JOURNAL

of
Technical
Analysis
Issue 61
Winter-Spring 2004

SM

Market Technicians Association, Inc.

A Not-For-Profit Professional Organization ■ Incorporated 1973
 JOURNAL of Technical Analysis Winter-Spring 2004 Issue 61
● ●

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

Journal Editor & Reviewers 3

The Organization of the Market Technicians Association, Inc. 4

Behavioral Finance and Technical Analysis 5

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

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

The Deviation Oscillator (DO) 13

2 Saleh Nasser, CMT

Momentum Leads Price: A Universal Concept With Global Applications 19

3 Timothy W. Hayes, CMT

notes

JOURNAL of Technical Analysis • Winter-Spring 2004 1

2 JOURNAL of Technical Analysis • Winter-Spring 2004
 Journal Editor & Reviewers
Editor
Charles D. Kirkpatrick II, CMT
Kirkpatrick & Company, Inc.
Bayfield, Colorado

Associate Editor
Michael Carr, CMT
Cheyenne, Wyoming

Manuscript Reviewers

Connie Brown, CMT J. Ronald Davis, CMT Kenneth G. Tower, CMT

Aerodynamic Investments Inc. Golum Investors, Inc. CyberTrader, Inc.
Pawley’s Island, South Carolina Portland, Oregon Princeton, New Jersey

Matthew Claassen, CMT Cynthia Kase, CMT Avner Wolf, Ph.D.

The Technical View Kase and Company Bernard M. Baruch College of the
Vienna, Virginia Albuquerque, New Mexico City University of New York
New York, New York
Julie Dahlquist, Ph.D. Michael J. Moody, CMT
University of Texas Dorsey, Wright & Associates
San Antonio, Texas Pasadena, California

Production Coordinator Publisher

Barbara I. Gomperts Market Technicians Association, Inc.
Manager, Marketing Services, MTA 74 Main Street, 3rd Floor
Marblehead, Massachusetts Woodbridge, New Jersey 07095

JOURNAL of Technical Analysis is published by the Market Technicians Association, Inc., (MTA) 74 Main Street, 3rd Floor, Woodbridge, NJ 07095. Its purpose
is to promote the investigation and analysis of the price and volume activities of the world’s financial markets. JOURNAL of Technical Analysis is distributed to
individuals (both academic and practitioner) and libraries in the United States, Canada and several other countries in Europe and Asia. JOURNAL of Technical
Analysis is copyrighted by the Market Technicians Association and registered with the Library of Congress. All rights are reserved.

JOURNAL of Technical Analysis • Winter-Spring 2004 3

 The Organization of the
Market Technicians Association, Inc.
Member and Affiliate Information
MTA MEMBER
Member category is available to those “whose professional efforts are spent
practicing financial technical analysis that is either made available to the in-
vesting public or becomes a primary input into an active portfolio management
process or for whom technical analysis is a primary basis of their investment
decision-making process.” Applicants for Membership must be engaged in the
above capacity for five years and must be sponsored by three MTA Members
familiar with the applicant’s work.
MTA AFFILIATE
MTA Affiliate status is available to individuals who are interested in tech-
nical analysis and the benefits of the MTA listed below. Most importantly,
Affiliates are included in the vast network of MTA Members and Affiliates
across the nation and the world providing you with common ground among
fellow technicians.
DUES
Dues for Members and Affiliates are $300 per year and are payable when
joining the MTA and annually on July 1st. College students may join at a
reduced rate of $50 with the endorsement of a professor. Applicants for Mem-
ber status will be charged a one-time application fee of $25.
Members and Affiliates
■ have access to the Placement Committee (career placement)
■ can register for the CMT Program
■ may attend regional and national meetings with featured speakers
■ receive a reduced rate for the annual seminar
■ receive the monthly newsletter, Technically Speaking
■ receive the Journal of Technical Analysis, bi-annually
■ have access to the MTA website and their own personal page
■ have access to the MTA lending library
■ become a Colleague of the International Federation of Technical Analysts
(IFTA)
4 JOURNAL of Technical Analysis • Winter-Spring 2004
Journal Submission Guidelines
We want your article to be published and to be read. In the latter regard, we
ask for active simple rather than passive sentences, minimal syllables per word,
and brevity. Charts and graphs must be cited in the text, clearly marked, and
limited in number. All equations should be explained in simple English, and
introductions and summaries should be concise and informative.
1. Authors should submit, with a cover letter, their manuscript and supporting
material on a 1.44mb diskette or through email. The cover letter should
include the authors’ names, addresses, telephone numbers, email addresses,
the article title, format of the manuscript and charts, and a brief description
of the files submitted. We prefer Word for documents and *.jpg for charts,
graphs or illustrations.
2. As well as the manuscript, references, endnotes, tables, charts, figures, or
illustrations, each in separate files on the diskette, we request that the
authorsÕ submit a non-technical abstract of the paper as well as a short
biography of each author, including educational background and special
designations such as Ph.D., CFA or CMT.
3. References should be limited to works cited in the text and should follow
the format standard to the Journal of Finance.
4. Upon acceptance of the article, to conform to the above style conventions,
we maintain the right to make revisions or to return the manuscript to the
author for revisions.
Please submit your non-CMT paper to:
Charles D. Kirkpatrick II, CMT
7669 CR 502
Bayfield, CO 81122
journal@mta.org
 Behavioral Finance and Technical Analysis
Interpreting Data from an Experiment on Irrational Exuberance, Part A:
Applying a Cusp Catastrophe Model and Technical Analysis Rules
Henry O. Pruden, Ph.D.
Visiting Scholar
Dr. Bernard Paranque
Head, Finance and
Information Department
A Cusp Catastrophe Model from the behavioral sciences provides a posi-
tive scientific theory as to the “why” of behavior in a stock market. Technical
market analysis furnishes a nominal theory of rules and principles about “how”
a trader or investor may profit from the behavior observed in a stock market.
Introduction
While watching the 1997 McNeil-Lehr Newshour Video depicting the Cali-
fornia Institute of Technology Experiment on Irrational Exuberance in securi-
ties trading, we became intrigued by the apparent strong parallels between the
trading behavior exhibited in the video film and the idealized graphical model
of the Cusp Catastrophe Model presented in Christopher Zeeman’s 1977 book
Catastrophe Theory Selected Papers, 1972-1997 (See Figure 1). Investigative
attention was focused upon the fold or cusp in the model which captures the
transition from bullish behavior to panic conditions. As outside observers, we
agreed with all of the comments made by Professor Charles Plott (McNeil Lehrer,
1997) of Cal Tech during the experiment, except for one critical exception.
Professor Plott claimed that there was no way that a participant or observer
could have predicted the break in prices and, hence, no way for any of the
players who were in the experiment to have capitalized upon the bubble’s burst.
We disagreed with Professor Plott’s conclusion. Instead, we hypothesized that
according to Cusp Catastrophe Theory a “dissipative gradient” occurs in the
behavior pattern of the trades in the experiment just before the catastrophic
plunge in price. Hence, the break in price action could have been anticipated.
Furthermore, we anticipated that close examination of the price behavior within
the zone of the Cusp, or threshold, would reveal behavior patterns that could be
profitably analyzed and interpreted according to the rules and indicators of
technical market analysis.
Figure 1. A Cusp Catastrophe Model of a Stock Exchange
JOURNAL of Technical Analysis • Winter-Spring 2004
Dr. Walter Baets
Professor of Complexity and
1
Knowledge Management
Technical market analysis and “behavioral finance” are similar in their roots.
Both are rooted in the assumption that man acts for behavioral reasons in ways
that, by the standards of classical economics, may seem irrational. Both ap-
proach the study of markets to identify patterns of human behavior that un-
cover opportunities for profits.
“Technical market analysis” has existed as a practice in real world financial
markets for over a century. It, too, has theoretical roots in psychology and soci-
ology which are often overlooked by the practical men and women of action
who practice investing, trading and analysis. If we envision a theory-application
spectrum, we can see “behavioral finance” occupying the theoretical pole while
technical market analysis occupies the practical applications end of the spec-
trum.
Arguably practitioners and students of technical market analysis champi-
oned the center stage of behavioral finance long before the arrival of what re-
cently has become known as “behavioral finance.” In his 1969 book, Stock
Market Behavior: The Technical Approach to Understanding Wall Street, Dr.
Harvey Krow defined technical analysis as synonymous with “behavioral fi-
nance.” In his preface to that book, Dr. Krow identified three competing schools
of thought in finance: fundamental analysis, the random walk, and the behav-
iorist. Technical analysis fell within the behaviorist or behavioral school, con-
cluded Dr. Krow.
The prominence of behavioral finance grafted to technical analysis was
boosted by October 9, 1993 issue of the Economist magazine. In that article,
the author Matt Ridley observed the linkage between technical analysis and
“behavioral finance.” Mr. Ridley stated that a combination of computer horse-
power and mathematical brainpower had made it possible to find new sources
of profit in the forecasting of financial markets. As the author stated:
What the new mathematicians are mining for is not inefficiencies in the
flow of information but something entirely different. They have found new
meat in the familiar fact that traders are a diverse bunch; by unearthing
some of its previously unrecognized effects...the most popular idea for ex-
plaining it has to do with the heterogeneity of traders in particular, the fact
that people reason differently about the information they receive, that they
have different time horizons...and that they have different attitudes to risk...
The efficient-market theory is...right that efficiency will delete time-arbi-
trage opportunities based on who does not have information, but wrong to
conclude that therefore the market cannot be beaten.
Ridley emphasized, “Prices do contain hints of what they will do next. Com-
puters have resuscitated chartism.”
As the Ridley article emphasized an appreciation that technical analysis
was evolving through the attempt to predict prices using computers to study
market behavior. For example, moving average timing and break out signals
produced profits by more than by chance.
As Ridley concluded, “Chartists – who prefer to be called technical analysts
– justify their techniques with quite reasonable arguments about the behavior of
investors. They do not claim to predict the behavior of the index so much as the
behavior of the people who trade in the market...a rising price is a band wagon.”
And there are models from behavioral science that capture band wagons. Tech-
nicians were studying the behavior of people who make markets run.
5
 Behavioral Finance: Cusp Catastrophe Model
“Catastrophe theory is a new mathematical method for describing the
evolution of forms in nature. It was created by Rene Thom who wrote a
revolutionary book Structural Stability and Morphogenesis in 1972,
expanding the philosophy behind the ideas. It is particularly applicable
where gradually changing forces produce sudden effects. We often call
such effects catastrophes, because the lack of intuition about the underlying
continuity of the forces makes the very discontinuity of the effects so
unexpected. The remarkable thing about the results is that, although the
proofs are sophisticated, the elementary catastrophes themselves are both
surprising and relatively easy to understand, and can be profitably used
by scientists who are not expert mathematicians” (Zeeman, 1977).
A Catastrophe Theory Model modified for the explanation of the evolution/
revolution of behavior in the securities market can be classified in the realm of
behavioral finance. (See Thaler, 1993; Statman, 1998 and Pruden, 1989). An
early model of the Cusp Catastrophe Model modified to explain speculative
crashes appeared in Zeeman (1976, 1977). Later, Pruden (1979) expanded upon
Zeeman’s use of the Cusp Model version of Catastrophe Theory to allow for
“buying stampedes” as well as “selling panics.” Pruden (1980) also established
connections between the Cusp Catastrophe Model and technical market analy-
sis. Whereas the Catastrophe Theory Model, like other models from the behav-
ioral sciences, provides a positive scientific theory as to the “why” of behavior
in the stock market, technical market analysis furnishes a nominal theory of
rules and principles about “how” a trader or investor may profit from the behav-
ior observed in the stock market. Hence, the presupposition is that behavioral
science models that explain the stock market behavior provide solid scientific
foundations upon which to base the principles and practices of technical market
analysis.
The Cusp Catastrophe shown in Figure 1 offers a unique three-dimensional
graphic model for structuring two independent and one dependant variable. It
furnishes a basis for classifying and interrelating price trends and sentiment
variables, thereby enhancing logical clarity and empirical predictability. Im-
plicit in the model is a fourth temporal dimension.
EQUILIBRIUM SURFACE
The Cusp Catastrophe model posits two parallel surfaces. The upper behav-
ior or equilibrium surface is represented by a price index such as the Dow-
Jones Industrial Average. This behavior surface is further subdivided into a top
sheet representing bullish behavior and a bottom sheet reflecting the domi-
nance of bearish behavior. Each point on the behavior surface is an equilibrium
juncture between supply and demand, even though incremental and transitory.
Near the center of the behavior surface of the model lies the Cusp
Catastrophe’s most interesting feature – a fold curve or cusp. What this sug-
gests is that there is no equilibrium (horizontal range) available until the top
sheet is reached after a buying stampede or the bottom sheet is reached after a
selling panic. Notice that the abstract model shows the behavior surface curv-
ing over to a threshold point, after which comes the panic sell-off. In the Cusp
Catastrophe model this all-important juncture along the top sheet is known as
the “dissipative gradient.”
CONTROL SURFACE
The market price or the equilibrium behavior surface is the dependent vari-
able. The independent, predictor or control variable, which accounts for the
index or to which the index may be ascribed, lies on the control surface below.
In Figure 2, the independent, predictors are shown as the emotional forces of
fear and greed.
The model featured in Figure 1 presents fear and greed as opposing factors.
The relative power of these two opposing forces is what animates market be-
havior. The gradual changing relationship between fear and greed gives rise to
sudden discontinuations in price behavior when thresholds are reached and pan-
ics or stampedes ensue.
6 JOURNAL of Technical Analysis • Winter-Spring 2004
Figure 2. Dissipative Gradient
CUSP MODEL IN OPERATION
Now let us imagine Figure 1 in operation. The flow of the market index
takes place over a smooth surface composed of equilibrium points. Changes in
the control variables, fear and greed, have unique responses on the behavior
surface. The dynamic process of the model causes the index to seek out local
points of stable, albeit temporary, equilibrium.
Starting at a bear market low, where the market index is on the lower attractor
sheet, the level of greed (demand) is suppressed by the level of fear (supply).
Mounting greed (e.g., expectation of higher prices) gradually overcomes fear
until the edge of the sheet is reached, at which point the market breaks out of an
upside reversal pattern via a catastrophe jump to the top sheet as the mood of
the market becomes decidedly bullish. The index then flows along a rising chan-
nel on the top sheet until the bullish potential is exhausted. At that point, both
greed and fear are high. Finally, as fear overcomes greed the market index is
pushed to a threshold on the top sheet, then the price index plunges to the bot-
tom sheet via a bearish catastrophe jump.
Catastrophe Theory analyzes equilibrium and its breakdown. As such, it is
ideally suited for understanding the stock market where price movements re-
sult from the balances and imbalances between buying power and selling pres-
sure, which in turn are animated by the forces of greed and fear.
Applications of Catastrophe Theory can be qualitative in nature. Catastro-
phe Theory does not pretend to render pinpoint or unalterable predictions far in
advance. The theory does not negate the art of interpretation.
In Catastrophe Theory the prior history of behavior states of the market is
required to predict the future. This undercuts the assumptions of the “random
walk” or efficient market hypothesis. Catastrophe Theory underscores the rel-
evance of the historical, chart approach to analyzing the market.
The Cusp model encompasses duality and opposition. There is room for a
greed axis and a fear axis. It brings the opposition between bullish versus bear-
ish sentiments into clear relief.
The Cal Tech Experiment on Irrational Exuberance
INTRODUCTION
When the internet bubble burst there was a massive opportunity to make
serious money through short selling or at least avoiding losing money already
earned. A predictive theory that would have alerted a trader to the potential
collapse would have been extremely valuable.
The Cusp Catastrophe Model could have been that predictive theory. The
Cusp-Catastrophe Model is based upon behavioral science/behavioral finance
to explain types of non-linear, discontinuous behavior. It is especially models
behavior of rapid change, such as a stock market bubble bursting. Catastrophe
theory has revealed that sudden change and behavior extremes are not only
natural and interrelated but, if one were to see the early warning signs, a col-
lapse would be predictable.
The Cusp Catastrophe Model posits that behavior is driven by fear and greed.
In the case of a stock bubble, price climbs along the top layer of the Cusp
Model. Eventually the speculative excess reflects increasing nervousness and
starts to de-escalate, moving toward the drop-off at the cusp. Within the cusp
itself there exists the small, incremental change downward, the “dissipative
gradient,” that marks the beginning of the collapse. Afterward behavior then
suddenly drops off the cusp and falls vertically in rapid collapse (See Figure 4).
Market behavior explainable by the Cusp Catastrophe Model was evident
after the U.S. stock market run up in late 1999 and early 2000. The market had
become extremely overpriced and signs of nervousness started to appear. There
was one market session in which the NASDAQ dropped over 500 points only
to make a surprising and outstanding recovery back before the end of the ses-
sion. The nervousness depicted by this sudden and dramatic price drop was a
sign of the impending collapse. The dot.com bubble having reached the cusp,
it was period for a catastrophic decline.
THE EXPERIMENT
Using the Cusp Catastrophe as a framework, we interpreted the research
data from a Cal-Tech Experiment on Irrational Exuberance that was produced
by WGBH television and shown on PBS (McNeil Lehrer, 1997). The Cal Tech
experiment furnished empirical data to “test” propositions derivable from the
Cusp Catastrophe Model. The experiment likewise offered an opportunity to
extract and highlight several nominal rules/indicators of technical analysis that
fit with the logic of the Cusp Model. The indicators of technical analysis that fit
with the Cusp Model were then also applied to the data of the experiment in an
effort to anticipate and profit from the catastrophic decline in price that fol-
lowed the bursting of the speculative bubble created during the experiment.
To further our research efforts, we stopped the video of the Cal Tech Ex-
periment at key junctures in order to photograph the charts that had recorded
the behavior of the traders during the experiment (See Figure 3 and Figure 4).
We blew up the pictures from the video that showed the transition from a bull
market to a bear market. Our interpretation of the expanded photos of behavior
led us to conclude that the Cusp Catastrophe Model coupled with technical
analysis principles and indicators could have explained the experimental data
and exploited the trading action generated by this laboratory experiment on
irrational exuberance. The data indicated that, as anticipated, a dissipative gra-
dient precedes a catastrophic collapse in price.
Professor Charles Plott, California Institute of Technology, conducted his
experiment with well trained, knowledgeable Cal Tech students. The students
had experience with similar experiments but they had not been exposed to the
exact parameters of irrational exuberance experiment. All the students were by
definition very bright, very rational individuals who were oriented toward mak-
ing the most profit available within the context of the risk they perceived.
Trading was done on a closed network of computers and students were al-
lowed to buy or sell one stock. The better they traded, the more money they
could make up to several hundred dollars. The students who held the stock at
the periodic divided payment junctures were the ones who would win the game.
The stock being traded was a fictitious oil company and to make things simple
it had only one oil well. As oil was pumped from the well, the stockholder-
student was paid dividends at pre-set intervals. When the oil ran out, the com-
pany was basically worthless.
JOURNAL of Technical Analysis • Winter-Spring 2004
Figure 3. The Overall Results of the Experiment
Figure 4 depicts the overall results of the experiment. It shows the average
value of the company as it depletes the oil (line A) and the absolute maximum
value of the company with oil at its maximum potential market value (line B).
Line A should represent the average stock price and line B should be the maxi-
mum price over achieved. Stock prices beyond line B were not rational because
everyone in the game knew that the value above line B was beyond any under-
lying asset value. At set intervals, the dividends were paid. These dividend
payment intervals are shown in Figure 4 by the dashed vertical lines. All par-
ticipants in the experiment knew this information before the game was played.
The prices established by the buyers and sellers in the experiment did not
drop as would have been expected from the logic of rational economic analysis
of the situation even though all players were rational and had the same informa-
tion. The traders in the Cal Tech experiment persistently traded at a prices that
were greater than the fundamental value indicated the company was worth. As
the experiment progressed, the traders in the experiment ignored the average
value line and then, surprisingly, crossed the maximum value line. The students
in the experiment paid for the stock in the experiment well beyond what even
the most optimistic investor should have paid. Apparently, chasing dividend dis-
tribution dates, they continued to trade was based upon the greater fool theory. It
was rational to buy overvalued stock so long as someone else would buy their
overvalued stock later on, after the dividend had been collected, thus allowing
the trader to continue to profit from dividends with little risk.
Eventually, as the oil well neared depletion, the market began to show signs
of nervousness. This nervousness by players in the experiment was very evi-
dent on the videotape since Professor Plott had tied price bids to purchase the
stock to lower sounds on the musical scale. The high notes on the chart re-
flected sell offers while the low notes were bid orders (See Figure 5). As the
market neared extreme upside valuations, there arose heightened nervousness
evidenced by a striking increase in the intensity of the lower notes. Both sellers
and buyers were shifting their expectations downwards apace with lowering
tones and the sound volume level increased rapidly. Such a change in the sound
of the market, the sentiment, has been often noted by traders on the floor of the
exchange as a harbinger of a reversal of price trend. As the experiment pro-
gressed the buy offers that were well below the existing price began to in-
crease, although the price level itself stabilized into a horizontal trend channel.
Ultimately there occurred a sudden, sharp drop – the catastrophic jump – in the
transaction price in the experiment. The market changed suddenly and swiftly;
sentiment flipped from bullish to bearish as the price plunged to its underlying
economic asset value.
It should be mentioned that this experiment was conducted without exog-
enous factors. There were no news or media reports, no external noise, and no
one was allowed to voluntarily enter or leave the game. These restrictions may
have contributed to the stability of the price data along a horizontal trend chan-
nel rather than prompting price to oscillate upward and downward as time pro-
gressed.
7
 Figure 4. Applying Technical Analysis sentiment played on key. Additionally, the picturing of the fear and greed vari-
ables sentiment as opposing forces in the Cusp Model was brought into dra-
matic display by two high notes versus the low notes in the Cal Tech experi-
ment. The Cusp Model revealed a new and powerful way for practicing techni-
cians to display and interpret indications of sentiment.
A tight trading range of channel of price behavior, predicted by the Cusp
Model, was created by the student investors in the Cal Tech experiment (Figure
6). That the price behavior adhered so closely to a linear trend channel was
surprising to the author, who expected to see broader and more jagged up and
down swings in price. The linear trend channel of price behavior occurring
during the experiment upheld the technical analysis practice of drawing linear
trend lines of support and resistance. The breaking of a “support line” drawn
along the horizontal price bottoms of the price channel created during the ex-
periment constituted the crossing of the Cusp and the onset of the catastrophic
downward plunge in price.
FIGURE 5. FEAR VS. GREED JUXTAPOSED

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

Applying the Cusp-Catastrophe Model

What occurred in the Cal Tech exercise was ipso facto an experiment dem-
onstrating the elements and efficacy of the Cusp-Catastrophe Model. The mar-
ket moved along an elevated course until it met with a bifurcation point. That
point was the maximum expected value or line B on Figure 3. The group of
students participating, motivated by greed, collectively decided to continue buy-
ing despite shrinking oil well resources. This build up of a speculative bubble
can be seen as taking place along the top sheet of prices on the Cusp Catastro-
phe model. The price moved smoothly along the upper level of the sheet until
the cusp. Then as fear started to play a stronger role while buying intentions
were becoming exhausted (fear was overcoming greed as a collective motive)
the threshold of the cusp was reached. Thereafter, the price plunge in the ex-
periment can be explained as the dropping off from the upper level of the cusp FIGURE 6. TRADING RANGE
in a dramatic swoon to lower level as the selling panic, the downward catastro-
phe jump erupted.
APPLYING TECHNICAL ANALYSIS
The Cusp Catastrophe Model itself and the application of the Cusp Catas-
trophe Model to the Cal Tech Experiment on Irrational Exuberance spotlighted
the efficacy of six principles of technical analysis and trading that are well
known but often overlooked or under-appreciated by technicians and traders.
These principles of technical market analysis and trading are:
■ Fear vs. Greed Juxtaposed

■ Trading Range Channels Along Tops and Bottoms

■ Descending Price Peaks: Dissipative Gradient

■ Catastrophic Panics Causing Price Gaps

■ Mental Discipline Needed to Win the “Greater Fool” Game

These six principles could play an analytical role alerting a trader, a partici-
pant in the Cal Tech Experiment, when to abandon playing the “greater fool
theory” game. These principles of technical analysis and trading were instru-
mental in the diagnosis of the “dissipative gradient” and thus the prognosis of
the decline (See Figure 4).
FEAR VS. GREED JUXTAPOSED
The Cal Tech experiment vividly revealed the classical role of sentiment as
the musical notes depicting bids and offers reflecting sentiment shifted down-
ward before the downward slide in price (Figure 5). The anticipatory role of

8 JOURNAL of Technical Analysis • Winter-Spring 2004

 Descending Price Peaks: Dissipative Gradient
Our expectation of a pattern of “descending price peaks” within the trend
channel but before the price break was a key reason why we had disagreed with
Professor Plott’s assertion that the break in price was unpredictable and un-
beatable. As he opined, there was simply no way to get out on the way down.
However, technical analysis with aid of the Cusp Model’s, “dissipative gradi-
ent” of descending price peaks led us to expect a window of opportunity that
would alert a few astute traders to exit before the crash. The evidence from the
Cal Tech Experiment on Irrational Exuberance confirmed that expectation: the
downward plunge in price at the end of the Cal Tech experiment was predict-
able (Figure 7).
Descending price peaks were long ago recognized by such technical ana-
lysts as Richard D. Wyckoff as a reliable pattern for prognosticating of behav-
ior for lower prices to come. The repeated attempts to rally which failed to
reach previous price levels (i.e., lower price peaks) showed that demand was
reaching exhausting. Greed/bullish sentiment was no longer supporting the el-
evated price, hence a price drop was about to occur.
Figure 7. Descending Prices Peaks
Figure 8. Catastrophe Panic Causing Price Gaps
The pattern of descending price peaks occurred in the experiment it was
reminiscent of the right-hand side of the classic price-reversal patterns analysis
employed by technical analysts. For example, within the classic head-and-shoul-
ders top formation, the technical-analyst-trader is counseled to enter a short
position on the third rally or pullback to the neckline of price support. Prior
rallies to higher prices would have been to the right shoulder and to the head of
that formation. In sum, the Cusp Catastrophe Model reveals the “triple descend-
ing peaks” pattern as a powerful technical tool. In our judgment, technicians
JOURNAL of Technical Analysis • Winter-Spring 2004
tend to overlook and underappreciate the pattern of descending peaks as a tip
off of weakness and harbinger of panic.
Once the panic decline gets underway, the scramble of offers to sell coupled
with the withdrawal of bids to purchase, leads to repeated “air pockets” or gaps
in price on the way down in price Data from the experiment revealed a gapping
phenomenon more pronounced and prevalent than the time honored “break away,”
“measuring” and “exhaustion” gap trio of technical analysis (Figure 8). The
“breakaway gap” corresponds to the catastrophe jump across the threshold.
Figure 9. Mental Discipline Needed to Win
the “Greater Fool” Game
The sixth technical analysis principle enumerated above, “mental discipline
needed to win the ‘Greater Fool’ game” has more to do with trading discipline
than with chart reading (Figure 9). When commenting on the rational versus
irrational behavior of the student-investors in the experiment, Professor Plott
observed that each person who was playing the game to win was acting ratio-
nally. One is tempted to amend Professor Plott’s statements with the words
“individually rational but collectively irrational.” To win the game, the student
trader had to engage in the risky behavior of buying. Those who did not partici-
pate in the game could not earn the all-important dividend reward available to
those who did play. The optimal winning mental discipline would have been to
play the game in order to have a chance to win and “continue to play with
confidence until the sentiment-mood started to shift. Then the trader-student-
game participant had to depart from the game as price behavior as evidenced
by the descending price peaks that follow after the early warning signals of
sentiment.” With the empowerment given to an active-aggressive trader by un-
derlying behavioral finance theory like the Cusp Catastrophe Model, and the
five technical analysis principles explained above, the participant in the game
could have played the game with confidence until the end of the opportunity
for profit.
Summary and Discussion
Catastrophe Theory began with the ideas of Rene Thom in the early 1960s.
Both the mathematics and the applications were present from the beginning,
each stimulating the other, as can be seen in Thom’s classic book on Structural
Stability and Morphogenesis. The concept was then popularized by the various
works of Christopher Zeeman, most notably in his 1977 book, Catastrophe
Theory: Selected Papers 1972-77. Then in 1979 Pruden described the logical
linkages between Catastrophe Theory, a dimension within behavioral finance
and technical market analysis. The Cusp Model of Catastrophe Theory pre-
sents a behavior path flowing along the top sheet until a threshold, a cusp, is
reached as the underlying emotions shift toward fear overcoming greed, then
suddenly the market price will jump downward. The clues given by the shift
toward dominance by supply over demand during the latter stages of a trading
9
 range will presage the development of a bearish trend in stock prices. But up
until that transition phase threshold point, the market would remain high and
delay its descent until remaining pockets of demand were exhausted.
Let us fast forward to the stock market shown in the Cal Tech Experiment
and then zoom in on the behavior brought about by bullish emotions vs. bearish
emotions during the latter phases in a trading range market. The moral of the
jump story applies directly. During the trading range the alternating price swings
up and down reflect the struggle between greed and fear, so the analyst - trader
must respect the fact that the market could jump either way...its behavior is bi-
modal. So to be effective the trader must remain neutral until the testing phase
on the right hand side of a stock market trading range. Before we reach a
conclusion regarding future trend direction, the market should be allowed to
define the line of least resistance and then and only then should a position, long
or short, be entered. The breakdown was anticipated by the descending price
peaks, “the dissipative gradient,” as shown on the Cusp Catastrophe Model.
Behavior changes gradually before the breakdown. On the top sheet of the
cusp catastrophe model one can see a slight curling over of the behavior path.
Stock market behavior would likely show, for example, a series of descending
peaks in price. Similarly on the bottom sheet of the cusp model one can see a
gradual curling upward of the bottom behavior sheet before the upward jump
(breakout) by a series of ascending bottoms during the ending stages or the
right hand side of a trading range. These descending price peaks and ascending
price bottoms are powerful, but under-appreciated, technical tools.
10 JOURNAL of Technical Analysis • Winter-Spring 2004
References
■ Krow, H. (1969), Stock Market Behavior: The Technical Approach to
Understanding Wall Street, Random House
■ Pruden, Henry O., (1999), “Life Cycle Model of Crowd Behavior,” Technical
Analysis of Stocks and Commodities.
■ Pruden, Henry O., (1979), “Catastrophe Theory: A Model for Stock Market
Behavior,” Market Technicians Association Journal.
■ Pruden, Henry O., (1980). “Catastrophe Theory: A Practical Application,”
Market Technicians Association Journal.
■ Pruden, Henry O. (1995), “Behavioral finance: What is it?” Market
Technicians Association Newsletter and MTA Journal, September.
■ Pruden, Henry O., (2003), “Catastrophe Theory and Technical Analysis
Applied to a Cal Tech Experiment on Irrational Exuberance,” Managerial
Finance Journal.
■ Ridley, M., “Survey: Frontiers of Finance,” The Economist, (October 9,
1993).
■ Rogers, Everett M., and F. Floyd Shoemaker (1971). Communications of
Innovations, Free Press.
■ Schwager, Jack D., (1996). Schwager On Futures: Technical Analysis, John
Wiley & Sons.
■ Shiller, Robert J., “Stock Prices and Social Dynamics” in Thaler, Richard
H. ed, (1993) Advances in Behavioral Finance, Russell Sage Foundation
■ Statman, Meir., (1998), “Behavioral Finance,” Contemporary Finance
Digest, Financial Management Association.
■ Thaler, Richard H., ed. (1993). Advances In Behavioral Finance, Russell
Sage Foundation.
■ Thom, Rene., (1972), Stabilite Structurelle et Morphogenese, New York:
Benjamin Press
■ Wyckoff, Richard D. in Charting The Market: The Wyckoff Method, Jack
Hutson, Ed. Technical Analysis of Stocks and Commodities.
■ Zeeman, E.C., (1977), Catastrophe Theory: Selected Papers, 1972-1977,
Reading, Mass: Addison-Wesley Publishing Company (1977), p. 1.
■ Zeeman, E.C., (1976), “Catastrophe Theory,” Scientific American, pp. 65-
83.
■ Zeeman, E.C., (1974), “On the Unstable Behavior of Stock Exchanges,”
Journal of Mathematical Economics, pp. 39-49.
 About the Authors
DR. HENRY O. PRUDEN
Hank Pruden is a professor in the School of Business at Golden Gate
University in San Francisco, California where he has been teaching for 20
years. Hank is more than a theoretician, he has actively traded his own
account for the past 20 years. His personal involvement in the market en-
sures that what he teaches is practical for the trader, and not just abstract
academic theory.
He is the Executive Director of the Institute of Technical Market Analy-
sis (ITMA). At Golden Gate he developed the accredited courses in techni-
cal market analysis in 1976. Since then the curriculum has expanded to
include advanced topics in technical analysis and trading. In his courses
Hank emphasizes the psychology of trading and as well as the use of tech-
nical analysis methods. He has published extensively in both areas.
Hank has mentored individual and institutional traders in the field of
technical analysis for many years. He is presently on the Board of Directors
of the Technical Securities Analysts Association of San Francisco and is
past president of that association. Hank was also on the Board of Directors
of the Market Technicians Association (MTA). Hank has served as vice
chair, Americas IFTA (International Federation of Technical Analysts): IFTA
educates and certifies analysts worldwide. For eleven years Hank was the
editor of The Market Technicians Association Journal, the premier publica-
tion of technical analysts. From 1982 to 1993 he was a member of the Board
of Trustees of Golden Gate University.
Professor Pruden is a visiting scholar at Euromed Marseille Ecole de
Management, Marseille, France during 2004-2005.
DR. BERNARD PARANQUE
Bernard Paranque is a doctor of economics ( University of Lyon Lumi re
- 1984) and holds the “Habilitation ˆ diriger les recherches” (1995). He
began his career as an associate economist in an accountancy firm in 1984.
In 1990, he joined the “Banque de France” (French Central Bank) busi-
ness department. From 1990 to 2000 he produced papers on the financial
structure of non-financial companies (www.ssrn.com). He was a represen-
tative of the Banque de France in the European Committee of Central Bal-
ance Sheet Offices between 1993 and 2002.
In 1999, he was on secondment from the Banque de France to the Sec-
retary of State to SMEs’ where he was in charge of the “business financing”
department. He was also a member of the French delegation to the SMEs’
working party of the Business and Environment Committee of the OECD.
His research refer to the “ conomie des conventions” and are focused
on the financial behavior of the non-financial organization and the promo-
tion of specific tools and assessment procedures designed to enhance SMEs’
access to financing.
He is co-author with Bernard Belletante and Nadine Levratto of “Diversit
conomique et mode de financement des PME” published in 2001. He is
also the co-author of “Structures of Corporate Finance in Germany and
France” with Hans Friderichs in” JahrbŸcher fŸr National konomie und
Statistik,” 2001.
He is associate researcher of the CNRS team IDHE-ENS Cachan in
Paris and member of the New York Academy of Science.
He joins Euromed Marseille Ecole de Management as Professor of Fi-
nance and Head of the “Information and finance” department.
JOURNAL of Technical Analysis • Winter-Spring 2004
DR. WALTER BAETS
Walter R. J. Baets is Director Graduate Programs at Euromed Marseille
- Ecole de Management and Distinguished Professor in Information, Inno-
vation and Knowledge at Universiteit Nyenrode, The Netherlands Business
School. He is also director of Notion, the Nyenrode Institute for Knowl-
edge Management and Virtual Education. Previously he was Dean of Re-
search at the Euro-Arab Management School in Granada, Spain. He gradu-
ated in Econometrics and Operations Research at the University of Antwerp
(Belgium) and did postgraduate studies in Business Administration at
Warwick Business School (UK). He was awarded a Ph.D. from the Univer-
sity of Warwick in Industrial and Business Studies.
He pursued a career in strategic planning, decision support and IS
consultancy for more than ten years, before joining the academic world,
first as managing director of the management development centre of the
Louvain Universities (Belgium) and later as Associate Professor at Nijenrode
University, The Netherlands Business School. He has been a Visiting Pro-
fessor at the University of Aix-Marseille (IAE), GRASCE (Complexity
Research Centre) Aix-en-Provence, ESC Rouen, KU Leuven, RU Gent,
Moscow, St Petersburg, Tyumen and Purdue University. Most of his pro-
fessional experience was acquired in the telecommunications and banking
sector. He has substantial experience in management development activi-
ties in Russia and the Arab world.
His research interests include: Innovation and knowledge; Complexity,
chaos and change; The impact of (new information) technologies on
organisations; Knowledge, learning, artificial intelligence and neural net-
works; On-line learning and work-place learning.
He is a member of the International Editorial Board of the Journal of
Strategic Information Systems, Information & Management and Syst mes
d’Information et Management. He has acted as a reviewer/evaluator for a
number of International Conferences (e.g. ECIS an ICIS) and for the EU
RACE programme. He has published in several journals including the Jour-
nal of Strategic Information Systems, The European Journal of Operations
Research, Knowledge and Process Management, Marketing Intelligence and
Planning, The Journal of Systems Management, Information & Manage-
ment, The Learning Organization and Accounting, Management and Infor-
mation Technologies. He has organised international conferences in the
area of IT and organizational change.
Walter Baets is the author of “Organizational Learning and Knowledge
Technologies in a Dynamic Environment” published in 1998 by Kluwer
Academic Publishers, and co-author with Gert Van der Linden of “The
Hybrid Business School: Developing knowledge management through man-
agement learning,” published by Prentice-Hall in 2000. Along with Bob
Galliers he co-edited “Information Technology and Organizational Trans-
formation: Innovation for the 21st Century Organization” also published in
1998 by Wiley. In 1999, he edited “Complexity and Management: A col-
lection of essays,” published by World Scientific Publishing. Recently he
co-authored “Virtual Corporate Universities,” published 2003 by Kluwer
Academic.
11
12 JOURNAL of Technical Analysis • Winter-Spring 2004
 2
The Deviation Oscillator (DO)
Saleh Nasser, CMT

Introduction Figure 1

The major aim of the Deviation Oscillator, or DO, is to track minor changes
in the strength of a trend. It usually does not track major reversals; however, it
can be very suitable with countertrend corrections. The DO moves in an un-
bounded range above and below a zero level and it can be used alone and/or
with other indicators. Its objective is to detect weakening bulls or bears as soon
as possible. Sometimes sellers begin to weaken, while the price is still declin-
ing; the DO will recognize this weakness and will begin showing some bullish
tendencies, even before prices begin to rise.
This indicator is derived from a chart with three moving averages; a mov-
ing average of the close, a moving average of the high, and another one of the
low. It can be observed that the MA of the close deviates between the MA of the
high and the one of the low. When prices rise the MA (close) approaches the
one of the high, when prices decline, it approaches the moving average of the
low. This confirms the notion that during a rise the price usually closes near the
high of the day, and vice versa. Based on this observation, the DO was created.
Thus, the DO calculates the deviation of the moving average of the close of a Now, to extract the Deviation Oscillator, line 2 is subtracted from line 1:
certain issue from the moving average of the high and from that of the low. Deviation Oscillator (DO) = [MA (high) - MA (close)] - [MA (close) - MA (low)]
Whenever the moving average of the close of a certain period deviates from the
low towards the high it indicates strength. When it deviates from the high to- This oscillator deviates above and below a zero line. Breaking the zero line
wards the low it indicates weakness. The DO is very useful when used with to the upside means that prices are getting closer to the lows and vice versa.
other indicators like MACD, momentum, and the stochastic oscillator. This To make visual inspection easier, the scale is inverted. Thus rises and de-
paper explains its calculation, its basic interpretation, how it can be used in clines of the DO will accompany rises and declines in prices.
combination with other indicators. Figure 2
The most important aspect of this indicator is divergences. When a diver-
gence occurs it means that a countertrend move should occur. The DO can be
used along with momentum as a confirming indicator, and to filter some of its
bad signals since at times DO diverges with momentum. It can also be used
with MACD as a setup. A MACD buy signal will be triggered when accompa-
nied by a positive divergence between DO and the price. This gives superior
results as opposed to using MACD crossovers alone.
Another oscillator that was extracted from DO is the “RCDO”. It is the
Rate of Change of the Cumulative function of DO. This oscillator is mainly
used for overbought and oversold conditions. This oscillator and its uses are
also explained in this paper.

The Calculation
1. Calculate a moving average of the close, a moving average of the high and
a moving average of the low. These calculations use simple moving averages
and a time span of 20 days.
2. Calculate the distance between the moving average of the high and the
moving average of the close (MA(high)- MA (close)). The greater the
difference, the closer MA (close) goes towards MA (low).
3. Calculate the distance between the moving average of the close and the
moving average of the low (MA (close) - MA (low)).
Figure 1 shows two lines that intersect with each other. When line 1 (MA
high-MA close) crosses line 2 (MA close-MA low) to the upside, then the mov-
ing average of the close is closer to the moving average of the low than that of
the high. When line 1 crosses line 2 to the downside, the moving average of the
close is nearer to the moving average of the high.
Microsoft chart with DO, after inverting the y-axis. Note that trading on
zero crossovers is not recommended as it suffers from whipsaws. Now a break
of the zero line to the upside (after the scale is inverted) means that the moving
average of the close is closer to MA high than MA low and vice versa.
A short cut for the calculation: to avoid inverting the scale, a simpler
calculation can be used. (MA close - MA low) - (MA high - MA close). We
will not have to invert the scale by using this calculation.
Use of the Deviation Oscillator
BASIC INTERPRETATION
Zero Crossover
Buying when DO crosses above the zero line and selling when it crosses
below it proved to be a losing technique, resulting in a total loss of 27.05% for
the 30 Dow stocks from 1999-2003. Results improved when a buffer zone was

JOURNAL of Technical Analysis • Winter-Spring 2004 13

 placed at 0.2 and -0.2. Thus the buy signal was not triggered until the upper
buffer zone was broken to the upside and the position was closed when a viola-
tion of the lower boundary occurred. The loss was reduced to 20%. The results
were worst when shorts were added; covering shorts and buying longs above
zero and closing longs and building shorts below zero with a loss of 35.5%
which was reduced to a loss of 24% by using a buffer zone.
Divergences
This is the most important aspect of the Deviation Oscillator. Even when
using DO with other oscillators, divergence analysis is employed. Divergence
is very important as it shows that there is hidden weakness or strength in the
market that is not apparent in the price action.
■ First type of divergence occurs when DO is rising and the price is still
declining (positive divergence) or the DO curve is declining while the price
is rising (negative divergence). This means (in the case of a positive
divergence) that despite that prices are still declining; the closing price is
getting closer to the high. The 20-day MA of the close is moving away from
the MA of the low and approaching that of the high. The decline is losing its
strength, as buyers are able to bring the closing price away from its lows.
If the price is declining and DO rising, buy at a breakout of a minor top,
with a stop loss below this top or below the nearest minor bottom, depending
on risk tolerance. Use this divergence as a setup and buy at a breakout.
Usually such a breakout will not be false because it was preceded by some
strength. If another indicator confirms this positive divergence, the signal
will be stronger. The same holds true when DO declines while the price is
still rising. It means that the bears are getting stronger as they are able to
bring the closing price away from the highs.
One of the most bullish signals appears when DO rises vertically, while the
price is still in a trading range or slightly declining.
■ Second type of divergence appears more often: it occurs when the price
makes a lower low while the DO follows a higher low (in the case of a
positive divergence), or when the price forms a higher high, while the DO
triggers a lower high (in the case of negative divergence). A positive
divergence in this case means that during the second bottom the MA of the
close was nearer to the MA of the high than during the first bottom. The
price violated support but with weaker sellers.
Figure 3
Philip Morris (MO) shows a very interesting story. During March 2003, the
DO witnessed a positive divergence with the price. During April and May, the
stock’s price began to form a higher low, confirming the previous divergence.
In May, while the price was trading sideways, the DO moved sharply upwards,
hinting of a continuation of the rise. At the end of the stock’s rise, from 18 June,
to early July, the DO began to move downwards, while the stock was still ris-
ing, signaling potential weakness that came later.
14 JOURNAL of Technical Analysis • Winter-Spring 2004
Using the Deviation Oscillator with Other Indicators
USING THE DEVIATION OSCILLATOR WITH MOMENTUM
The Deviation Oscillator can be used as a confirming indicator for momen-
tum divergences. Usually, when momentum witnesses a positive divergence,
this divergence will be more meaningful if it is confirmed by a similar diver-
gence in DO. A divergence triggered by both momentum and DO is a strong
signal. A positive divergence in this case means that the decline is decelerating;
and the MA of the close is getting closer to the MA of the high.
Another way to use DO along with momentum is to track divergences be-
tween both indicators. Sometimes the price makes a lower low, confirmed by
momentum, which also triggers a lower low formation. This action might not
be confirmed by DO, which follows a higher low formation, thus diverging
with momentum. Such divergences are very useful as they are usually followed
by a minor reversal in the trend. The same can occur at a market peak, when
momentum continues making a higher high, while DO follows a lower high
formation. It was found, however, that positive divergences give better results
than negative divergences.
Testing was done on the 30 Dow stocks to see how positive divergences
between DO and momentum affected the price:
■ 75.8% of the time a positive divergence between DO and momentum led to
a rise in price of more than 5%.
■ 12.9% led to movements less than 5%, either positive or negative. The
divergence had no effect.
■ 11.29% of the time, momentum was a better indicator and a decline exceeded
5% occurred after a positive divergence.
A positive divergence here means that momentum was triggering a lower
low, while DO was showing a higher low formation. The buy signal should be
triggered the day after the divergence occurs, or after an up day with high vol-
umes for more confirmation. A stop loss could be placed below the latest minor
bottom. Using candlesticks patterns for buying can also be useful.
The logic behind such a divergence is as follows: the price is declining, and
still accelerating to the downside, however, MA (close), which is already very
near to MA (low), begins to move towards MA (high). In other words, buyers
are getting stronger as they are able to close the market away from its lows.
Figure 4
The chart of Newmont Gold (NEM) shows a positive divergence between
DO and Momentum during July 2002. As the price was making a lower low,
momentum confirmed this weakness, while DO triggered a higher low forma-
tion. Prices rose afterwards from around 24.5 to 30. During October and early
December 2002, both DO and Momentum diverged with the price action, thus
confirming each other’s strength. As the price was trying to find support near
its first bottom, both indicators witnessed a higher low formation. A healthy
rise followed afterwards. In the beginning of April 2003, as price was slightly
rising from 25, DO witnessed a sharp rise to the upside, indicating that prices
are moving rapidly to their highs. Momentum was rising but at a slower pace.
Usually a sudden rise in DO is considered as a very bullish action as it means
that the closing price is moving quickly towards the highs.
 USING THE DEVIATION OSCILLATOR WITH MACD Thus, the buy signal will be triggered at the second MACD bullish cross-
One very useful technique is to use DO as a setup for buying and use MACD over after a positive divergence between the DO and the price. Exit will take
crossovers for actual buying and selling signals. The MACD crossover method place at the first bearish MACD crossover.
generates buy and sell signals when the MACD line crosses above or below its The rationale of the “two cross” system is that more strength appeared be-
signal line. The MACD is one of the indicators that give early signals when a fore the actual buy signal. A bullish MACD crossover during the first DO bot-
new trend is underway. This is a very good merit of the MACD, but obviously tom tells us that there was more strength in the market than the first “one cross”
a merit that often suffers from whipsaws. Eliminating bad MACD signals by system. Obviously, as the market makes a lower low, the MACD will trigger a
using another indicator enhances our trading results. Using D.O. along with bearish crossover, which will be followed by a new bullish crossover while the
MACD reduces whipsaws. DO diverges with prices.
The tactic used is to buy when the MACD line crosses above its signal line Figure 6
only after a positive divergence occurred between the DO and the price. Exit
on the first bearish MACD crossover. The main drawback of this system is that
it exits early. Traders and technicians can find better exits by additional re-
search.
Main Rule for combining D.O. and MACD: Buy when the DO creates a
positive divergence with prices and the MACD triggers a bullish crossover.
Exit after the first MACD bearish crossover.
This tactic can also be used with other indicators. The reason why the DO
can be used as a setup when it triggers divergences with prices is that its diver-
gences are even more meaningful than momentum divergences.
To increase objectivity, three distinct buy signals can be defined, dependent
on the behavior of MACD.
“One cross” system is a positive divergence occurs between the DO and
the price, and then MACD triggers a buy signal after or during the second DO The S&P 500 chart shows an example of the “two cross” system. During
bottom. The MACD thus gives only one bullish crossover after the divergence February and March 2003, DO witnessed a positive divergence with price ac-
between the DO and the price. The buy is executed when the MACD signals a tion. In February, during the first bottom, MACD triggered a bullish crossover.
bullish crossover after the DO positive divergence and exit at the first bearish As the price declined during March, MACD witnessed a bearish crossover,
crossover. followed by a new bullish crossover, which coincided with a higher DO bot-
Figure 5 tom. This is a positive divergence between DO and the price action, followed
by a MACD buy signal. The only difference here is that the MACD witnessed
two bullish crossovers instead of one. The letters “A” and “B” on the chart
show the two MACD crossovers. The two vertical lines show the buy and exit
signal. This trade was profitable, however, prices continued moving to the up-
side after the exit was triggered. As was mentioned previously, the main draw-
back of this system is that it gives a premature exit signal.
“Cross and a test” system should be expected to give the best results as
the MACD witnesses a bullish crossover during the first bottom, but does not
witness a bearish crossover afterwards. During the second bottom, and while
the DO is positively diverging with prices, the MACD line declines slightly to
test its signal line, before rising again. The buy signal is triggered as soon as a
positive divergence between the DO and the price is identified and the MACD
line moves upwards after testing its signal line. The logic of this system is that
there was strength from the beginning (bullish MACD crossover during the
first bottom) but the temporary weakness was much less than that of the “two
The chart of JP Morgan Chase shows the “One cross” buy signal. During cross” system, as the MACD line did not witness a bearish crossover. It only
February 2002, a positive divergence occurred between DO and the price ac- tested its signal line and moved upwards again. The buy will be triggered the
tion. Following this divergence, a bullish MACD crossover occurred (see the second day as the MACD line begins moving upwards once again.
vertical line). Only one MACD buy signal occurred after the DO divergence. Figure 7
The two vertical lines show the buy and sell signal. As stated, the exit signal is
triggered with the first MACD bearish crossover after a buy is signaled.
“Two cross” system occurs when MACD triggers two buy signals. The
first crossover coincides with the first DO bottom, while the second MACD
crossover coincides with the second DO bottom. During this time, the DO trig-
gers a higher bottom, while the price follows a lower bottom formation (posi-
tive divergence). What really happens is that during the first DO bottom the
MACD gives a buy signal. During the second DO bottom, an MACD bearish
crossover, followed by a new bullish crossover occurs. The trick of this tactic is
that it gives us a false bearish crossover; however, using DO in conjunction
with MACD will eliminate such a whipsaw. Even if the trader is whipsawed by
selling at the MACD bearish crossover, he will quickly re-enter with the new
buy signal as it coincides with a positive divergence in the DO.

JOURNAL of Technical Analysis • Winter-Spring 2004 15

 During February and March 2003, McDonald’s chart shows the DO wit-
nessed a positive divergence with price. MACD triggered a bullish crossover
during the first bottom, and a test between the MACD line and its signal line
took place during the second bottom. No bearish crossovers occurred. The buy
was triggered at point B and the exit signal took place with the first bearish
crossover afterwards. This system is very profitable and it has the merit of
being objective. Its drawback is the premature exit signals that often occur.
The DO and MACD system was tested across the 30 Dow stocks from 1999
through 2003 with relatively good results. The “two cross” and “cross and a
test” gave a superior results compared to the “one cross” in terms of % profit
per trade. On the other hand, the “one cross” was better in terms of % of prof-
itable trades than the “two cross”. Most of the buy signals fell in the category of
“one cross” and “two cross.” A small percentage triggered the “cross and a
test” system. Usually when the MACD gives a buy signal and begins to decline
again, it will witness a temporary bearish crossover before witnessing a new
buy signal.
Overall, 41.4% of the buy signals were triggered by the “one cross” system;
48.7% were triggered by the “two cross”; while only 9.7% were “cross and a test.”
Testing results of the DO versus MACD
OVERALL RESULT
% of positive trades % of negative trades % of even trades
(profits above 5%) (losses above 5%) (less than 5% trades)
73.17% 6.5% 20.33%
tive. The result is an oscillator that moves slower than the normal Deviation
Oscillator but can show overbought and oversold conditions when used in com-
bination with other oscillators.
The ROC of the Cumulative Deviation Oscillator moves faster and when
used with the stochastic oscillator it serves as a confirming indicator for over-
bought and oversold conditions. Obviously, the indicator can be used in many
ways and with other indicators; here it used as a confirming indicator for the
stochastic and Bollinger Bands. When all three indicators confirmed each other,
a buy was triggered. The upper boundary of the Bollinger Bands was used as an
exit signal. Obviously, exit signals were not perfect, but the important thing is
that nice profitable moves followed buy signals. The technician should find
other exit tactics than the ones used here, especially when profitable moves
occur.
A buy signal is triggered when the stochastic reaches oversold, the RCDO
reaches oversold, and the price tests the lower boundary of the Bollinger Bands.
There is a small problem here. The RCDO is unbounded, unlike the stochastic,
so oversold can be identified after a certain area is touched at least two times.
There are no pre-defined levels to be used as oversold and overbought.
Figure 8

% Profit/ trade % loss/ trade

17% 7%
73% of the trades were profitable with an average profit of 17% per trade. On the
other hand, 6.5% of the trades were negative, with an average loss of 7% per trade.
The rest, 20.33%, were even trades with almost no profit or loss. Some of these even
trades witnessed sharp rises afterwards, but only after the MACD gave an exit signal.
No. of days No. of days No. of days Novellus (NVLS) shows the price, the DO, the RCDO, and the stochastic.
for profitable trades for negative trades for even trades During December 2000- September 2001, there was three times where the sto-
30 18 23 chastic and the RCDO reached oversold, while the price was testing the BB’s
This shows us the average number of days in each trade. Profitable trades were held lower boundary. A rise followed this situation in all three instances.
almost a month, on average, before selling.
To summarize the trading rules:
Largest profit Largest loss ■ BUY when the stochastic oscillator reaches oversold, the RCDO reaches
oversold and the price touches the lower boundary of the Bollinger Bands.
53.2% (INTC) 10.88% (AA)
■ EXIT either when the price touches the upper boundary OR when it violates
the 20 days moving average to the downside (after rising from the lower
DETAILED RESULTS boundary and breaking the moving average upwards).
1. one cross Stop loss should be placed below the lower boundary of the Bollinger Bands.
% of profitable trades % profit/ trade This system was tested on the Dow 30 stocks and the results were promis-
74.51% 13.36% ing. While 22% of the trades were breakeven trades (plus or minus 5%), 62.5%
2. two cross of the trades were profitable with an average profit of around 14% per trade,
% of profitable trades % profit/ trade while 15% were losing trades with an average loss of 9.1% per trade.:
68.33% 18.23% All of the testing was done with visual inspection. More precise testing
3. cross and a test
might be slightly different from the results presented here.
% of profitable trades % profits/ trade
91.67% 19.95%
Conclusion
The DO is a tool that can be added to the technician’s arsenal. It is by no
RCDO means a full system of its own. As all other technical indicators, the DO is a
subjective indicator that can be interpreted differently from one technician to
RCDO is an oscillator extracted from the Deviation Oscillator that is mainly
another. This paper did not examine weekly and monthly charts, but at times,
used for overbought/oversold purposes. The RCDO is the Rate of Change (ROC)
major divergences are revealed in long-term charts. Figure 9 shows the weekly
of the cumulative function of the Deviation Oscillator, in this paper a 5-day
S&P 500. Bullish action in the weekly DO occurred during October 1990 and
ROC is used. RCDO smoothes the Deviation Oscillator. While the cumulative
Jan 1991, as it was rising sharply, hinting that a big rise in the stock market
function alone can be used to show longer-term trends, the cumulative curve,
might be under way.
does not provide actionable information. Taking its ROC makes it more sensi-

16 JOURNAL of Technical Analysis • Winter-Spring 2004

 Figure 9 Metastock Formulas
■ To calculate the Deviation Oscillator:
h-c: Mov(H,20,S)-Mov(C,20,S)
c-l: Mov(C,20,S)-Mov(L,20,S)

Deviation Oscillator: Fml(“h-c”)-Fml(“c-l”)

(Do not forget to invert the scale of the DO)
■ To calculate the CDO:
CDO: Cum(Fml(“Deviation Oscillator”))
■ To calculate the RCDO:
RCDO: ROC(Fml(“CDO”),5,$)*100

This paper used a 5-day ROC of the CDO. Other values can be used to
change the sensitivity of the RCDO.

The DO can be used as a confirming indicator or as a setup for other techni-
cal tools (as shown with the DO-MACD system). The default time period for
daily charts is a 20-day simple moving average for the high, low, and close.
Changing this time period can be done to increase or decrease the sensitivity of
the indicator.
It is important to note that one of the strongest signals that the DO presents
occurs when price is moving sideways (or slightly declining) while the DO
witnesses a vertical move to the upside. This action indicates that the moving
average of the close is quickly running towards the moving average of the high,
despite the apparent stability in price action. This is a very strong signal of a
potential strength.
A final note that is worth repeating here is that the DO proved to be more
useful in signaling price strength. A positive divergence is much more impor-
tant than a negative divergence. DO is best used as a tool to enter the market;
however, exits should be based on other tools.
Biography
Saleh Nasser, CMT is the Chief Technical Analyst for Commercial In-
ternational Brokerage Company (CIBC) in Cairo, Egypt. His main job is to
recommend to brokers and investors of the company what to buy/sell and
how to manage their positions. CIBC is the largest brokerage firm in Egypt.
Saleh began working in the stock market using technical analysis in
1997 at United Brokerage Corporation, a small brokerage company based
in Cairo. He then worked as Chief Technical Analyst for Fleming CIIC,
also in Cairo, Egypt. Saleh is the head of the education committee in the
Egyptian Society of Technical Analysts (ESTA), as well as the Treasurer
and Member of the Board of Directors of ESTA. He conducted many courses
and seminars, teaching brokers, investors, and undergraduate students about
technical analysis. Saleh was graduated from Cairo University in 1995 with
a BA in Economics.

JOURNAL of Technical Analysis • Winter-Spring 2004 17

18 JOURNAL of Technical Analysis • Winter-Spring 2004
 3
Momentum Leads Price:
A Universal Concept With Global Applications
Timothy W. Hayes, CMT
Momentum leads price. This Dow Theory tenet is the force behind an ever- After identifying 42 markets with sufficient data history for back-testing,
expanding universe of applications, from overbought/oversold and trend-fol- including indices for 22 developed markets and 20 emerging markets, we de-
lowing indicators to trading systems that use moving rates of change to com- veloped a proprietary momentum formula and tested various strategies for
pare individual stocks and market sectors. The benefits of using relative price overweighting and underweighting. Cognizant that overfitting can lead to dis-
momentum for U.S. stock and sector selection have received academic atten- appointment when a system becomes operational, we tested the momentum
tion and have been applied to active portfolio management1. But can relative formulas and strategies in-sample over a period of about two years from early
price momentum be applied to global strategy, allocation, and selection deci- 1994 to early 1996, developed the system, and then confirmed its effectiveness
sions? This paper demonstrates that the answer is “yes,” pointing to real-time in an out-of-sample period from early 1996 to August 1999. But the biggest
performance data in detailing the methodologies behind systems that use mo- test would be the real-time test, the test of whether the system would provide
mentum to rank market indices and sectors from different countries. value-added information when put to use in real-time.
The global application of relative momentum has far-reaching implications Before reviewing the results of that test, let’s take a look at how the system
– the potential uses of momentum as a leading indicator of price changes ex- works. Ranking the markets from strongest to weakest by applying the same
tend well beyond national borders. While major market moves tend to be glo- weekly momentum composite to each market, we developed a system that dem-
bal in scope, some markets are stronger than other markets in these moves and onstrates the tendency for momentum to lead price. The optimal results showed
some sectors are stronger than other sectors, enabling investors to maximize that when a market has gained relatively strong momentum, that market has
bull market profits by identifying the leaders and avoiding the laggards. Mar- tended to enjoy subsequent and persistent relative strength. Specifically, a
ket profits can be realized by allocating to the right country, sector profits can market gains overweight status (i.e., it’s a buy) when it rises into the top three
be realized by allocating to the right sector, and the optimal mix is allocation to of the 42-market ranking, remaining an overweight until it drops out of the top
the right sector within the right country. An awareness of the weakest markets 13. A market drops to underweight status when it falls into the bottom three,
and sectors can benefit portfolio managers with equity exposure mandates or remaining an underweight until it rises out of the bottom 13.
traders who can profit by shorting in a bear market. The challenge is to identify Chart 1
emerging strength and weakness with accuracy and consistency.
How relative momentum facilitates this process, and why “momentum
leads price,” is that it detects acceleration and deceleration. For example, if
two cars leave a starting point with the same acceleration, and if the drivers
stop accelerating at the same time, the cars will subsequently coast in tandem,
all else being equal. But if one driver accelerates, or keeps the pedal on the
metal for a longer period of time, his car will coast further. If the driver of the
second car starts to accelerate while the first car is coasting, that car could take
the lead. When the field includes dozens of cars – i.e., markets or sectors –
identifying the accelerators can be next to impossible in the absence of a proven
systematic approach, one that has not only performed well in a back-test pe-
riod, but also stood the test of real time.

The Global Market Ranking

In the late 1990s, we set out to determine if a sys-
tem based on relative price momentum could be de- Table 1
veloped using primary indices for markets around the Global Market Ranking System Ranking Statistics
In-sample Out-of-sample Real-time Entire period
world. Such a system could help identify relative
1/23/94 - 2/11/96 2/11/96 - 8/19/99 8/19/99 - 6/29/03 1/23/94 - 6/29/03
strength shifts among regions, between developed and
Overweight Performance
emerging markets, and among specific countries. We % gain per annum 25.1 38.4 9.6 23.1
hypothesized that a methodology used successfully to % of weeks outperformed universe 57.9 65.8 55.7 60.0
rank U.S. sectors and groups would be effective in rank- Standard Deviation (annualized) 21.1 21.0 17.5 19.7
ing the market indices. Specifically, we used a Ned Information Ratio* 1.12 1.90 1.05 1.34
Davis Research approach that applies a momentum Universe Performance
composite to each sector or group in a list, sorts the %gain per annum 3.3 11.6 -2.5 3.8
list from the highest momentum composite to the low- Standard Deviation (annualized) 9.1 15.0 13.8 13.4
est, and applies a strategy that overweights those with Underweight Performance
strong momentum and underweights those with weak % gain per annum 5.0 4.9 2.5 3.9
momentum. The use of a momentum composite (for % of weeks outperformed universe 50.5 41.3 50.2 47.0
example, the total of four-week, 10-week, and 40-week Standard Deviation (annualized) 15.4 23.7 20.6 20.8
rates of change) is intended to reduce whipsaws and Information Ratio* 0.17 -0.29 0.51 0.11
allow the system to more accurately identify signifi- *The information ratio measures the excess return per unit of risk. It is calculated by dividing the annualized average of the one-week excess returns
by the annualized standard deviation of the one-week excess returns.
cant changes in momentum.

JOURNAL of Technical Analysis • Winter-Spring 2004 19

 Table 2.
Global Market Ranking
Composite Position Current
Rank Previous Week 4 Weeks Ago Market Reading Entry Date Entry Price Current Price Gain/Loss (%)
Overweight
Ranked 1-3 - Buy/Overweight
1 1 3 Indice D.C. Bursatil 210.45 9/22/2002 7347.61 13852.41 88.53
2 2 3 Merval Index 169.43 6/30/2002 350.65 733.85 109.28
3 3 2 IBB General Index 124.57 6/16/2002 1252.08 2075.77 65.79
Ranked 4-13 After Reaching Ranks 1-3 - Hold/Continue to Overweight
4 4 4 Lima Exchange Index 102.36 1/26/2003 1559.49 1826.61 17.13
Underweight
Ranked 30-39 After Reaching Ranks 40-42 - Continue to Underweight
33 34 34 Seoul Exchange Index 102.36 1/12/2003 628.36 677.28 7.79
39 39 32 Helsinki HEX General 2.33 6/15/2003 5540.84 5626.86 1.55
Ranked 40 -42 - Sell/Underweight
40 40 42 Amsterdam ANP-CBS General -3.40 7/28/2002 484.70 434.80 -10.30
41 42 39 Brussels Bel-20 Index -3.56 6/15/2003 1948.02 1940.66 -0.38
Full Rank
Rank Previous Week 4 Weeks Ago Market Country Composite Current Price
1 1 1 Indice D.C. Bursatil Venezuela 210.45 13852.42
2 2 3 Merval Index Argentina 169.43 733.85
3 3 2 IBB General Index Colombia 124.57 2075.77
4 4 4 Lima Exchange Index Peru 102.36 1826.61
5 8 12 Colombo Exchange Index Sri Lanka 82.64 1051.43
6 6 6 Mishtanim 100 Israel 81.55 459.42
7 5 10 Bangkok SET Index Thailand 74.25 457.51
8 7 7 Jakarta Exchange Index Indonesia 66.76 506.78
9 9 5 Sao Paolo Exchange Index Brazil 66.74 13024.12
10 11 15 BSE 100 India 57.66 1810.34
11 14 16 I.P.C. Mexico 51.63 7083.45
12 10 9 IGPA Index Chile 49.83 5958.84
13 17 11 Austrian Traded Index** Austria 43.15 1313.11
14 15 22 Manila Exchange Index Philippines 43.07 1236.60
15 13 13 Warsaw WIG Index Poland 41.68 15930.57
16 16 21 Madrid General Index** Spain 40.93 728.03
17 12 8 Prague PX-50 Index Czech Republic 35.42 535.50
18 22 31 OBX Stock Index** Norway 35.25 500.84
19 20 17 S&P 500 Index** U.S. 27.38 976.22
20 18 26 Taiwan Trade-Weighted Index Taiwan 23.61 976.22
21 21 18 S&P/TSX Composite** Canada 23.50 6979.12
22 25 24 Stockholm Affarsvarlden** Sweden 20.79 156.66
23 19 35 Straits Times** Singapore 20.54 1477.73
24 31 40 Frankfurt Xetra DAX** Germany 20.45 3224.66
25 32 28 KFX Copenhagen** Denmark 19.55 217.65
26 23 19 Milan MIBtel Index Italy 19.38 18615.00
27 35 41 Athens Exchange Index** Greece 17.11 1901.48
28 24 20 NZSE Capital Top 10** New Zealand 16.57 2108.22
29 30 25 Kuala Lumpur Composite Malaysia 15.75 691.45
30 28 36 Topix Index** Japan 14.34 903.06
31 29 38 Paris CAC 40** France 13.17 3109.02
32 27 37 Swiss Performance Index** Switzerland 9.25 3459.41
33 34 34 Seoul Exchange Index South Korea 7.59 677.28
34 33 30 London FTSE 100** U.K. 7.01 4067.80
35 38 14 Budapest Exchange Index Hungary 5.47 7858.58
36 26 23 Hong Kong Hang Seng** China 5.21 9657.21
37 37 29 All Ordinaries** Australia 3.21 3018.00
38 36 27 ISEQ Overall Index** Ireland 2.48 4257.11
39 39 32 Helsinki HEX General** Finland 2.33 5626.86
40 40 42 Amsterdam ANP-CBS General** Netherlands -3.40 434.80
41 42 39 Brussels BEL-20 Index** Belgium -3.56 1940.66
42 41 33 Johannesburg All-Shares Index South Africa -25.36 8347.23
Rank Date: 6/29/2003 ** = Developed Market

20 JOURNAL of Technical Analysis • Winter-Spring 2004

 The system is thus symmetrical, as the relative momentum strength needed Chart 2
for a market to gain overweight status is of the same magnitude as the relative
momentum weakness needed for a market to enter the underweight category.
Accordingly, the number of overweight markets has tended to be in line with
the number of underweight markets. We estimate that over the course of the
simulated and real-time periods, markets have remained in the overweight cat-
egory for an average of 26 weeks, while the average holding period for the
underweights has been 17 weeks.
Chart 1 features the equal-weighted composites of the overweights and
underweights, constructed with weekly rebalancing. The performance of the
overweights and underweights can be compared to the performance of the equal-
weighted 42-market composite, which is represented by the dashed line in the
chart. As indicated in the top row of Table 1, the overweights have gained 23%
per annum over the entire time frame, outpacing the universe gain per annum
of 4%. They have beaten the universe in 60% of the weeks, as indicated in the
second row. Most significantly, the overweights not only outperformed during
the in-sample and out-of-sample periods, but also in real-time, passing the test
of its ability to identify markets with relatively strong momentum and thus
persistent relative strength. Also throughout, they have performed well on a Of course, not all of the overweights continue to perform well. Some exit
risk-adjusted basis, as indicated by an information ratio of more than 1.0. This the list with a loss. But a reassuring quality of the system is that, by staying
ratio is calculated by dividing the annualized average of the one-week excess with strong markets for big gains and dumping decelerating markets with noth-
returns (the performance of the overweights less the performance of the uni- ing worse than a small loss, it holds to the adage, “let profits run and cut losses
verse) by the annualized standard deviations of those excess returns, thereby short.” And as exemplified by the Argentina example, it cares not about why a
measuring the excess return per unit of risk. market is doing what it’s doing, or whether it’s doing what it should be doing
When comparing the per annum performance of the underweights to the based on “the fundamentals.” Rather, its only objective is to identify relatively
universe per annum gain, we would want to see persistent underperformance. strong momentum and get on board, without the fundamental distractions.
But in fact, the underweights have performed about as well as the universe
over the entire period and have actually outperformed in real time, with no The Global Sector Ranking
greater tendency to outperform in a given week than to underperform. Clearly
the system’s value is its ability to identify winning markets, not losing markets. The next challenge was applying the concept and approaches to global sec-
Among the system’s most useful indications was its identification of strong tors, an undertaking that started with the development of a sector line-up. For
relative momentum among emerging markets in late 2001 and 2002, support- this we used the capitalization-weighted, U.S. dollar-priced Dow Jones sector
ing the case for emerging markets, in the aggregate, to outperform developed data, replicating the global sectors on an equal-weighted basis. By giving all of
markets. And for individual markets, one of the ranking’s best real-time calls a sector’s stocks the same weight, a single stock with an exceptionally high
was its overweighting of Argentina in June 2002, a time of political instability market-cap will not dictate a sector’s relative strength changes. We required
and economic worry. The market, however, sensed that the fears were over- that a sector include at least four stocks large enough to surpass our market-cap
done and began to rally. The market has remained overweight ever since, and cut-off, resulting in 130 sectors. After a 2002 rebalancing, the line-up included
at this writing had gained 109% over the period, as indicated in Table 2 featur- 131 sectors, with 18 industry classifications and 16 countries represented. The
ing the Global Market Ranking. Over the same period, the 42-market universe breakdown is shown in Table 3.
gained 3%. With the sectors established, we set out to develop a system using the same
methodologies used to create the market ranking, formulating a momentum
Table 3 composite assigned to each sector, ranking the sectors in descending order from
Global Market Ranking System Ranking Statistics 100 to 02, testing in-sample to determine the optimal strategy for overweighting
Sectors Sectors and underweighting, and then confirming the reliability of the system in an
Sector Ranked Country Ranked out-of-sample period. Like the market ranking strategy, the resulting sector
Automobiles 4 Australia 11 ranking strategy overweights a sector when its relative momentum is one of the
Banks 10 Canada 16 strongest, then holds the sector even as the relative momentum recedes. It does
Basic Resources 5 Denmark 1 the opposite for underweighting. This system provides another demonstration
Chemicals 4 France 8
of how momentum leads price, illustrating that after a sector experiences un-
Construction 7 Germany 8
Cyclical Goods & Services 10 Greece 1 duly strong momentum, its relative strength is likely to persist even after the
Energy 5 Hong Kong 10 relative momentum has started to worsen. Specifically, a sector earns over-
Financial Services 9 Italy 6 weight status when it reaches a ranking of 95 and remains overweight until it
Food & Beverage 8 Japan 18 drops to 60 or lower. A sector becomes an underweight when it drops below 5
Health Care 7 Netherlands 3 and remains underweight until it rises to 40 or higher.
Industrial Goods & Services 12 Singapore 6 Thus like the market ranking, the sector ranking system is symmetrical.
Insurance 8 Spain 3
But the sector system is faster than the market system, as indicated by esti-
Media 8 Sweden 2
Non-Cycliacal Goods & Services 8 Switerland 4 mated average holding periods of 13 weeks for the overweights and 12 weeks
Retail 5 U.K. 16 for the underweights. As indicated in Chart 2 and Table 4, other differences
Technology 8 U.S. 18 are the longer in-sample period (January 1985 to January 1993), longer out-of-
Telecom 6 sample period (January 1993 to May 2001), and shorter real-time period (May
Utilities 7 2001 through June 2003).
In the case of this ranking system, it’s the underweights that have shined in

JOURNAL of Technical Analysis • Winter-Spring 2004 21

 Table 4
Global Sector Ranking System Ranking Statistics
In-sample Out-of-sample
1/13/85 - 1/8/93 1/8/93 - 5/4/01 5/4/01 - 6/29/03 1/13/85 - 6/29/03 the markets or sectors separately.
Overweight performance
% gain per annum 26.8 29.1
% of weeks outperformed universe 56.4 61.3
Standard Deviation (annualized) 17.0 16.4
Information Ratio* 1.01 1.29
Universe performance
%gain per annum 15.9 12.4
Standard Deviation (annualized) 13.9 11.9
Underweight performance
% gain per annum 7.1 5.0
% of weeks outperformed universe 46.0 45.9
Standard Deviation (annualized) 16.7 20.4
Information Ratio* -0.78 -0.40
*The information ratio measures the excess return per unit of risk. It is calculated by dividing the annualized average of the one-week
excess returns by the annualized standard deviation of the one-week excess returns.
real-time. While the composite of the overweights has dropped -10% per an-
num in the real-time period, the universe has lost -13% per annum, a modest
excess return. And the overweights have outperformed in 55% of the real-time
weeks. Meanwhile, the underweights have substantially underperformed, los-
ing -26% per annum in real time. And they have outperformed in only 41% of
the real-time weeks, with a decisively negative information ratio.
It should be recognized that for most of the real-time period, the global
market trend has been pointed lower, so we have yet to see what the results will
look like in a sustained global uptrend. But the out-of-sample results could be
an indication, as the market trended higher during most of that period. The
overweights gained 29% per annum, with a high information ratio and
outperformance in 61% of the weeks. The underweights underperformed but
managed to gain 5% per annum. Over the entire time frame, the overweights
have gained 23% per annum and outperformed the universe in 59% of the weeks,
the universe has gained 11% per annum, and the underweights have gained 2%
per annum, outperforming the universe in 45% of the weeks.
Even considering the modest real-time outperformance by the overweights,
we can be confident that over the long-term, the Global Sector Ranking will
prove itself effective in identifying overweights as well as underweights. Such
a statement cannot be said about the Global Market Ranking’s ability to iden-
tify underweights. Why is the sector ranking more effective in identifying
underweights? One possible explanation is the sector ranking’s shorter hold-
ing period. Since the sector ranking uses a momentum formula with rates of
change that are shorter than those used in the market ranking, it keeps the sec-
tor ranking more sensitive to market declines, which typically are shorter than
market advances with endings that are typically more climactic, decisive, and
faster to complete3. The slower market ranking has tended to be late in identi-
fying the underweights and late to remove them from underweight status. The
market ranking has had far better luck with the overweights, especially during
sustained market advances.
Another attribute of the Global Sector Ranking is that it helps answer the
question of what’s currently more important, country or sector? At times, the
overweights will be dominated by different sectors from a specific country,
indicating that allocation to that country is the key to outperformance. At other
times, the overweights will be dominated by a sector from different countries,
indicating that allocation to that sector is key. But over the long-term, both are
important. Peter Hopkins and C. Hayes Miller explained in a 2001 paper that
“it is not yet totally clear that geographical importance has permanently dimin-
ished on a global basis or that sectoral importance has increased globally ...
from 1992 through 1995, country effects were 1.5 to two times as important as
industry effects, but now the importance of country and the importance of sec-
tor or industry group are about equal.”4 By identifying opportunities driven by
22 JOURNAL of Technical Analysis • Winter-Spring 2004
the sector and/or the market, and likewise identifying the
risks, the Global Sector Ranking allows for a more com-
Real-time Entire period prehensive assessment than could be gained by ranking
Although the sector ranking’s real-time history is
-10.3 22.8 shorter than that of the market ranking, it has several suc-
55.4 58.5 cesses to its credit. During the bottoming process of July-
14.5 16.5 October 2002, the ranking detected relative strength among
0.24 1.07 Technology sectors and Canadian sectors. Accordingly,
as indicated in Table 5 showing the Global Sector
-12.8 10.6 Ranking’s overweights and underweights, the Canadian
18.2 13.7 Technology sector attained overweight status in early No-
vember 2002 and had gained 48% as of the end of June
-26.1 1.7
2003. The Canadian Telecom sector has been letting its
41.1 45.4
profits run for an even longer period, gaining 67% from
30.1 20.3
-0.83 -0.60
the end of September through June.
In revealing momentum deterioration and assigning un-
derweight status, the ranking proved prescient with its
warnings of worse things ahead for European insurance
sectors. Between early November 2002 and early February 2003, the insur-
ance sectors for France, Germany, the U.K. and Switzerland all dropped to
underweight status, and by mid-March all four were down by more than 20%.
By mid-May they had all exited the underweight category, confirming that the
risks had diminished for those sectors. In fact, it was European sectors in gen-
eral that dominated the underweight category in mid-March, then dominating
the overweights by mid-May. Sectors from the Pacific region were then perva-
sive among the underweights.
Uses and Complements
The sector ranking’s information can thus be applied in numerous ways. It
can be used to identify a strengthening sector of stocks in a specific country,
serving as a screen for investors looking for the strongest stocks in the stron-
gest countries. Conversely, it can be used to identify potential underperformers
among a list of buy candidates, warning against buying a stock in a relatively
weak sector within an underperforming country. It can also be used strictly
along sector lines or country lines.
More broadly, it can be used to gauge the extent to which a sector theme is
global in scope, or a country theme regional in scope. For instance, overweight
status in the vast majority of Technology sectors would confirm the global
scope of that sector’s relative strength, while overweight status in the vast ma-
jority of European sectors would carry a strong message of regional relative
strength.
The system can also be used for its indications about the global market
trend. With a preponderance of defensive sectors, such as Food & Beverage,
among the overweights, and higher beta sectors, such as Technology, among
the underweights, the system would describe the market as risk averse. With
Health Care and Technology sectors dominating the overweights, and Banks
and Utilities dominating the underweights, the system would reflect a market
preference for growth over value. It could then be determined if those indica-
tions were consistent or inconsistent with those provided by a domestic rank-
ing system. The greater the confirmation, the stronger the message of global
participation and sustainability.
Other good complements to the ranking’s indications are breadth measures
that can be created using the global sector database, indicators on the breadth
of everything from the global universe itself to regions, countries, global sec-
tors, and sectors within individual countries. For example, with the majority of
Technology sectors overweight in the sector ranking, a sign that the sector’s
relative strength is global in magnitude, we could turn to Charts 3 and 4 (on
next page) for confirmation of strength among the stocks within the sector.
The top two clips of Chart 3 plot the daily price and relative strength lines for
the global Technology sector, the aggregate of all the stocks in the ranking’s
 Table 5
Global Sector Ranking

Previous 4 Weeks Composite Position Entry Current Current

Rank Week Ago Sector Country Reading Entry Date Price Price Gain/Loss(%)
OVERWEIGHT
Ranked 95-100 – Buy/Overweight:
100 90 98 Telecom Canada 94.50 09/29/2002 56 93 67.0
99 75 69 Technology Canada 93.74 11/10/2002 143 212 47.7
98 78 100 Telecom U.K. 90.53 05/18/2003 261 290 11.2
97 98 32 Technology Singapore 88.70 06/22/2003 69 66 -3.4
96 96 79 Media Canada 88.09 03/23/2003 244 302 24.0
*96 82 84 Utilities Canada 82.44 06/29/2003 201 201 0.0
*95 87 87 Construction Australia 82.29 06/29/2003 410 410 0.0
Ranked Greater Than 60 and Less Than 95 After Reaching Ranks 95-100 – Hold/Continue to Overweight:
93 91 96 Banks Australia 80.00 03/30/2003 633 790 24.7
91 97 30 Cyclical Goods & Services Italy 77.86 06/22/2003 98 95 -2.3
90 65 99 Technology U.S. 76.34 05/11/2003 1727 1855 7.4
90 74 52 Insurance Canada 75.88 06/08/2003 1446 1412 -2.4
88 83 64 Banks Canada 73.74 10/20/2002 271 365 34.9
87 95 85 Utilities Spain 72.67 12/08/2002 1324 1695 28.0
87 100 83 Financial Services Germany 72.67 05/04/2003 2401 2748 14.5
80 94 72 Industrial Goods & Services Denmark 68.40 04/27/2003 3857 4636 20.2
79 80 44 Technology Germany 67.79 06/08/2003 2476 2406 -2.8
78 96 77 Banks Spain 66.87 04/06/2003 1363 1596 17.1
77 93 60 Banks Italy 66.11 04/27/2003 368 413 12.4
76 68 88 Technology U.K. 65.50 05/18/2003 345 355 2.7
70 99 75 Banks Greece 62.14 05/11/2003 422 497 17.9
69 61 91 Media Australia 61.83 04/06/2003 825 970 17.6
67 67 83 Media France 60.31 05/25/2003 1110 1147 3.3
66 64 68 Technology France 59.85 01/19/2003 756 950 25.6
61 63 87 Financial Services U.K. 55.57 06/15/2003 902 845 -6.3
61 77 80 Retail Germany 55.57 05/04/2003 371 394 6.2
UN DER WEIGHT
Ranked Greater Than 5 and Less Than 40 After Reaching Ranks 0-5 – Continue to Underweight:
33 34 16 Cyclical Goods & Services Australia 41.37 03/23/2003 228 264 15.5
32 15 8 Insurance Japan 40.92 06/15/2003 302 310 2.6
29 3 9 Non-Cyclical Goods & Services Singapore 38.32 05/04/2003 513 552 7.6
25 9 6 Retail Japan 36.03 06/08/2003 345 354 2.5
22 7 26 Telecom Hong Kong 33.44 03/30/2003 74 81 9.7
12 10 3 Health Care Australia 27.18 05/25/2003 1767 1843 4.3
10 22 3 Media Japan 25.50 11/17/2002 488 475 -2.6
9 6 25 Utilities Hong Kong 24.73 04/20/2003 526 570 8.3
8 6 27 Media Hong Kong 24.43 04/20/2003 79 91 16.0
7 9 36 Food & Beverage U.S. 23.05 05/18/2003 1968 2055 4.4
6 22 1 Health Care Japan 22.44 05/04/2003 256 261 2.3
Ranked 0-5 – Sell/Underweight:
4 2 2 Media Netherlands 16.18 05/11/2003 346 369 6.6
*3 17 12 Food & Beverage U.K. 15.88 06/29/2003 587 587 0.0
3 4 48 Utilities Japan 15.57 06/22/2003 369 363 -1.8
2 3 18 Chemicals U.S. 10.53 06/15/2003 740 713 -3.7
1 1 9 Basic Resources U.K. 7.33 03/30/2003 402 465 15.5
0 0 0 Chemicals Switzerland 1.22 03/02/2003 2915 2949 1.2

* = New Overweight or Underweight Rank Date = 6/29/2003

JOURNAL of Technical Analysis • Winter-Spring 2004 23

 Chart 3
Chart 4
eight Technology sectors. And the bottom two clips plot the sector’s advance/
decline line and percentage of issues at 30-day new highs. Chart 4 uses weekly
data to feature the global Technology sector along with the percentages of the
sector’s stocks that are above their 10-week and 40-week moving averages.
The sector’s relative strength would have short-term breadth confirmation with
its advance/decline line above it 50-day moving average and moving higher
with a rising percentage of 30-day new highs. And the sector would have longer-
term breadth confirmation with more than 70% of the sector’s stocks above
their 10-week moving averages and more than 55% above their 40-week mov-
ing averages.
For regions and countries, the Global Market Ranking could serve as an
24 JOURNAL of Technical Analysis • Winter-Spring 2004
additional overlay, useful for assurance that the sector ranking’s indication of
market relative strength has longer-term confirmation. If, for instance, the sec-
tor ranking would indicate relative strength among Japanese sectors, we would
gain more confidence in the staying power of that relative strength if Japan’s
Topix Index would rise to overweight status in the market ranking. More broadly,
with sectors from Asia Pacific countries dominating the overweights of the
sector ranking, our longer-term confidence would increase if the region’s mar-
ket indices would dominate the market ranking’s overweights.
Separately or in conjunction with one another, the sector and market rankings
are thus useful for identifying changing themes, information that’s essential
when developing global market strategy and making allocation recommenda-
tions. The rankings can also be used as screens and for input to the decision-
making process – i.e., whether to buy a certain ETF, a country fund, or a stock
in a specific sector. The next generation of these systems would combine a
global sector ranking with a ranking of individual stocks that can be bought
upon rising to overweight, sold when dropping from overweight, shorted upon
falling to underweight, and covered when rising from underweight. Such an
executable, long-short system would be especially appealing to hedge funds,
demonstrating that in leading price, momentum leads to profits as well.
Conclusion
This paper has demonstrated how relative momentum can be used to de-
velop a ranking of 42 markets around the world, a ranking that has proven
effective in identifying winning markets. The paper has also shown how rela-
tive momentum can be used to develop a ranking of global sectors, a ranking
that has held its own in identifying relative strength in a down market while
proving adept at identifying underperformers. Moreover, based on our real-
time experience using these systems, we can say that they certainly deserve to
be the starting point for identifying new themes and emerging leadership. Know-
ing that a market or sector is emerging as a momentum leader is far more im-
portant than knowing why it is doing so, a determination that often can only be
made in hindsight. Rather, understanding the market’s current dynamics, that
the current differences in relative momentum will lead to differences in perfor-
mance – that momentum leads price – is the most valuable and useful knowl-
edge that one can have.
Endnotes
1. The Journal of Finance published “Do Industries Explain Momentum?” by
Tobias J. Moskowitz and Mark Grinblatt (1999) and “The Profitability of
Momentum Strategies by Louis K.C. Chan, Narasimhan Jegadeesh, and Josef
Lakonishok (1999). The Rydex Sector Rotation Fund ranks industries based
on several measures of price momentum. The fund buys baskets of stocks
to replicate the performance of the top-ranked industries.
2. Since 131 sectors are ranked from 100 to 0, more than one sector can have
the same rank.
3. According to Ned Davis Research, there have been 33 bull markets since
1900, the median bull lasting 573 days. There have been 32 bear markets,
the median lasting 375 days.
4. “Country, Sector, and Company Factors in Global Equity Portfolios”
published by The Research Foundation of the Association for Investment
Management and Research.
Biography
Timothy Hayes, CMT, is the Global Equity Strategist for Ned Davis Re-
search. Tim oversees the firm’s global and U.S. equity allocation services,
authoring the firm’s weekly Stock Market Focus and International Focus pub-
lications. He also is editor of the firm’s bi-monthly Investment Strategy. Tim
holds the Chartered Market Technician designation and is an MTA member.
He has written a book, The Research-Driven Investor, published in November
2000. He is a regular guest on CNBC television and is often cited in The Wall
Street Journal and other publications. In 1996, Tim won the Charles H. Dow
Award for groundbreaking research in technical analysis.