Market Technician No 58

It has been a testing time in the markets and the articles in thisissue of the Journal demonstrate how the tools of technicalanalysis can be used to pick up early on shifts in sentiment. Atour December meeting, Anthony Bolton spelt out the reasonswhy he felt the market was due a correction and the presssubsequently reported that Fidelity had been busy buying putoptions.Yet again, Anthony Bolton has proved to be right onthe market trend. When John Noyce was asked if he wouldwrite up his talk on the emerging markets he said that hewould but that he felt that the yen was a much moreinteresting subject for an article. John submitted his article inmid-February just before a meeting of the G-7 financeministers when the dollar/yen rate was hovering around the¥120 level. The lack of any specific policies to support theJapanese currency as a result of the meeting promptedrenewed selling pressure and the yen briefly popped above¥121 before the sharp correction set in that John had soperceptively anticipated.

In February, the STA was formally contracted by IFTA to createand mark IFTA’s CFTe1 and CFTe2 exams internationally on anongoing basis. This is a major coup for the STA and reflectsvery well on the high regard with which STA Education is heldaround the world.

We would like to take this opportunity to thank Jim Howshipfor kindly making his collection of books on technical analysisavailable to the Society.

Another person whose contribution to technical analysisdeserves recognition is John Brooks. He has been a technicalanalyst for the last 44 years and was one of the founders ofthe Market Technicians Association of the USA, later becomingPresident of that organisation. He was also one of the firstpeople to acquire a Chartered Market Technicians (CMT)

designation. Later he served as Chairperson of theirEducational Foundation for many years and was instrumentalin establishing accredited classes at college level. In 1998, Johnwas given the MTA’s annual award for an OutstandingContribution to the Field of Technical Analysis, a well deservedhonour. More recently, he was one of the main influencesbehind the establishment of the American Association ofProfessional Technical Analysts (AAPTA) and he currentlyserves on its Board of Directors. However, his work in thepromotion of technical analysis has not been only confined tothe US. He was one of the founders, in 1985, of theInternational Federation of Technical Analysts (IFTA), whichtoday includes 25 nations and has 7000 members worldwide.John served as IFTA’s Chairperson from 1996-1998, andthrough this and other varied roles in IFTA,‘Brooksie’ has beena guiding light of the organisation and has made many friendsin technical analysis round the world. He has also been amember of the STA for a number of years. Beside all this, Johnis the author of a book called ‘Mastering Technical Analysis.’ Forhis great contribution to technical analysis worldwide, theBoard has voted to make him a Fellow of the Society.

Finally, advance warning of a couple of dates for your diaries.Reuters have kindly offered to host the Society’s summerparty on 11th July and this year’s IFTA conference will be heldin the Egyptian Red Sea resort of Sharm el-Sheikh from 8-11thNovember.

IN THIS ISSUE

STA Exam Results . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2

P. Desmond Food for thought . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

A. Bolton How I use technical analysis

in my decision-making process . . . . . . . . . . . . . . . 4

R. William Book review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5

Bronwen Wood Memorial Award . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5

D. Watts Bytes and pieces . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5

J. Noyce A technical assessment of the yen . . . . . . . . . . . . 6

R. Adcock Momentum, trending and sentiment. . . . . . . . . 8

COPY DEADLINE FOR THE NEXT ISSUE 31ST MAY 2007

PUBLICATION OF THE NEXT ISSUE JULY 2007

FOR YOUR DIARY

Wednesday 9th May Monthly meeting

Wednesday 13th June Monthly meeting

Wednesday 11th July STA Summer partyat Reuters

N.B. Unless otherwise stated, the monthly meetings will take

place at the Institute of Marine Engineering, Science and

Technology, 80 Coleman Street, London EC2 at 6.00 p.m.

April 2007 The Journal of the STAIssue No. 58 www.sta-uk.org

MARKET TECHNICIAN

MARKET TECHNICIAN Issue 58 – March 20072

CHAIRMAN

Adam Sorab: [email protected]

TREASURER

Simon Warren: [email protected]

PROGRAMME ORGANISATION

Mark Tennyson-d'Eyncourt: [email protected]

Axel Rudolph: [email protected]

LIBRARY AND LIAISON

Michael Feeny: [email protected]

The Barbican library contains our collection. Michael buys new books for it

where appropriate. Any suggestions for new books should be made to him.

EDUCATION

John Cameron: [email protected]

IFTA

Robin Griffiths: [email protected]

MARKETING

Clive Lambert: [email protected]

David Sneddon: [email protected]


Karen Jones: karen.jones@ commerzbank.com

MEMBERSHIP


REGIONAL CHAPTERS

Alasdair McKinnon: [email protected]

SECRETARY

Mark Tennyson d’Eyncourt: [email protected]

STA JOURNAL

Editor, Deborah Owen: [email protected]

WEBSITE

David Watts: [email protected]


Deborah Owen: [email protected]

Please keep the articles coming in – the success of the Journal depends

on its authors, and we would like to thank all those who have supported

us with their high standard of work. The aim is to make the Journal a

valuable showcase for members’ research – as well as to inform and

entertain readers.

The Society is not responsible for any material published in The Market

Technician and publication of any material or expression of opinions

does not necessarily imply that the Society agrees with them. The

Society is not authorised to conduct investment business and does not

provide investment advice or recommendations.

Articles are published without responsibility on the part of the Society,

the editor or authors for loss occasioned by any person acting or

refraining from action as a result of any view expressed therein.

NetworkingWHO TO CONTACT ON YOUR COMMITTEE

Autumn 2006

DISTINCTIONSMichael Estrey Khaldoun Al-Janini

Christopher Hine K J Perumal Raja

Mark Andrew Lim

PASS Tarek Al-Showaier Marc Dagher

Mark Paul Cullen Mathieu Lebrun

Matthew Daniels Fabien Letheuil

Stefano Errico Ngian Yew Pin

Nicole Ooi Alhaitham Al-Ghothami

Hussain Alquatari Nabil Effat

Visual Trader 3.0

Nirvana Systems, Inc has released Visual Trader 3.0 which provides

a visual tool for equity sector ranking and analysis. The program

enables the user to identify sector rotation and then focus in on

strongest or weakest stocks in those sectors. It allows the user to

play back past market behaviour to test a strategy and see the

results. A visual demonstration is available, see:

ttp://www.visualtrader.com/VTDemo/

SnapSheetsevery popular Worden, with its Telechart software, has released a new

modular charting package.You simply add the necessary modules

you need together as your needs change by mixing and matching

the pieces you want. As all the standard modules, such as charting,

back testing and scanning etc, communicate with all the others it

makes a seamless package. Combine this flexibility with Worden’s

data and you have an excellent equity analysis package, see the

website for further details:

http://www.worden.com

Data ConversionWith so many propriety databases for so many TA programs, data

conversion can become a real issue. There are very few flexible

programs that can convert between data formats. One of the few

tools is Data Shark that can convert between formats like

Metastock,Omega, AIQ,ASCII Telechart etc. It is a pity they don’t

have more UK format TA conversion tools, but they may add other

data types upon request. One of the few essential tools for the tool

box.http://www.datasharks.biz/DataConverter_Info.php

Another Data SourceApart from Q-data in the UK, searching for longer terms data series

can be frustrating. Finding long term data on the North American

markets is also challenge so Prophet Data may be worth a try – they

have decades of data series for most North American Equities and

Futures in Metastock data format. A useful resource and especially

when combined with a data converter.

http://www.prophet.net/

STA diploma exam

Bytes and pieces

Issue 58 – March 2007 MARKET TECHNICIAN 3

One of the indicators that we

monitor at Lowry’s reports is the

percentage of Lowry stocks

trading above their 10-day

moving averages. This indicator

has proved to be very helpful for

our clients in measuring the short

term extremes of market

selectivity. A number of

significant buying opportunities

have been identified in the past

after periods of market weakness

have caused the percentage of

stocks above their 10- day moving

averages to drop below 10%.

For example, as a result of the

recent intense stock market drop

beginning on February 27th, the

10-day % indicator dropped from

its early-February’07 peak of

84.6% to a low of just 3.77% on

March 5th, reflecting a deeply

oversold market condition. The

table below lists all similar cases

since 1990 in which the

percentage of stocks above their

10-day moving averages has

dropped below 10%, and the

resulting market action, as

measured by the DJIA, over

subsequent 2 weeks, 3 months,

and one year periods:

In summary, since 1990, there

have been 18 cases in which the

percentage of stocks above their

10-day moving averages has

dropped below 10%. In 78% of

those cases, the market was up an

average of 2.98% in the next two

weeks. In 94% of the cases, the

market was an average of 8.9%

higher in the next 3 months. And,

in 94% of the cases the market

was up an average of 20.1% in the

next 12 months. The chart below

of the Dow Jones Industrial

Average shows the approximate

locations of each of the dates

included in the above table.

Paul Desmond is the President of

Lowry’s Reports Inc., the oldest

technical advisory service in the US.

www.lowrysreports.com

Food for thoughtBy Paul Desmond

Date Lowest DJIA % Change DJIA % Change DJIA % ChangeLevel 2 weeks later 3 months later 12 months later

Aug. 23, 1990 1.93 + 5.5% + 2.30% + 21.1%

Oct. 11, 1990 9 + 5.0 + 5.8 + 25.9

Nov. 19, 1991 9.75 - 0.7 + 11.9 + 8.9

Apr. 4, 1994 4.06 + 0.8 + 1.7 + 16.0

July 16, 1996 6.14 + 2.3 + 12.2 + 48.8

Oct. 27, 1997 3.07 + 5.5 + 10.5 + 16.8

Aug. 31, 1998 4.71 + 6.4 + 20.9 + 43.6

Sep. 21, 2001 4.51 + 10.7 + 21.8 - 4.4

July 23, 2002 1.89 + 7.4 + 10.9 + 19.4

Sep. 24, 2002 5.55 - 2.4 + 10.6 + 22.7

Jan. 27, 2003 4.94 + 0.9 + 6.0 + 32.8

Mar. 12, 2003 7.13 + 9.0 + 21.6 + 34.1

May 10, 2004 7.45 - 0.32 - 0.45 + 2.91

Jan. 5, 2005 6.94 - 1.19 - 0.49 + 2.68

Apr. 15, 2005 9.41 + 1.04 + 5.49 + 9.78

Oct. 12, 2005 7.93 + 1.25 + 7.3 +16.94

May 18, 2006 8.55 + 1.07 + 1.86 ?

June 13, 2006 7.93 + 2.04 + 7.4 ?

Feb. 27, 2007 8.04 ? ? ?

Average Gain/Loss 2.98% 8.88% 20.90%


General investment approach

The main thrust of Anthony Bolton’s investment approach is tolook for securities that are, in his view, mis-valued by the market.He is, therefore, very much a contrarian investor, buying intounfashionable companies and sectors. In particular he tries toidentify:

• Industry anomalies

• Turnaround or recovery situations

• Unrecognised growth

• Attractive assets

• Corporate potential

Bolton is currently responsible for managing Fidelity’s SpecialSituations Funds. Most of the portfolio is invested in ‘mid-cap’and larger ‘small-cap’ stocks and around 15-20 per cent is inoverseas companies. The average holding period for a stock isone to two years.

Technical analysis overlay

Bolton finds technical analysis provides a useful discipline to hisportfolio management. He uses it as a cross check for hisfundamental views and to help decide when it is appropriate tobet against the crowd and when it is not. He also uses it todetermine the size of a position. If the fundamentals look goodbut are not confirmed by a positive technical reading, he willopen a relatively small position and add to it if and when thetechnicals signal an upturn in buying momentum. When thefundamentals and technicals are both giving positive signals, hewill take a bigger initial position in the stock. If the technicalsbegin to deteriorate, he will start selling the stock.

Technical analysis also helps to pick up on changes in sentimentand investment flows. It is the general perception of what a stockor market is worth that is important in determining whathappens to the price. Another important indicator of sentimentwithin a company is what the directors are doing in terms ofbuying and selling their own company’s shares. The rise in

directors’ sell to buy ratio on both sides of the Atlantic is just oneof the reasons why Mr Bolton believes it is likely that we will seeanother leg to last year’s correction.

Market outlook

Mr Bolton reminded the audience that he first addressed the STAin 1987 and almost two decades later he is again in a bearishframe of mind. The reasons for his more cautious stance are:

• The bull market is over three and a half years old. Since March2003 the market is up 87% which is around the average rise inbull markets but in terms of length it is the second longestsince 1966 (see chart 3).

• Value opportunities are scarce (see chart 4).

• Investors’ appetite for risk has returned and they are notdifferentiating between high and low risk stocks (see chart 5).

• There has been a mini bubble in both commodities andinfrastructure investments

Against these negatives, he pointed out, must be weighed thevery strong support that is coming into the market from privateequity funds.

How I use technical analysis in my decision-making processThis article is a brief summary of a talk given by Anthony Bolton to the Society on 6th December, 2006

Chart 2: UK & US equities with directors selling and buying

Chart 1: How I look at a company

Chart 3: UK (FTSE All Share) bull markets > 20% since 1966


Summary

The bull market is long in the tooth and so this is the time to befocusing on the good quality, larger growth stocks. In Fidelity’sSpecial Situations media stocks have the largest weightingfollowed by oil and gas.

Mapping the MarketsDeborah Owen and Robin Griffiths, Profile Books 2006 £20

It is a privilege to commend this book to the great multitude ofinvestors, traders and analysts, who are eager to enhance theirknowledge of the global financial markets - whether in equities,currencies, interest rates or commodities.

"Mapping the Markets", the brainchild of two well-knownpractitioners in the world of technical research; Deborah Owenand Robin Griffiths, amalgamate the disciplines of economic andtechnical analysis, showing how investors can position themselvesto benefit from both specialties.

The authors expound on the work of Joseph Schumpeter - thisbeing the backbone of their methodology - and illustrate howSchumpeter's 'three-cycle schema' culminate in trends in thestockmarket that last for generational periods of time (seculartimeframes) or in cycles of shorter duration. Particularlyinteresting is the revelation of the four-year cycle in the USstockmarket, otherwise dubbed the Kitchin cycle in Schumpeter'swork, and is shown to have become phase-locked with the USpresidential-election cycle.

At the microscopic level, the authors share a unique system foridentifying stocks and conducting top-down analysis that begetsfrom the four-year cycle. The methodology aims to identify thestrongest trending markets and stocks based on short, long andrelative strength trends and is particularly useful for determiningsector rotation within the business cycle. Having applied thisanalysis, they illustrate simple chart patterns that can be utilisedin conjunction with this methodology to sharpen market timing.

On another note, the book is instrumental in revealing how moreesoteric concepts like demographics and natural resourceallocation are key in paving the economic destinies of countriesand is apropos in interpreting China and India's boom story.

Finally, it is worth highlighting that the primary strength of thisbook is separating the wheat from the chaff to provide a no-nonsense approach to deciphering financial markets in theirchanging landscapes.

I only wish that I had this book ten years ago!

Chart 4: On price-to-book, equities are expensive

Chart 5: US sentiment model

Chart 6: Positioning

Book reviewBy Ron William, Bloomberg

Bronwen Wood Memorial Award

The Bronwen Wood Memorial Award is normally awarded to

the candidate with the best mark in the diploma examination

but this year it was felt that two candidates deserved to be

recognised. Michael Estrey and Mark Andrew Lim submitted

exceptionally good papers and impressed the examiners with

the depth and range of their knowledge of technical analysis.

They both obtained 94%. Congratulations to both of them.


The major cross exchange rates against the yen (cross/JPY) basedin October 2000 and, since then, we have seen a marked weakeningof the yen against all of the major developed currencies, i.e. thecross/JPY rate has moved higher.The initial part of this move didnot receive that much attention but, over the last few months, asmulti-year highs have been reached on a number of well-tradedcrosses, such as GBP/JPY, the yen’s decline has hit the headlines.Thisis a good time to take a step back and look at the big picture. Is theyen really “going down for ever” as some analysts would have usbelieve or is it just the time we should start to be cautious? Thisshould be a time when technical analysis is at its best.

The chart below shows how the yen has performed versus anequally weighted basket of the “G10” currencies; USD, EUR, GBP,AUD, CAD, NZD, NOK, SEK and CHF. A move higher on the chartreflects yen weakness, whereas a move lower shows the yenstrengthening (the same convention as the quotation of individualG10/JPY foreign exchange rates).

Even a quick glance at the chart shows just how far the market hasmoved over the last six years. In October 2000 the basket stood at74.35, by January ‘07 the monthly close was 114.74 - a rally of54.32%. Keep in mind that’s a 54.32% depreciation of the yen on avery broad basis; it being, by definition, the average amount whichthe JPY has depreciated against the constituents of the basket overthat period. No wonder funding in yen has become so engrained inthe psyche of global investors and households alike. Fund at nearzero and your liability also depreciates over time.

That’s enough of the history, what’s going on technically? The firstthing to note is that the basket has now reached the major highmade in August ‘98.That is the point from which the last majorcorrection in the basket began when - although arguably differentin structure - the last “global carry trade” had built up.Those in theforeign exchange markets at that time will remember the speedand depth of the correction that followed. At this point it’simportant to highlight that the aim of this article is not toscaremonger that a similar move is coming now.With our old friendhindsight, we know that there were specific catalysts which helpedto speed up the market correction in ‘98. However, technical

analysis is all about looking ahead, and seeing how strong a marketreaction is likely to be if, and when, a suitable catalyst emerges. Agood indicator to look at in this regard is the period the market hasbeen above/below certain moving averages, in order to ascertainwhether the market has become “historically stretched” in terms ofthe duration of the current trend.We believe the 55-day movingaverage is very helpful in this respect (note 55 is part of theFibonacci Sequence; 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55....).The daily chartof the same G10/JPY basket shown below highlights just how longthe market has been above this particular average. It is the longestabove-trend period in history and is given added significance bythe fact that the market closed above the ‘98 high on 26th May ‘06and has not traded below this level since.

This extended period does not, in its own right, give a signal to lookfor a reversal. In terms of the number of days above the average,the market has been moving into uncharted territory for some timenow but it does indicate the size of positions that have been builtup in the “carry trade”.

From a technical stand point, the market is, therefore, very stretchedas it approaches a major pivot.

So what would the signal of a larger correction or turn be?Theoretically, the answer is relatively straight forward. At the timeof writing (mid-February), the test of the moving average assupport is the eleventh such test since the market closed above themoving average in May ‘06 - an incredible number of tests of oneindividual support level. In the light of this, a close below it wouldseem to be pretty significant and, in our experience, would openthe way for a potential target of the 200-day moving average whichstands 3.5% below the 55-day moving average.That may not soundmuch in terms of a correction, but two things are important. Keepin mind that this would target a 3.5% broad appreciation of the yen.Also, the 200-day moving average is only an initial corrective target;corrections/turns will often extend further than the initial target.

Earlier we highlighted that the G10 basket has now reached themajor high dating back from ‘98 (August).With this in mind, it’sinteresting to look back at how the market subsequently traded, andspecifically the moving average setup, after the ‘98 highs were set.

A technical assessment of the yenBy John Noyce

Figure 1

Figure 2


The two charts shown above in chart 3 show just this; the upperone being the G10/JPY basket back in ‘97-’98 and the lower one thebasket’s recent performance. As can be seen, the relationship withthe 55-day moving average worked in ‘98 too. As the market wentinto the January ‘98 highs, it had also been above the 55-daymoving average for a “significant” period - although not anythinglike as long as the current position. Once it had broken down belowthe 55-day moving average, it quickly moved lower to slightlybeyond the 200-day moving average before again beginning totrend higher. As the market moved up to the actual cycle high inAugust ‘98, the basket rate had, therefore, been above the sameaverage for an extended period.The close below this line was asignificant signal, and note that the correction (in fact turn in trend)that took place afterwards took the market significantly beyond theinitial 200-day moving average target.

To sum up: Our G10/JPY basket is now at, and correcting from, amajor long term pivot. It is also more stretched in terms of theperiod it has spent above/below this one moving average that it hasever been before.The risks of a larger downside correction grow.

With that broad view in mind, we will now look at USD/JPY (Chart 4), one of the most important yen-related currency pairs. It,too, has moved significantly higher (in this case over the past twoyears), moving from a low of ¥101.67 in January ‘05 to a high of¥122.20 in January this year. At the lows in early ‘05, you wouldregularly hear phrases such as “..any bounce is a sell, the rate justhas to go down, it’s only the BOJ that’s going to hold it up.”.We’renow a long way above those levels and the Bank of Japan hasn’tintervened in the USD/JPY market for over two years.With theupward move has come a sea-change in sentiment. Now thecommon phrase is “..you’ve got to buy the pull-back, think of thecarry, so what if the Bank of Japan is going to raise rates to 0.5%?”Well, the jury is still out on whether this is a major turn or not butjust as at the lows in January ‘05 were a warning sign that themarket was basing prior to an upside turnaround, so there arewarning signs now that the market is topping out and potentiallyturning to the downside or at least a meaningful correction.

At first glance the monthly chart of USD/JPY, appears to have cleanlybroken above the long term downtrend from the ‘98 highs and twoother resistance points that come in around the same level.

But is it really that simple? If you look at the weekly price actionshown on Chart 5, it is not so clear. Although not as significant asthe support provided by the November ‘99 low at 101.25 in January‘05, the December ‘05 high (resistance level) comes in at 121.40.

Thus far, the market has not been able to hold above this importantresistance point. Instead, it has spent three weeks consolidatingunder it in a volatile fashion.To end the period of consolidation themarket has now posted a bearish weekly reversal (to achieve this, atsome point during the period, the market must trade above theprior period’s high, but then reverse to close below the previousperiod’s low). In this case, the sequence was achieved with a closebelow 119.96. In turn, this is causing weekly momentum to turnlower from very similar levels to that seen at the December ‘05highs, i.e. the high from which the prior significant downside turnwas made.The daily charts have also formed a double top which,although only a short term development, targets a move to 117.78calculated as the distance from the neckline (6th February low at119.96) to the trend across the two highs which create the doubletop (29th January and 12th February highs) projected from theneckline itself (6th February low at 119.96).

In conclusion, the warning signs are that just as USD/JPY appears

to be making a clear break to the upside on the monthly charts, it

is actually becoming tired and susceptible to a downside turn.

Given the developments discussed previously on our G10/JPY

basket, the warning signs are that a material turn to the downside

may not be far away, just as it appears the “all clear” has been

sounded for the trend to continue. Remember,“the carry trade

will go on for ever”, just as “USD/JPY was a sell on any bounce at

the lows in January ‘05”.

John Noyce, Technical Analyst, Citigroup

Figure 3 Figure 4

Figure 5


Throughout my years within the financial industry and, inparticular, my involvement with technical analysis, it’s becomeapparent to me that there are three distinct areas that dominatemy market appraisal – sentiment, momentum and trending. I havefound that a consistent approach to each gives me a reliableinsight into where the market stands at the present and, moreimportantly, where it is likely to go over the coming days, weeksand even months.

SentimentIt is always difficult to develop a true feeling for sentiment, as itoften comes down to an individual’s own subjective reading ofhow a market has been trading (which in turn actually reflectshow that person is positioned). Too bearish – and the directionalrisk is likely to swing to the upside; too bullish – and more oftenthan not, you have to think very carefully about being long. True, anumber of services are available (the traders’ positioning reportby the CFTC and Stone McCarthy, to name but two), however,using these takes time to allow the data to be collated andreported. For example, consider the scenario where data iscollected for a period ending on a Tuesday, yet won’t bepublished until the following Monday – and an event such as theU.S. payroll number or another important release occurs duringthat “between” time. Again, it comes down to a subjective readingof how the market has traded between data collection andrelease. So is this data really all that useful in determiningsentiment and, as such, directional risk?

I firmly believe that these services are helpful for the longer term,since why should a few data releases change a developing/on-goingtrend in positioning that can’t be picked up at the next publicationdate. However, my own analysis is mostly short term (3-7 days),which is why I have a problem with these particular positioningservices. So does it again come down to only a subjective readingof how the market is positioned – which can work for a while butnever on a consistent basis – or is there a more objective way toapproach the subject of sentiment?

For me, the best measure of day-to-day sentiment is to look athow the market is actually trading and set clear objective criteriato price action. Get that right and at least half the battle is won. Todo this, I use Japanese candlestick charts.

Candlestick AnalysisThe Japanese were the first to use candlestick analysis, in tradingthe rice futures market. In the 1700s, a Japanese trader namedHomma established that, while there was a supply:demand linkfor rice, – prices were also influenced by the emotions of thetraders. Homma realised that he could gain an edge for histrading from understanding how emotion helped predict futureprice movements.

Candlestick analysis, with pattern names such as Piercing Line,Morning Star and Doji, initially appears quite confusing to abeginner. But it really is very easy, and best of all, provides a veryobjective approach to all markets (not just rice!). If the criteria ofa particular reversal aren’t met, then it isn’t a reversal.

The candle itself simply represents the difference between theopening price on any given day and the closing price. If the daycloses higher than the opening, then the body of the candle iswhite; if it’s lower the candle body is black. The day’s high and loware marked by vertical lines extending above or below the body(the “shadow”).

Why is the open/close relationship so important in terms ofsentiment? Quite simply, the opening price represents the firstopportunity to trade, and gives us the first reference of what themarket feels is ‘value’. The close is the last reference, and thefurther the closing price is from the open, the more significantthat day is in terms of bullish or bearish sentiment. The only othertype of candle is a Doji, which occurs when there is no differencebetween opening and closing prices, so no body is evident. Thishighlights trader indecision as to just where directional risk lies,and often occurs after a strong move either up or down,signalling that a consolidation is due.

Also important when gauging sentiment within a candlestick chart ishow a market closes in relation to the day’s high or low. A traderalways has a decision to make coming into the close, whether tohold a position overnight (or the weekend). If one is confidentthat a position is right and that the market will continue to movein one’s favour, there’s no position change and the trader looks forthe trend to remain in force. If this feeling of confidence isreflected across the market, no substantive closing of positionswill develop, so the settlement will be towards the day’s high orlow (depending on the general trend). But consider the situationif that same decision process resulted in traders deciding theywere losing confidence in their view, and thus felt it prudent toclose positions before departing for the day. In such a case,buying or selling (depending on market positioning) willmaterialise coming into the close, causing prices to either sell offfrom the day’s high or rally from the low. If the market has showna strong directional move with large candle bodies andsettlements towards the limits of the day’s range – but thenclosing prices suddenly start to fall back from the highs – we canassume that bullish confidence is waning, increasing the risk of a

Momentum, Trending and SentimentBy Richard Adcock

Chart 1: Types of Candlesticks


more prolonged consolidation phase. [NOTE: I review this furtherwithin stochastic momentum tools.]

Bearing all of this in mind, consider the examples in Charts 2 and3 (where sentiment changes have been flagged by how themarket closed in relation to the session high); these gaveimportant signals to just where the directional risks lay for thelonger term. In Chart 2, at the May 2nd low, no bullish reversalpattern was evident, so the view was that price strength waslimited before the overall bearish trend was resumed and newlows scored. Price action went on to post five consecutive bullishwhite candles as the consolidation developed and traders’perception of ‘value’ was higher at each close compared to theopening price. That said, it’s clear from the actual size of eachcandle body that sentiment was never aggressively bullish. Nowlook at the blue arrow-highlighted day when prices actuallyopened on a bullish gap higher, then hit a new recovery high. Atthat point there was nothing to indicate the consolidation/rallywas ending, until, for whatever reason, selling pressurematerialised, the high was rejected, and the closing price wasbelow the day’s opening price – thus sentiment had turnedbearish again with a black candle posted, breaking the pattern ofwhite candles. The more bearish themes were developed furtherthe following session, when an opening gap lower developed,confirming the negative sentiment and resumption of the on-going bearish trend.

In Chart 3, we see how this type of sentiment monitoring cansignal the end of a more balanced sideways trading range, andprompt a new, higher, aggressive trade. For the initial phase ofthe highlighted area, it is clear that no dominant force is in place(the candle bodies’ relatively small and long shadows above andbelow the open/close relationship reflect rejection of theattempted higher and lower prices; i.e., sentiment is balancedand prices are moving sideways). However, on the final day of thehighlighted area, we can see that a large white candle has beenposted and the close is actually the session high, so unlike theprevious eight days there’s not been any selling into the close,reflecting a clear change from the neutral sentiment to a muchmore bullish position, from which fresh price strengthdeveloped.

So we can see that, by studying the open/close relationship andhow the day’s representative candlestick body compares to eitherthe high or low, we can get a very good feel as to whethersentiment is changing. It should also suggest if we should beginlooking for either a consolidation phase or a resumption of theongoing directional trend (of course, that doesn’t even begin tolook at reversal patterns that can form).

Candlestick Reversal PatternsThere are a number of reversal patterns that work well oncandlestick charts; each can be very important in highlighting asentiment and directional change over a period of just 1-, 2-, or atthe most 3-days. I won’t review every pattern, but I will discussone pattern from each of these short-term periods, explainingwhy I see them as critical in flagging trend changes. For anyonewanting to look at candlestick patterns in greater detail, Irecommend Steve Nison’s book, Japanese Candlestick ChartingTechniques1.

Chart 4 shows a bearish reversal pattern – it means the marketmust have been previously trading within a strong directional uptrend, with limited corrections, new highs being consistentlyposted and, predominately white candles – all reflecting theongoing bullish sentiment. On the day the reversal forms,everything appears as if the trend is being extended – priceshave gapped higher at the open, and further strong supportdeveloped to post a new price high. However, at some timeduring the day, a rejection of this new extreme develops and

Chart 2: Sentiment Turns Bearish

Chart 3: Ending the Consolidation

Chart 4: Shooting Star Pattern – Bearish 1-Day Reversal


prices sell off, leaving a large shadow above the open/closerelationship, which in turn is within the lower third of the day’sentire range. It doesn’t matter if the market closes lower than theday’s opening trade (thus the candle body can be black orwhite); the activity highlights a clear rejection and shift insentiment. If that is confirmed by a black candle the followingday, this marks the end of the bullish trade and the start of atleast a more extended consolidation/correction phase.

On chart 5 as is always the case with any bearish reversal pattern,the market had been trading within a bullish and consistenttrend. The first day of the pattern appears like any other withinthe uptrend, it’s a bullish white candle and a new recovery high isscored. The second day then sees prices beginning the session ina bullish way (with an opening gap higher, and possibly but notnecessarily a new high), but a rejection develops during the dayand prices sell off, closing lower than the opening trade (thus ablack candle body) as well as below the prior day’s opening price– so this open/close relationship has been completely ‘engulfed’.Clearly, this is a very quick shift in sentiment, going from bullishon the open to bearish at the close, and it represents the end ofan up trend and a much deeper, prolonged sell-off.

For the pattern to be a bullish engulfing reversal, – the marketmust have been trading in a downtrend. The first day of thepattern thus has a black candlestick body, and prices are making anew low. The next day’s opening price is lower on a bearish gap,

followed by a strong rally that closes above the previous day’sopening price, creating a white candle and engulfing the firstday’s open/close range.

Again, for any candlestick reversal pattern to be valid, the marketmust have been trading within a clear trend, as the smaller therecovery or correction, the less significant the signal. This is just astrue (if not more so) for the Morning Star pattern, which is a 3-dayreversal, signalling a more important shift in long term sentiment.As with the prior examples, in the case of the Morning Starpattern, the first day’s chart appears as a normal continuation ofthe directional trend, with a new low scored and a black candleposted, as sentiment remains negative with the first reference of‘value’ lower at the close versus the open. However, on the secondday, the market opens on a gap lower (maintaining the bearishsentiment) – but we begin to see sentiment changing, in thatsellers fail to extend the trend lower, and the open/closerelationship is relatively small. The third day of the reversal isundoubtedly bullish, the session opens on a gap higher (bullishsentiment; traders want to buy as soon as possible) and a strongrally ensues (thus a large white candle that closes above the mid-point of the first day’s open/close relationship, confirming thepattern is in place and that the market is setting into a newbullish trend).

The bearish version of the Morning Star pattern is perhaps not toosurprisingly called “Evening Star”, and is a mirror image of thebullish pattern. The first day is a large white candle, maintainingthe drive to new highs within the bullish trend, followed by a gaphigher on the second day and a small candle body, as sentimentbegins to show the first sign of change. The third day of thebearish pattern leaves no doubt that the directional shift iscomplete, with a gap lower followed by strong selling pressurethat creates a large black candle settling below the mid-point ofthe first days’ open/close relationship.

[NOTE: While some technical analysts don’t require it, in anyreversal pattern within candlestick work, I have to see thefollowing day to confirm the sentiment change (via a whitecandle following a bullish reversal and a black one after a bearishpattern). If no confirmation is seen, I declare the pattern invalidand of no significance to the daily and weekly view.]

MomentumI consider momentum-based indicators extremely valuable indetermining important turning points for markets, but they canbe quite infuriating, given their habit of highlighting overboughtreadings, yet the market continues to stay that way, with pricescontinuing to power ahead. In certain circumstances I would evenargue that ‘overbought’ momentum readings are actually a buysignal, as they often confirm that sentiment is bullish (which iswhat will drive the market higher). That said, my use of momentumtools is based more from a timing perspective, with any cross up ordown often an important signal, whether it be against ‘overbought’,‘oversold’ or neutral readings.

Stochastic MomentumWithin his work, George Lane2 highlighted that as prices rise (orfall) strongly within a bullish or bearish trend, closes tend to betowards the high or low of the day’s range. This reflects thatsentiment remained strong (traders not looking to take profitscoming into the close, and content to carry risk overnight).Stochastics extend this approach to a slightly longer period by

Chart 5: Engulfing Pattern – Bearish 2-Day Reversal

Chart 6: Morning/Evening Star Pattern – Bullish/Bearish 3-Day Reversal


taking the latest price and comparing it to the range of the last Xnumber of days (X = any value; for me, 10 days gives the bestsignals). So as prices move within a directional trend, thestochastic indicator line will rise or fall, until the current closinglevel begins to move away from the extreme of the 10 day range,reflecting changing trader sentiment and a recovery/correctionabout to develop from oversold/overbought readings.

However the main problem with momentum indicators is thatthey can get over-extended and stay that way for prolongedperiods as prices maintain the ongoing directional move (chart 7).So I am not really interested in the crosses lower from high stochasticreadings, or the turn higher from low levels, as these could simplyreflect a period of noise as the indicator fails to unwind over-extended conditions as we know can often happen. Instead, whatis even more important to me is when the indicator crosses back tothe upside in a bullish trend (or to the downside in a bearish one),which signals that the correction against the main trend is ending,and the original directional move is about to be re-established, thuspresenting a strong buy/sell signal.

TrendingIn theory, it should be easy to tell if a market is trending bullish orbearish, but that’s not always the case. To help establish whererisks lie, a number of trending-based indicators are available to thetechnician. In my opinion, the best for ease of use and confirmation ofthe directional trend is “Moving Average Convergence Divergenceindicator” (MACD). Used alongside the stochastic momentum, theMACD can provide some very useful signals.

MACD Trending IndicatorThis indicator measures the gap between a short-term and alonger term (I use 10- and 20-day) exponential moving averages,and delivers an indicator line (the blue line on Chart 8) togetherwith a 3-day average of the indicator itself (the red line on Chart8). As prices move aggressively in one direction or the other, the10-day average will follow action much faster than will the 20-day,so the gap between the two averages widens.

Some use the MACD in a similar manner to the stochastic; a crosslower from ‘overbought’ readings is a sell, while a cross higheragainst ‘oversold’ conditions is a buy. I find this difficult, as anymoving average based indicator is ‘lagging’, so price movement is

required to actually see a signal. Therefore, So while the MACDcan be useful, it is often late, hence I tend to use crosses in theMACD as confirmation signals, preferring to use the MACD indicatormore to signal the direction of the main trend. So if the MACD is>zero the market is in a bullish trend; if it’s <zero, the market istrending bearish.

Momentum/Trending RelationshipThus, we have an indicator that gives good directional signals butlags market movement, taking time to turn higher or lower (theMACD) and one that is not always reliable at highlightingoverbought/oversold signals, but shows when a consolidation hasended and the directional trend set to be established again (thestochastic). What if we combine the two; maybe the problems ofeach will cancel out.

So we use the MACD to confirm in which direction the market istrading (any cross from negative to positive will give a buy signal,and from positive to negative a sell signal) and the Stochastic totime when consolidations are over (if momentum turns higherwith the MACD >zero it’s a buy signal, or lower with the MACD<zero, it’s a sell). In other words—we are buying when momentumturns up in a bullish trend and selling when it turns down in a bearishone, which I believe are the strongest and most reliable technicalsignals we can see.

Let’s look at Chart 9 (below) in closer detail. The important thing

Chart 7: The Problem with Momentum Indicators (in this case Stochastics)

Chart 8: The MACD Indicator – Signals Can be Lagging

Chart 9: Buy and Sell Signals Using the Momentum/Trending Relationship


to remember in using the momentum/trending relationship isthat if Stochastics cross, we filter it against the MACD. Ifmomentum crosses down and the trending tool is >zero weignore the signal completely; if the MACD is <zero it’s a new sellsignal (red arrows on Chart 9). On the flip side, if the stochasticcrosses up with the MACD <zero that is ignored, but if thetrending indicator is >zero, it’s a buy signal (blue arrows onChart 9). The brown arrows highlight when the MACD crossed itsown moving average to confirm a similar turn in stochastics (inother words, when we have both momentum and trendingmeasures highlighting the risk of a more extendedconsolidation/recovery phase). In this situation, we do not wantto hold risk, and sell all positions, waiting to see how thesituation develops. Either the MACD will cross zero to give us asignal, or stochastics will be crossing up or down (confirmed bythe MACD being > or < zero) to highlight that the directionaltrend is about to resume.

December 2006 - January 2007 was a very interesting phase formarkets, with prices under significant pressure for no obviousfundamental reason. Using the momentum/trending relationship,we actually saw our combined approach give some strongsignals.

The three long recommendations seen during the lateOctober/early November 2006 consolidation period (the last 3blue arrows on chart 9 when the MACD crossed >zero on Oct31st followed by Stochastics crossing higher on Nov 10th andNov 21st) were closed when the stochastic cross was confirmedby a turn lower in the MACD on Dec 7th 2006, we had theindication that a more extended consolidation/correction wasabout to occur, so we closed the long recommendations. Wedidn’t recommend shorts, since we didn’t know at the time if thecorrection would be limited before the up trend extended again(signalled by momentum crossing up with the MACD >zero) or anew downtrend was about to develop, reflected by the MACDclosing <zero, to give us a new shorting signal on December18th at 108.12). Subsequent bounces in price prompted thestochastic to cross higher, but without these confirmed by theMACD (which continued to fall <zero), each following cross lowerin momentum gave us the signal to add to shortrecommendations – on Dec 22nd at 108.05; Jan 11th at 107.10;Jan 23rd at 106.285 - as we were confident each time thedowntrend would continue having seen momentum turn bearishagain within a downtrend. We established a total of 4 shortrecommendations within that particular sell-off, only closing allpositions on February 1st 2007 at 106.215, when the MACDfinally crossed above its own moving average, following thestochastic signal seen earlier on January 30th.

The idea behind the momentum/trending relationship is that it keepsyou in a position and adds to it even though momentum can be atoverbought or oversold readings. We all tend to question howsustainable a move will be, on the ill-conceived perception thatoverbought prices means strength can’t continue, and oversoldprices highlight that selling pressure will end and a rally is aboutto occur. But this just simply is not the case. By following thesetype of signals highlighted in the table below, we can still add topositions when we have confirmation that the trend will continue,even though prices are ‘over-extended,’ and when to stand asideand close all positions because we simply don’t know how long aconsolidation is going to take, or if it is going to turn into a trendreversal.

Signal Action

MACD closes >zero BUY signal

Stochastic crosses down with MACD >zero Do nothing

Stochastic crosses up with MACD >zero BUY signal

MACD crosses down with stochastic falling CLOSE all positions

MACD closes <zero SELL signal

Stochastic crosses up with MACD <zero Do nothing

Stochastic crosses down with MACD <zero SELL signal

MACD crosses up with stochastic rising CLOSE all positions

Don’t forget that any indicator is a derivative of price and so I useCandlestick analysis alongside the momentum/trending relationship.As such, a candlestick reversal outweighs momentum/trendingconditions. By that, I mean that if a bearish engulfing pattern isformed and confirmed, I would reverse long positions to go short,even if momentum is rising at the same time, as trending tools arebullish. The sentiment change reflected by the reversal will bemirrored, in time, by the indicators.

SummaryThere is a confusing array of technical tools and techniqueswidely used within the market these days. Most are verysuccessful, but at the end of the day, it is the investor’sresponsibility to assess what suits his trading style and what canbe trusted to deliver the type of signals to follow with confidence.

I have found that a consistent approach combining sentimentmeasures with momentum and trending tools can help establishthe trend direction, when to add risk within that trend, and whento reduce exposure and actually sit on the sidelines because Isimply don’t know which way the market is going. In that lattersituation, I would rather wait for confirmed signals than make acoin toss (50/50) call.

Richard Adcock, Director Fixed Income Technical Strategy, UBSInvestment

1 Japanese Candlestick Charting Techniques: A Contemporary Guide to theAncient Investment Techniques of the Far East, by Steve Nison (who is widelyconsidered the expert on candlestick charting in the Western world).

2 George Lane is known as the “Father of Stochastics” for his work on thestochastic oscillator.

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Market Technician No 58

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