of style index benchmarks and we focus specifically on Russell since the majority of institutionally managed U.S. equity funds are benchmarked against Russell indexes.

To analyze the extent to which momentum may exist, we analyze various formation periods to rank the six style indexes (Small Value/Growth, Mid Value/Growth, and Large Value/Growth) based on their prior period return. For each index held, we then calculated subsequent returns for various holding periods.

Focusing on twelve month formation and one month holding period returns, we begin our test of style index momentum by ranking the six Russell style indexes based on prior twelve month performance. To construct the long portfolio, the style index with the top prior twelve month performance is purchased and held for a minimum of one month. Next, on a monthly basis, the portfolio is analyzed for rebalancing based on the prior twelve month performance relative to the other five indexes. For the 34 years analyzed, 1972-2005, the long portfolio return was 18.77% annually, while the 2001-2005 return was 11.38%.

The short portfolio is constructed similarly, except the short position is established in the style index with the worst prior twelve month performance. As with the long portfolio, the short position is held for a minimum of one month and on a monthly basis is analyzed for rebalancing. For the 34 years analyzed, the short portfolio returned 7.40%, while the 2001-2005 period return was 4.59%. This, combined with the long portfolio, results in the long-short portfolio return of 9.25% annually over the 34 year period and 4.31% for the 2001-2005 period.

To summarize style index momentum trading strategies have outperformed the market on both a raw and risk-adjusted return basis. Even though the excess returns vary, they are robust through time and after controlling for potentially confounding 
effects. Additionally, the returns are not driven by any single style index and portfolio reconstruction is, on average, only required every six months.

Samuel L. Tibbs, Ph.D., CFA, completed six years in the U.S. Navy and then decided to pursue his education in finance due to a personal interest in investing. Professor Tibbs earned his doctorate in finance from the University of Tennessee in 2003 and became a CFA Charterholder in 2006. His research interests, in addition to momentum trading strategies, include corporate crime and credit ratings. Currently he is an Assistant Professor of Finance at East Carolina State University.

Stanley G. Eakins, Ph.D., was Vice President and Comptroller at the First National Bank of Fairbanks and a commercial and real estate loan officer. Since receiving his Ph.D. from Arizona State University in 1990, Professor Eakins has been at East Carolina State University and is currently the Associate Dean for the College of Business following five years as chair of the Finance Department. He is the author of Finance, 3rd Edition and is the co-author of Financial Markets and Institutions, 6th Edition, both published by Prentice Hall.

Editor’s note: This is a summary of the paper which was recognized as a runner-up in the Dow Award competition. The complete paper may be downloaded from the MTA web site.

There are two crucial factors when trading with oscillators. Firstly, the Probability Density Function (PDF) of the detrended data depends heavily on the way the detrended data is computed. Secondly, one must anticipate the turning point of the detrended data because if one waits for confirmation with these relatively fast indicators most of the move is over before trade entry or exit can be made. Taken together, these two factors can infer the best trading system to be employed.

Detrending using RSI techniques typically results in the data having a Gaussian-like PDF. Therefore, one can use the traditional 20% and 80% levels as entry points – with the added trick that one sells short when the RSI crosses above the upper threshold and buys when the RSI crosses below the lower threshold. This is done because the probability of the data crossing these thresholds signals a reversion to the mean in advance of the turn.

Detrending using a highpass filter typically results in a nearly uniform probability distribution of the detrended data. In this case one can apply a Fisher Transform to “Gaussianize” the PDF. Having done this, one can create a trading system crossing upper and lower thresholds similar to the RSI trading system.

If the data are detrended using a Stochastic-like approach, the PDF of the resulting detrended data is similar to the PDF of a theoretical sine wave.  In this case, the best trading system constructed by assuming the data are a sine wave and then correlate that data with the frequency and phase of a pure sine wave. Having the correlation, one then simply advances the phase of the sine wave to get the anticipatory turning point signal.

The paper presents examples of the PDFs and the results of the trading systems over a range of symbols and the full duration of the futures contracts to demonstrate the robustness of the approach.